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Longboat Key Wednesday, Jul. 6, 2011 9 years ago

My View: Debt causes direction of market to stay questionable

by: George Rauch

Right now, even though the market has sold off recently, we remain in what is technically called a bull market. Under current economic circumstances, it’s amazing the market is not at half of its current value of 12,250 points. At half current values, a market priced at 6,125 points would represent a cash yield on the Dow Industrials of 4.8% instead of the current 2.4%, far more realistic when the average dividend yield over the last 100 years is 4.6%. In analyzing what is ahead, we can at least get some idea of the risks involved in further investment in the stock market.

For 50 years we have used debt to fuel growth by increasing the money supply through government deficit spending. Growth fueled by anything other than savings is an invitation to disaster. Without real political reform, U.S. economic outlook is disastrous. More than 200 years ago, Thomas Jefferson wrote, “I place the economy among the most important virtues, and public debt as the great danger to be feared. To preserve our independence, we must not let our leaders load us with perpetual debt. We must make our choice between economy and liberty, or profusion and servitude.” 

Here is what we are looking at: The dollar will lose its reserve status; the U.S. will sink into a more severe slump than we are experiencing; and there is likely to be a currency collapse far greater than what has already occurred, because 65% of the world’s monetary reserves are in dollars. This will create a panic for gold, and a new currency will have to be created. The battleground in the next five years is the future of the dollar and the dollar’s reserve status. 

International contracts are written in dollars. As previously written in Market Watch, there are several viable movements currently under way to replace the dollar as the world’s reserve currency. As always, debtor countries such as the United States want to maintain dollars as the reserve currency. Similarly, countries that are holding dollars as part of their reserves represent the economies that want to make the change. These countries have whopping trade balance surpluses with America. And, as they continue to hold those surpluses, they risk the value of reserves deteriorating further as the dollar goes down in value. Countries such as China, that hold large dollar reserves, do two things when dollar reserves are at risk of losing value:

1. They add to their gold reserves, which China has done, now becoming the fifth-largest holder of gold in the world behind the U.S., Germany, France and Italy, respectively.

2. They try to make their own currencies into a currency fully acceptable around the world. China is already doing that successfully by using its currency, rather than dollars, to settle international contracts.
We are a petroleum-based economy. The price of petroleum is important to the U.S. and our competitive position in the world. Estimated reserves of natural gas in our country were recently upgraded to 2.2 trillion cubic feet, enough to satisfy consumption for 100 years. We are importing 51% of our oil now, down from 60% only a few years ago. Our newly discovered oil fields, especially the Bakken Field in North Dakota, South Dakota and Montana, are estimated to be Saudi-sized reserves. Off shore, where moratoriums on drilling exist, there are another 60 billion barrels of oil, enough for us to become fully independent, and be exporters of oil within 15 years. 

The U.S. pays an average of $2.72 for each gallon of gas that we bring to this country and resell. Here are competitive economies relative prices: Norway — $7.41; Germany — $6.82; England — $6.60; Italy — $6.40; France — $6.04; Japan — $5.40; and Canada — $3.81. It’s easy to see mathematically that if the dollar ceases to become the world’s reserve currency, fuel prices would substantially increase. That would increase the cost of production of U.S. goods by 10% to 20%. It would be difficult to be price competitive in world markets under those conditions; the dollar would continue to fall until American-made products can be purchased abroad at a “favorable price.” This is not only an ugly scene — it’s probable. Here are a few other reasons to suggest the stock market might be in for a rough couple of years:

1. Ben Bernanke’s speech recently suggested that the U.S. economy is headed in the right direction. QE2, he claimed, was responsible for adding 700,000 full-time jobs. Although that sounds good, the cost of each new job comes to $850,000. 

2. The rise in the Standard and Poor’s Index of 500 stocks under QE2 has mostly been a result of the decline in the purchasing power of the dollar, the price in which the shares are measured. 

3. Housing prices continue to go down, and although the government says inflation is running at 3.1% annually, we all know inflation exceeds 3.1%.

4. Yale University professor and housing expert Robert Shiller expects the stock market to gain only between 2% and 3% annually over the next decade. He sees no resurgence of consumer spending because the “real” unemployment rate is 16%, and, he points out, housing prices continue to head south.
5. Seventy percent of the money borrowed in the worst week of our crisis (October 2008) was borrowed by foreign banks. Because the Fed refuses to be audited, we do not know how involved the Fed is with the debts of the rest of the world’s countries that are at risk of going into permanent default (Greece, Spain, Ireland, etc.). How much is the U.S. taxpayer at risk because of the obligations that the Federal Reserve has undertaken, in secret, on our behalf, outside of Congress’ authority?

Public debt has been the bane of governments throughout history. The great Austrian economist, Ludwig Von Mises, called this the “Crisis of Interventionism.” Interventionism aims at confiscating (stealing) the “surplus” of one part of the population and then giving it to the other part. Once this surplus is exhausted by total confiscation, a further continuation of the policy is impossible. The crisis of interventionism is summed up by the adage: “The problem with socialism is that eventually you run out of other people’s money!” It is not coincidental that growth of public debt fits hand-in-glove with large and invasive government.

For real recovery to take place there must be political reform. We’re in this mess because of unethical politics. There is the usual noise out of Washington that reform is on the way. The Democrats and the Republicans were complicit in creating today’s problems. So far, all “reform” proposals are designed for political expedience instead of real reform. Reform can only come from a vastly smaller government. Otherwise, our government will continue to increase our public debt until further catastrophe occurs. 

The wise investor will try to protect himself from the stock market. Gold and silver have a long way to go up in price, because the dollar has a long way to go down. Cash provides the patient investor with great future buying opportunities. For investors who cannot resist the stock market, A-plus growth stocks selling at low PEs and yielding more than 3% are Abbott Labs, Chevron, Coca-Cola and Johnson & Johnson.
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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