Market Watch - January 4, 2010

What Will the Next Year Hold?

December 31st, 2009 represented the closing of the worst decade in U. S. stock market history. While it is not possible to guess what the next decade will render, it is possible to look ahead at a few of the challenges facing our economy in 2010. The outlook is not good. Opportunities to make money in the stock market will be limited.

The Dow Jones Industrial Average is the U. S. stock market that is performing the best right now, and it is overpriced. Operations around the world act as a hedge against U. S. and foreign currency fluctuations. That’s why the demand for the DJIA stocks is greater—they represent investments in well known companies, operating all over the globe, that are viewed as a haven of safety in uncertain stock markets. But at 18.5 times earnings, the Dow is way over its historical average of 14.4 times earnings.

As mentioned in the two last Market Watch articles, there is little upside for U. S. stock markets in 2010. The chart below takes a look at historic, and present, Dow Jones Industrials Averages. The yield is the amount of money paid in dividends on the Dow Jones stocks, divided by the Dow Jones Industrial Average. At the top of the chart you will see current values in 2009 representing a 2.6% yield on the Dow Jones Industrial’s stocks based upon a current price of 10,500 points on the Dow. Yields in 1949, ’74, ’80 and ’82, represent post WWII stock market bottoms. Note that if we were to reach those values today, the stock market would be less than half its current value. Most importantly, the average historical yield on the Dow is 4.3% of cash dividends paid as a percentage of the Dow Jones Industrial Average. If those historical averages were reached today, instead of being 10,500 points, the market would be 6,349 points.

The chart is telling us the current stock market is considerably overvalued. In support of that are some recent studies done by reputable analysts: James O’Shaughnessy, Chairman of O’Shaughnessy Asset Management, feels we are in for a 3-5% a year return until 2020, as compared to annual returns of 14% in the 20 year period leading up to 2002; Steve Leuthold, mentioned in previous Market Watch articles, predicts a 10 year average return of 5% annually, when price earnings ratios are 18.5 times earnings, as the Dow is now.

Stock market profits are made based upon the level at which the stock has been purchased. You can see from the above that great buying opportunities occur when the market reaches a true bottom, which has not yet occurred. Mathematics points to stock market returns of 5% or lower over the next several years, which means the investor, may be better off to sit on, and accumulate, cash.

Why cash?

Investors are reluctant to keep cash because of the current low yields. But these low yields were fixed by the Fed, and over the long run, central banks cannot fix interest rates. The Fed has pushed interest rates down to almost zero for banks borrowing from each other, short term. That usually cannot last long because the forces of the market ultimately dictate yield on bonds, the most important measure of which is the ten year Treasury Note. Interest rates are currently creeping up because foreigners are reluctant to accept U. S. bonds that are financing our current deficit, at the interest rates for which the Fed wants to sell the bonds. With the dollar going down, foreigners are going to want a higher interest rate to compensate for the loss of the value of the bonds. If they do not receive higher rates, they will simply sit on the sidelines and not purchase our debt. In 2010 the U. S. government will have to finance $3.5 trillion, an almost impossible task in a $14.1 trillion economy. Foreigners, biggest buyers of U. S. Debt the last several years, are aware of the fact that our current debt is 3.6 times our GDP, which is up from 1.6 times our GDP in 1980. Huge debt build up is like a bell shaped curve. At the top of the slope, the apex, is where purchasers say ‘enough’. The unwinding of debt buildups is very painful, and that’s where we are.

Nobody knows, because of the magnitude of our debt, how this will play out. The conservative investor will save his cash, and sit on the sidelines, until obvious buying opportunities exist at realistic prices. It is unlikely that those opportunities will present themselves in 2010, but the odds of the markets moving sideways, or down, appear greater than further increases in stock prices. Furthermore, the risks are greater that something bad will happen, rather than something good happening. That is additional reason for the conservative investor to hoard cash until a clearer vision of the investment future is available.

Problems to be faced in 2010

The first problem we face is the one discussed above, the refinancing of $3.5 trillion of U. S. federal debt. The only place that money can come from is if the government continues to make (print) money to buy their own bonds, which is what they will, and are, doing. That is inflationary. Investors are reluctant to invest in low interest paying securities when high inflation is expected around the corner. Henceforth, yields will have to go up. As yields go up, the price of bonds will fall. Falling bond prices are bad for the stock market. Increases in interest rates essentially mean more money is being used to pay for interest on the bonds that otherwise might have been turned into earnings for stockholders and, hence, higher dividend income. That’s not happening.

The new Federal Health Bill is likely to be instituted in 2010. It’s 1990 pages long and 363,000 words—twice as long as the Bible. By their own admission, not one Congressman, and not one senator, have read the bill. It has been put together by Democratic “staffers” who are usually young, idealistic, pro-government, and economically liberal.

Fannie May and Freddy Mac, both government GSAs (government service agencies) are again in trouble and had to be infused with capital last week. This will continue, as will the problems with the automobile industry, and banks the Fed has deemed “too big to fail”.

Nobody has figured out how we will pay for this new health bill, reduce our deficit, or get government spending under control. Such huge undertakings, until appropriately satisfied, will probably continue to frustrate the private sector and, accordingly, the markets in 2010.

The public is beginning to wake up and see that Wall Street and the government worked in concert to defraud them. There is pressure upon the Fed to be audited in a bill signed by 300 congressmen. Central bankers control the money of the world. They are accountable to no one, which never works because man’s greed cannot be controlled by man. The bankers, recently refinanced gratis the U. S. taxpayer, are giving all sorts of reasons why the Fed has saved the country, why the Fed cannot be audited, and how great central planning has been for our economy. Money control is people control, and people control is the ultimate power. Government has a monopoly on power. The Fed, owned jointly by the government and the banks that were “too big to fail”, have more power than any bankers or governments in history. They are going to fight tooth and nail before giving up that power.

Summary

2010 is a year of many uncertainties. The twin killer of excessive government debt, and excessive government spending, must be contained, or 2010 will be a piece of cake compared to what we’ll face beyond 2010.