Welcome to the Room - December 1, 2006
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Last Updated Novemeber 24, 2006
Stock Market – The Hidden Long-Term Cycle
David will be back next week so let me say that I hope you enjoyed your Thanksgiving holiday. Thanksgiving is my favorite as it is not as commercial as Christmas, includes family, and I always enjoy good food.
This week I turn to stocks as they have reached new highs on the Dow Industrials, and are giving comfort to economic predictions that we will manage our problems. Because stocks are the most important yardstick for most investors, and because their signal is immediate and not managed by government manipulators, they are an indicator of how our economy is doing. The long-term chart below shows the stock market on a log scale so that we can visually compare the times of big rise. It went through unprecedented big rises in both the 1920s and the 1990s.
The Long View
There are long-term cycles of the stock market that are revealed only when inflation is removed. The big drop in real terms during the inflationary 1970s is completely hidden in the chart above of stock prices not corrected by inflation, but is revealed in the chart below. The chart shows stocks after inflation is removed. The cyclic pattern of the losses in the high inflationary 1970 is striking.
There are commentators that often warn of the similarity of the roaring twenties and the dot-com 1990s, but the similarities to the 1970s are completely hidden to the observer who doesn’t correct for inflation. The important conclusion is that we have experienced several multi-decade cycles, and the possibility that we are in for a long-term, low real return in stocks has historical precedent.
What Measures Can Help Predict the Long-Term Cycle?
The key driver for stocks is earnings, which are soaring to record levels. The chart below shows earnings as a ratio to GDP so that we can get perspective over the long periods from the Great Depression. Corporations have been able to take advantage of cheap imports and cheap foreign labor to raise profits by cutting expensive U.S. workers. The result is U.S. wages have stagnated while profits have risen faster than GDP.
The consumer has not expanded his income, but has expanded his spending by borrowing, mostly against housing. The problem under the surface is that offshoring jobs has increased profits but has not put money in consumer’s pockets, so there is a long-term slowing in the U.S. economy as consumers can no longer expand their borrowing to continue the economic expansion.
The simplest model of our economy is that workers earn wages to spend on the products of the businesses. The output of industry should roughly match the income of the workers, so that the money goes “round and round.” We now have an imbalance with workers borrowing to keep the spending going, while owners of corporations have increased profits from cheap foreign labor. Foreigners have loaned us the money to buy their goods and we have sold off our wealth to maintain our lifestyle. The projections of continued profit expansion in an environment where workers are not expanding their income says that we are in for a slowing, where profits fall. The apparent cyclic high for profits would be vulnerable with further dollar weakness raising the cost of imports.
The ratio of earnings to stock prices is relatively low, meaning, stocks are high because of the still low interest rate environment. When money markets or bonds pay low yields, stocks appear more attractive and Price/Earnings (P/E) multiples expand. The lowering of interest rates has supported stocks for 2 decades. That environment is turning around as rates are starting up. The low of the 10-year Treasury was in June of 2003 at 3.25%. The very short-term recessionary fears have put a cap on the short-term rise in rates, but if my government inflationary stimulus scenario develops, we can expect higher rates which will hurt P/E multiples. The economy grew at only 1.6% in the third quarter of 2006, so economic slowing is already appearing. Lower earnings from recession, combined with potentially higher inflation and rates, are problems for stocks.
P/E multiples are off record highs, and while not at extremes of the 2000 bubble, they do not offer a safe buy.
Dividend yield is extremely low, meaning investors are paying high prices for stocks:
The Government Input to Inflation
The key to discerning the big cycles is noticing how inflation made 1970 much worse profit for investors than seen on the surface. My scenario for the future is that we will have more inflation driven by government deficits because this is the easy way for the government to fund the wars and retirement while keeping the economy apparently expanding. One of the big debates is whether we will face deflation as occurred in the 1930s.
I have been looking at the projections for government deficits in more detail in other analysis, but here I want to point to the fulcrum event that changed how the long-term cycles will unfold in the future: the removal of the gold standard in 1971. After running deficits from the Vietnam war and selling off half our gold, the government declared an end to redeeming dollars for gold and became unfettered by limits from the quantity of gold held. The resulting inflation affected the cycle of the 1970s revealed in the inflation-adjusted chart of stocks. This long-term view shows that for centuries the dollar stayed at a relatively stable value as measured by the wholesale price index, but that after leaving the gold standard in 1971, prices moved up and have not returned.
This chart complements the inflationary view of projected government deficits suggesting that many things may rise in price, as the dollar will be falling as fast.
The pattern of the stock bubble in the 1920s is compared to that of the 1990s in the chart below by overlaying the inflation-corrected values for the S&P 500. The pattern is similar, but the consequences so far are very different. The depression was very serious with 25% unemployment by 1934. This time is different with unemployment below 5%.
Potential Concerns Going Forward
The question is whether the potential slowing we are already seeing from the housing bust will spread to other businesses, creating a longer-term slowing. The housing slowing will slow the consumer borrowing against that housing, which will cut consumer spending enough to cause corporate profits to fall. Falling profits will lead to cutting employment and that could slice spending again, in a self-defeating spiral.
A key tipping point will be how the current recession is handled. If the last recession is an example (and Bernanke gives every indication of following suit), the “Fix” will be for the Fed to lower rates and the government to add more deficits to keep the recession from becoming deep. The seeds planted by this reaction will lead to an inflationary recession, what I call stagflation. Other important drivers, like the demographics of old people putting demands on the Medicare and retirement systems, and potential skirmishes over scarce resources (energy) leading to perhaps serious war, bring us to higher deficits that cannot be absorbed, because we are on a weak platform now of overleveraged debt.
The next decade-long cyclic slowing will not spiral into a deflationary quagmire of the 1930s, but into a frothy situation of unexpected high prices but little new wealth.
What This Means for Investors
This is not a time for stock market investors to be complacent about the prospects going forward, because of the long-term cycles and the prospects for earnings and inflation. My view for the decade-long direction for stocks is that prices may appear steady, but that inflation will erode the real returns. The huge rise in stocks in the 1990s parallels the rise in the 1920s, suggesting a slowing of values of equities in the decade ahead. But the stimulus from our governing bodies is likely to hide that slowing under an inflationary cloak, more like the 1970s, thus providing nominal returns that don’t keep up with inflation.
The conclusion of all of this is to be careful of traditional dollar-denominated investments like stocks and bonds, and to be looking for safety against dollar weakness and inflation in physical assets, like precious metals and energy.
In the tidbits and news area I caught a few unexpected items that might be worth noting below:
- We know that government wants to keep inflation to appear low. There has been suspicion that they cancelled the old M3 measure of money supply so we couldn’t tell if there have been increases. This chart suggests that if we were still getting numbers they would be in the 10% range of growth: http://www.shadowstats.com/cgi-bin/sgs/data
- While ordinary news reports only modest increases in normal Fed measures of money supply, the credit markets derivatives ballooned 30% last year to $370 T notional value. The Credit Default Swaps alone are at $15.7 Trillion - a number bigger than the U.S. GDP. These markets are now in tumult as seen in the strange reading where the guarantee plus underlying are trading less than the Treasury. An important report from the Bank of International Settlement published last week shows how big and fast growing these new Financial Engineering instrument have become. http://www.bis.org/publ/otc_hy0611.pdf
- Unknown to most market watchers is that the Treasury holds auctions of repurchase agreements, not unlike what the Fed does. They say of this offering: “Treasury will periodically auction excess operating funds to participants for a fixed term at a rate determined through a competitive bidding process.” These aren’t big, at single-digit billions, but they are frequent with 277 auctions since starting in 2002. You can see the results of the individual auctions here, as confirmation that they do this. I’m suspicious where the Treasury gets “excess funds” when the government is running big deficits. http://www.fms.treas.gov/tip/reports.html