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Longboat Key Wednesday, Aug. 18, 2010 9 years ago

Highly volatile market continues to bear high risk

by: George Rauch

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 simultaneously exceeded their highs for the year July 26. 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 above average historical price-earnings ratios of 14 times earnings.

2. Because the Obama administration wants 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 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 more than 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 not to get too excited about the market highs just reached. This remains a highly overpriced market in which the odds of making much money in the next several years are stacked against the investor.

If everything mentioned above is true, why is the market at these levels?

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 substantially goes down during a trading day, it usually closes substantially up 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 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 now have almost $1 trillion in cash, a record. 

If U.S. companies have almost $1 trillion in cash, why shouldn’t that auger well for the future of the companies and the stock market?

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.

With about $1 trillion 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?

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. Although Microsoft increases its dividends annually, 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.

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 not?

There are primary and secondary trends 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 simultaneous joint confirmation of new yearly highs of the Dow transports and the Dow industrials. 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.

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, which indicates 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% — the benchmark rate for pricing Treasury notes. Fixing interest rates only aids the bankers and the government — everybody else pays for it.

U.S. federal debt is now 90% of our GDP. 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 risks. 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, Longboat Key, is chief executive officer of Bradenton-based General Propeller and a former Wall Street investment banker.

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