A Risky Market - Going Nowhere

A Risky Market - Going Nowhere

The stock market remains overvalued and in a position where the average investor could get hurt again as badly as he did in 2000. We face deflation, on the one hand, from cheap Asian labor, the ability to shop prices on the Internet, world over-production of goods and vicious price-cutting by retailers. We face inflationary pressure, on the other hand, with real-estate prices going through the roof, interest rates moving up, historically high fuel prices and rapidly increasing food prices.

The broad money supply (M3) is increasing at the rate of $1.5 trillion this year (14%), after a record increase of $1 trillion last year - money printed out of nowhere with no asset backing - which could end up being extremely inflationary. In the face of this huge expansion of the money supply and the 45-year lows in interest rates, unemployment is still a problem, the Standard & Poor's Index of 500 stocks is at the same level as it was in 1998, and the Dow Jones & Co. 30 Industrials are just below its price level of 12 months ago. Corporate loan demand is tumbling, which means business has very little appetite for capital improvements and new employees.

Federal Reserve Board Chairman Alan Greenspan just announced that "the core price index" only increased at the rate of 2% for the first quarter of this year; but the "core price index" leaves out fuel, food, and housing prices, which makes one wonder about the purpose of the "core price index." The government announced last week for May "higher than expected inflation, weaker than expected economic growth, higher than expected increases in consumer and producer prices, larger than expected increases in trade and current account deficits and a larger than expected increase in unemployment claims."

To top it all off, the following groups of stocks are now in "descending downward patterns": home building stocks, semi-conductor stocks (everything has a chip in it), retail stocks and financial stocks. Financial stocks (interest rate sensitive) comprise 53% of stocks traded on the NYSE.

This looks like really bad news. Market Watch has written that cash flow is improving. We are confused. Should we go to the flea market and look for a hari-kari knife or should we shout with glee?

Neither one. Cash flow has increased because of government's unparalleled manufacturing of money, the government's deficit spending, foreigners' willingness to accept U.S. dollars that continue to depreciate in value, and radically increasing real-estate prices, which has encouraged consumers to borrow against their homes and spend the money. This points to a period of stagnation, indicating that the market will mark time and go nowhere.

Why stagnation? With an increasing cash flow in our economy, doesn't this bode well for economic growth, and doesn't this henceforth provide potential for an increasing stock market?

We have built into our economy about $33 trillion worth of debt. From 1944 to 1981 we had an extended rise in interest rates and from 1981 to 2003 we had an extended drop in interest rates. The latter cycle is now over and has reversed itself. So, we can expect a long and gradual increase in rates. Increases in rates adversely affect corporate earnings and take consumers money out of the spending stream to service debt, money that would otherwise be used to purchase goods and services and spent on vacations.

By far, the most important single market, U.S. stocks, is particularly overpriced. There is little doubt that rapid increases in interest rates would cause a world economic crash. The federal government continues to struggle to keep interest rates low and let them rise as slowly as possible, hoping that inflation can be contained. This might provide for a general, long-term deflating of the bubbles in stock prices, bond prices and real estate. That is the federal government's plan and the best we can hope for, but there's no plan for increasing savings and lowering our debts.

Well, isn't the federal government's plan working?

Yes, miraculously it is working and we have so far avoided what could have been a huge crash in our markets more severe than the market sell off which has already occurred. Unlike the Japanese government in 1989, our government acted very quickly when it first saw the bubble deflating by reducing interest rates to 45-year lows and by flooding the markets with new amounts of cash so that "easy money" was available. Our current position is that this has worked, but it has worked for all the wrong reasons, which will require a reckoning in the future. In the long run, making money out of nothing with no asset backing creates inflation. The stimulation of consumer spending by making money cheap to borrow has created a bubble in debt that must be faced in the future. The deflating of the Japanese bubble has been painful and has seen the Japanese stock market move from almost 40,000 to just under 12,000 today. Comparable numbers in our market would move the Dow Jones Industrials into the 5,000 area.

Are there any other bright spots or potential problems on the horizon?

The big bright spot is, of course, the sheer power of this country. Economically, militarily and politically we have no peers. In spite of the media questioning our leadership, the world would be far worse off today without the United States.

A big pending problem is the elections. We are currently fighting two wars. The House of Saud is under serious pressure with the leadership old and frail and the youth split between pro-Islamic and pro-Western factions. The Middle East holds 75% of the world's known oil reserves. The American lifestyle is dependent upon a large continuous flow of reasonably priced oil. Should the United States and its allies pull out of the Middle East, it would be very dangerous for the U.S. economy.

Fifty years ago the only great demand for oil and gas was from the United States. The rest of the world was destroyed and in reconstruction. Now, Western Europe demands copious amounts of oil and gas. The former U.S.S.R. is creating tremendous demand for petro-chemicals. Last year China passed Japan as the No. 2 user of oil and gas in the world. For their own selfish economic reasons, their own inconsistent thinking frustrates these various regions. If they don't participate with, and help, the United States in the Middle East, they may have better oil pricing and a more available future supply. If that happens, however, and it causes a huge reduction in consumer demand in the United States, then U.S. purchasing power will be reduced, thereby throwing many of those countries into a worse state of recession then that in which they already exist.

Is there any stock market history that could give us a clue as to where the markets might head in the next several years?

There is. We had a bull market in this country from 1949 to 1966. When the bull market became compromised in 1966, the federal government began to create large amounts of money. From 1966 to 1973 the money supply rose by 93%. From 1974 to 1981, we had price inflation that averaged 9.4% annually. Because of that inflation, by 1982 the market had lost 75% of its value in real terms from 1966. Similarly, during the increasing interest rate cycle of 1966 to 1981, we had a flat stock market that went nowhere.

From 1996 to 2004, the money supply increased by 93%. Between 1996 and 2000, the market went from 5,000 to 11,700, and from 2000 to 2004 the market has gone down as low as 7,400 and is currently at 10,400. The rapid increase in the money supply, and the attendant rapid decrease in interest rates, would logically dictate that a healthy bit of inflation is in our future. While the above sheds a little light on what could happen, absolutely nobody knows, or can predict, what will happen.

Conclusion

Four things control stock prices: values, fundamentals, interest rates and investors' sentiment. Currently the value of the S&P 500 stocks is unrealistically high. Fundamentals are poor. Interest rates are increasing. But happily, investors' sentiment continues to remain high.

The bottom line is that investing in this stock market is a huge gamble. It is obvious the market is in a long-term trading range. Most investors only make money over a long period of time because they invest in the market during a rising trend. The market is currently in a downward trend. Having reached the bottom of the interest-rate cycle, and with interest rates now increasing, the investor is gambling by being in this market.

Caveat Emptor!

George Rauch, Longboat Key, is chief executive officer of Bradenton-based General Propeller and a former Wall Street investment banker.