Market Watch: Beware of the new bull market

Nobody has any idea what the stock market will do over the next several years, because nobody knows what the monetary policy of the country will be, either in the next six weeks or the next six months. The market has so many dislocations, even though it is going up, it remains dangerous. In spite of the “crash” we have had over the last few years, the stock-market lows have not degenerated to historic bear-market values. At this point, the Dow Jones Industrials are selling at 20 times earnings, 43% above the historical mean of 14 times earnings. At these levels, history indicates the mathematical return over the next 10 years, including dividends, is under 5% annually on the stock markets.
 
What evidence is available that indicates returns, including dividends, as low as 5% over the next 10 years?
There are two studies of note. Steve Leuthold, whose work we have referred to before in Market Watch, recently published a chart showing that returns on the Dow Industrials, when selling at 20 times earnings, are historically 4.8% over the ensuing decade. 

Studies by James O’Shaughnessy, chairman at O’Shaughnessy Asset Management, indicate the S&P 500 Index should return 3% to 5% a year, including dividends, until the year 2020, compared with the 13.85% in the 20-year period up to 2002. His studies indicate that if you select any random 20-year period between 1927 and now, the real rate of return on the S&P 500 is about 7%. Whenever the market produces exceedingly higher than or exceedingly lower than the 7% return, we spend the next 20 years reverting to the long-term mean.
 
Leading indicators point out that we are in a new bull market, and Wall Street analysts are expecting 10% to 15% gains in corporate earnings this year. Doesn’t that bode well for a continually increasing stock market?
If the stock market were priced at 13 times earnings rather than 20 times earnings, one could make a case for a new bull market. However, with these high price-earnings ratios, the market has already accounted for good earnings over the next several years. Any gains to be realized have already been priced into the market. Furthermore, and, most importantly, Wall Street only makes money in a bull market. Continued bear markets will bankrupt more Wall Street firms, which is one good reason why Wall Street needs a bull market.

Market Watch has written that two of the old Wall Street adages are “don’t fight the tape” and “don’t fight the Fed.” The “tape” indicates that the market continues to gain upward momentum. And the Fed continues to infuse large amounts of cash into the economy. Under these favorable circumstances, doesn’t it make sense to be in this market?
The solutions our government has devised to solve problems provide for even more government. Government doesn’t solve problems — it creates them. Most of the money injected into the economy by the Fed does not help the little guy — it helps the big banks at the expense of the little guy.
 
How can that be? Wouldn’t the public catch on to this quickly and let Congress know it?
The public does not really understand what is happening. Here are two recent examples.

1. In the “Cash for Clunkers” program, the government sold it as a way for the less fortunate to trade in their gas guzzlers and receive big tax credits. The government created a smoke screen around what it really wanted to accomplish, which was further bail out the automobile companies. It paid $3 billion to automobile manufacturers who were in desperate need of cash. The amount of dollars theoretically saved annually on fuel costs was less than 12% of the $3 billion, or around $350 million. So, we spent $8.57 for every $1 we saved, not a wise use of money.

2. The money the government gave the banks is not filtering down into the economy in the form of loans. Try to get a loan from a bank and learn how difficult it is to get it done. What’s really happening is that the government is keeping interest rates close to 0% for short-term money to encourage the “carry” trade.
Here’s a simplified explanation of how the carry trade works. A bank borrows money at close to 0% and uses that money to purchase securities that yield, say, 2%. The spread between the 0% interest cost and the 2% yield is booked as earnings, just like the spread between the interest rate on a loan and the cost of carrying the loan would be booked as profit. Not only is it more profitable and less risky for the banks to be involved in the carry trade, but it is a more certain way of increasing earnings than taking the risk of making loans.

This is simply another government smoke screen selling the public on the fact that we are being helped. In fact, the Fed pushed interest rates to almost zero, and is encouraging the carry trade for two reasons. 1. The carry trade’s easy profits can quickly improve a bank’s balance sheet and 2. Most of the carry trade is in government securities. So the carry trade, then, provides another avenue to finance government deficit spending. 
 
What other dislocations could hurt future earnings?
There is the continued creation of debt that must be repaid; the continuing annual deficits of the federal government scheduled to exist through 2018; the pending new health-care program which has not been funded; the unfunded Medicare and Social Security obligations; financing wars; the reserve status of the dollar in the future; and the huge number of unemployed. The government has proved it cannot manage our finances; it cannot manage the post office; it cannot manage the banks; it cannot manage Freddie Mac or Fannie Mae; it cannot manage Social Security; it cannot manage Medicaid and Medicare; and it has no clue as to how we will fund and manage the new health-care program.

This is not a scenario for an increasing stock market, because the only way the government is going to manage its way out of this mess is by higher taxes. Borrowing money frustrates future earnings. And increased taxes negatively affect the stock market.

Market Watch has written frequently about gold. In spite of the big run-up in gold, is gold still a viable economic alternative?
Gold is a hedge against the depreciating values of paper currency. The purchasing power of the dollar has gone down, causing the price of gold to seem like it’s going up. The chart (see box above) indicates gold has outperformed the Dow the last 10 years. With future uncertainty concerning debt, government policy, the Federal Reserve System’s policies and future taxes, it is highly probable that over the next 10 years gold will continue to outperform the Dow. Over the last decade, gold has increased on a compounded annual basis at more than 15%. The Dow over the last decade, however, has returned to just under 1% annually.

Conclusion
Interest rates are continuing to go up, which causes bond prices to go down. Bonds do not look like a good long-term investment. It appears interest rates will continue to climb causing bond prices to remain suppressed. 

Short-term money market instruments going out 12 to 18 months are a good way to maintain liquidity. As prices continue to go down, cash is going up in value on a relative basis. We are able to buy a bigger basket of goods with cash now than we could 24 months ago.

If one must dabble in the stock market, there are a few A-rated stocks that pay dividends of 3% or more, stocks that are selling at price-earnings ratios lower than their historical average and stocks that are proven dividend payers with 12-year records of increasing earnings and dividends. Those few stocks are: Abbott Labs (ABT); Altria Group (MO); Automatic Data Systems (ADP); Chevron Corporation (CVX); Coca Cola (KO); Kimberly-Clark (KMB); McDonald’s (MCD) and Sysco Corp. (SYY). They are all well-managed companies that represent good opportunities for long-term capital gains. They operate all over the globe and they’re priced right.

Caveat Emptor.

BOX
Dow/Gold Comparison
                                                                               DJIA                  1 ounce of gold
Dec. 31, 2000, closing prices                                 9,976 points                         $276
Dec. 31, 2009, closing prices                                10,584 points                     $1,114
Annual compounded return on investment            <1%                                    >15%

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