Market Watch - August 6, 2010
There's some good news and some bad news in the stock markets recently. The good news is that the Dow Industrials and the Dow Transports exceeded their highs for the year, simultaneously, on July 26th. This is confirmation of a trend that, under Dow Theory, concludes we are in a bull market in stocks. The bad news is that this is not a "fixed rule", and it's unlikely the market can go much higher from these levels for a variety of reasons:
| 1. | The S & P 500 index of stocks is selling in excess of 18 times annual earnings. That is an extremely expensive market and well over average, historical, price earnings ratios of 14 times earnings. |
| 2. | With the Obama administration looking to increase taxes in every possible way, it is unlikely the stock market will go much higher until the tax issue is resolved. Additional taxes will negatively affect the earnings capacities of the Standard and Poor's 500 companies which will, in turn, reduce their earnings. That is likely to cause the price of stocks to go down; |
| 3. | The stock market has never pulled out of a depressive state with unemployment over 10%, and a surplus of houses on the market like we have today. Until there is an absorption of excess labor in the market and the glut of homes existing on the market today, there is no mathematical reason for the market to go substantially higher. There is every reason for the market to deteriorate from these already overpriced levels. |
The conclusion here is to not get too excited about the market highs just reached. This remains a highly overpriced market in which the odds of making much money the next several years are stacked against the investor.
Question: If everything mentioned above is true, why is the market at these levels?
Answer: Nobody knows. The market has a mind of its own. There is a trend, however, that is evident during most down trading days. When the market goes down substantially, during a trading day, it usually closes up substantially, from its low that day, right at the end of the trading session. This indicates an effort by Wall Street traders to keep the market from going down. Another trend is what is called "distribution days". A distribution day is when 90%, or more, of stock exchange volume is selling. These are called distribution days because that action indicates large funds are turning stock into cash. American corporations themselves now have almost $1 trillion in cash, a record.
Question: If U. S. companies have almost a trillion dollars in cash, why shouldn't that auger well for the future of the companies and the stock market?
Answer: The first thing that would provide us with an idea that the market could increase substantially in value, would be that corporations are hiring, and making investments in capital goods again. None of that is happening—rather, U. S. companies are hoarding cash. There is nothing else to do with the cash except to pay it out in dividends. There is reluctance, however, to pay out too much money in dividends. Nobody can predict what the taxes will be to close the continuing fiscal deficit of $2 trillion annually.
Question: With about a trillion dollars of cash, and no idea what to do with it, why not pay out large, one time, cash dividends to shareholders like Microsoft did a few years ago?
Answer: Two reasons: (1) the current administration has mentioned many ways of raising revenue, one of which has been a "one time, large tax." Corporations are hoarding cash until the situation in Washington is resolved. (2) If one is investing in stocks in this market, it's wise to invest in a company that's loaded with cash and continues to increase dividends like Microsoft. While Microsoft annually increases their dividends, the one time, high dividend was paid because Microsoft had no choice. If you have "too much" cash, the IRS can force a company to pay a dividend to shareholders. It's called the "excessive retained earnings tax", and it's levied upon companies that have cash "far in excess of their operating needs".
Question: Why would the government care?
Answer: Recipients of dividends are taxed at the income tax rates, or higher, if the "alternative minimum tax" is applied. Cash "stuck" with a corporation is already taxed. It cannot be taxed again until paid out in dividends to stockholders. The government likes us to pay taxes, and the government doesn't want cash hoarded. No cash movement, no taxes!
Question: Market Watch mentioned that a simultaneous new high, for the year, of the Dow Industrials and the Dow Transports, "confirms a bull market trend….but, that's not a hard and fast rule." Is the market in a bull trend or is the market not in a bull trend?
Answer: There is a primary trend, and a secondary trend, to the market. We are clearly in a bear market primary trend—down from 14,000 points. The secondary trend is bullish as indicated by the joint confirmation, of new yearly highs, of the Dow Transports and the Dow Industrials simultaneously. That's a very strong Dow Theory confirmation. If the secondary "bull market " trend is to be sustained, and turned into a "primary bull trend", the unemployed must be absorbed by our economy, housing starts will have to become significant again, the tax issue must be resolved, and government must balance income and spending.
Question: Why don't we balance the budget? Wouldn't that solve our fiscal problems?
Answer: It would solve our problem, but we don't have the political will. 50% of tax filers in this country pay no income taxes. Balancing our budget would require that they share the tax burdens. Another 50% of the population either receives transfer payments, of welfare, in one form or another, or they work for the government. Balancing the budget would entail losing millions of votes for a majority of our Congressmen, and Senators.
Conclusion
Right now, even though the market has advanced above its June record for the year, supply continues to dominate demand. Distribution days are overwhelming, compared to bull and bear markets in the past, indicating huge volatility. Volatility in the stock market equates with confusion and uncertainty.
Cash continues to pay almost nothing, which is difficult to accept. On one hand we are looking at staggering inflation in the future, and on the other hand, the stock markets are so overvalued for these economic times, that investors are caught in a "Catch 22". Many investors need income from their investments, and the income is small because the Federal Reserve Bank continues to keep interest rates suppressed from economic reality. Economic reality is not ".0021%" which is the benchmark rate for pricing Treasury Notes. Fixing interest rates only aids the bankers and the government—and everybody else pays for it. If interest rates were realistic on our $12 trillion of national debt, it would cost the government at least 4.5% annually or $540 billion in interest charges. It's less than half of that because of the fixed interest rate. That cannot remain "fixed" forever. Something's got to give.
U. S. federal debt is now 90% of our GDP, "third world type economics". While the economy remains in a depressive state with prices generally going down, high inflation caused by printing too much money, is looming on the horizon. That's what we are doing by printing an additional $2 trillion a year to distribute into the monetary system of the world when the whole world's savings don't aggregate $2 trillion. The Federal Reserve and the U. S. government are making a concerted effort to print enough new money to "get the economy going again". The problem with that theory is simple: the results are either inflation (which the Fed and the government are trying to "manage") or hyperinflation, which even they know would be catastrophic.
We remain on the slippery slope of the economic pendulum. We have reached the top of the bell shaped curve in terms of debt build-up and risk, and it is just not known if this type of irresponsible public financial behavior can be either sustained or contained. It is likely we will have continuing decreases in prices (deflation) as long as unemployment remains high. On the other hand, we have no clue as to what could happen with the tax system, the economy, or the stock market. These are dangerous times to take risk. It's not wise to build on one's base of equities in this market; but rather, realize as much cash as possible, and remain a judicious investor.
Caveat Emptor
George Rauch
August 6, 2010
