Weekday Commentary from Jim Puplava
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How Much Longer Will John Q. Hold On?
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Market WrapUp for the Week
Monday l Tuesday l Wednesday l Thursday l Friday
Monday's Stock Market WrapUp
Looks Like the ‘20s and ‘30s
Yes, Virginia, this is looking more like your grandfather’s market. Instead of profits, investors suffered through another quarter of losses. According to The Wall Street Journal, many analysts are worried the markets could decline for a third year in a row -- something that hasn’t happened since 1941. As the WSJ points out, back then the world was at war and trying to work its way out of the Depression. There are many similarities to the late 20’s and 30’s that parallel today’s markets. Let’s start with the 20’s, which were an extraordinary time of prosperity for the country. Technology was advancing at an unprecedented rate. We had the electrification of the cities, the airplane, the radio, and talking motion pictures. There were new home appliances and the automobile was becoming ubiquitous. The Fed was printing plenty of money, which found its way into the financial markets. Credit was expanded, the markets kept liquid, and the general public believed there was no better way to get rich than to invest in stocks.
We had prohibition back then. Today we have tobacco company condemnation. Instead of outlawing tobacco, the government has found it more profitable to tax the h_ _ _ out of it. Today, the average bloke that smokes in New York City will have to pay $7 for a pack of cigarettes. The city increased its per-pack tax from $0.08 to $1.50 -- almost a 20-fold increase. In April the state increased the state tax to $1.50 a pack, making New Yorker City smokers pay almost double the national average. The state unknowingly just expanded the black market for cigarettes. New York will soon get a lesson in economics as many smokers vow to buy their cigarettes in nearby states or on the Internet. The City hopes to raise $111 million in taxes over the next year. It is doubtful the actual taxes will even come close to that figure as most smokers will begin to buy their cigarettes in the black market.
What’s next? Will we see a new crime-fighting bureau headed up by a modern-day Elliott Ness to crack down on the illegal cigarette traffic? Will the ATF make raids on unsuspecting smokers who buy their cigarettes illegally? Will citizens be subject to roadblocks and border checks to stop the illegal flow of contraband coming into the state?
Government Response to Lower Tax Revenues
As the recession and bear market in stocks cuts deeper into tax revenues, states, cities and the federal government will be searching for new ways to fleece citizens in order to support governments from the federal level down to the state and city. The government doesn’t know how to rein in expenses. They only know how to spend money. When the money isn’t there to cover expenses, they either raise taxes or they print money and inflate (which is a subtler means of taxation). With the economy showing signs of weakness, raising taxes is the wrong thing to do. Taxes are already at record levels, so the tax increases will be one more burden to a slowing economy. Hold on to your wallet because more taxes are coming your way: higher income taxes, sales taxes, use taxes, higher permits costs, and higher fees. Like Roosevelt’s tax increases of the 1930’s (when income tax rates were raised to over 90%), the higher taxes will choke off incentives to earn, invest and expand the economy. In place of the private sector, the government sector will begin to mushroom in size and we will have economic stagnation as a result.
History Repeating?
Another factor so reminiscent of the 20’ and 30’s is the current spate of scandals. In the 30’s we had Samuel Insull and the collapse of Insull system of public utility companies. Back then, many railroads and utilities had lines of credit with banks to finance property additions, carry fixed charges, or meet maturing debt. The expectation was that much of this bank credit would be funded with permanent financing. With the stock market crash and The Depression that followed, much of this financing never took place. Loans weren’t rolled over. When financing proved impossible to get, the result was receivership.
The late 20’s were also a period filled with questionable financing for new public companies. Investment banks brought scores of companies public that were of inferior investment grade. The methods used to sell the IPOs were clouded by questionable methods of presenting the facts. Earnings reports were just as bogus as the present batch of reports we now call earnings. Between 1927-29, as a result of the investment mania-taking root, Wall Street was only too eager to supply the analysis their pitchmen could use to sell the public bogus investments. It was only after the stock market collapsed and the Dow lost 90% of its value, that the government stepped in during 1933 and 1934. In 1940 the SEC was established and new security law regulations separated investment banking from the banking side of business.
Those laws worked for a while until the mania markets of the 90’s when Washington and Wall Street lost any sense of integrity and morals. The 90’s were truly a decade of greed. It became a time when companies tried everything they could to meet analysts’ estimates in an effort to elevate their stock. Most CEOs were literally robbing shareholders with obscene compensation packages richly laced with generous stock option grants. Those stock option grants provided the incentive to cook the books. Even better, the expense of the options did not have to be recognized.
Unfortunately, There's More to Come Out
Now the government vows to do something about it. But where was the SEC during the boom years of 1995-99? It will be a miracle if they can restore public confidence. It is my belief that there are more Enrons, Global Crossings, Tycos, and WorldCom’s waiting to be discovered. The 90’s were a period where ethics, integrity, honesty, and truthfulness were completely abandoned. It was evident from the White House to Wall Street that integrity meant nothing. It was every man for himself in an effort to get rich. Time Magazine even did a cover story on America’s new passion for lying. The article pointed out that it was okay to lie if it helped you get what you wanted. Sadly, we are now living in the aftermath of that era.
The problem going forward is how to restore integrity, honesty, and truthfulness. It can’t be legislated. In my opinion, that only comes with a person’s relationship with God. I have never read in a history book a government’s ability to legislate morality or ethics. In fact, most history books, including Edward Gibbon’s "The Decline and Fall of the Roman Empire" point to the decline in morals and integrity as a major reason at to why empires fall.
Last Quarter's Blues
Looking back at today’s markets and last quarter, the same problems that have plagued the markets are still with us. Weak corporate earnings, accounting scandals, and fears of another terrorist attack are still with us. The most amazing thing about this market is that John Q is still hanging on. Even though this year is the third year of negative returns for investors, they cling to their mutual funds and stocks in the hopes the Fed, the government or maybe Santa Claus will bail them out of their losses. While insiders are selling at record levels according to the latest Vickers Report, John Q. keeps buying and holding. According to a recent report, investors poured more than $25 billion into equity funds during the months of April and May. The month of June erased all of those contributions with losses in equity. The markets have lost $1.4 trillion since the beginning of the year.
In the quarter’s performance, gold and silver were at the top of the list for the second year and the second quarter in a row. Behind precious metals was real estate. At the top of the list following gold funds were specialty funds that use a combination of bear market strategies, such as shorting stocks, gold, or foreign currencies. However, for the average investor, it was another quarter of losses. The average equity fund was down 14% during the quarter.
What Happens When More Want What There's Less Of?
Gold funds were by far the stellar performer this quarter and since the beginning of the year, followed by short-selling funds. Where people have made money in this type of market is gold, shorts and foreign currencies, such as the Euro. Gold funds are finally starting to catch on with Main Street investors as more than a passing fancy. However, gold investing is still relatively obscure as a means of investment. Total funds invested into gold are only about $4 billion compared to the $3 trillion invested in all equity funds. The market’s availability for investing in gold and silver stocks is so small it recently forced Vanguard to close its Precious Metals Fund, which took in $124 million of new cash this year, and now has $628 million under management. The consolidation in the gold mining industry has limited the number of stocks to invest in according to company officials. The fund only holds just 28 stocks, and 10 of its holdings account for 74% of the fund’s assets.
You can imagine just how explosive these markets will become if only a fraction of that $3 trillion decides to move in the nation’s 41, $4 billion in asset-sized gold mutual funds. This is a very select and thin market. That is why when gold and silver move, these companies will explode to the upside. It isn’t because of a mania as so many idiots on Wall Street caution. It is because of scarcity of supply. Common sense tells you that when demand is greater than supply, prices rise. When that supply is scarce, as is the case with physical metals or with the choice of mining stocks, the price goes up. In this case, if even 5-10% of that mutual fund money moves into gold and silver, the prices of bullion and the equities are headed north of the moon.
What Happens If...
This is Washington and Wall Street’s greatest fear. What happens if investors no longer decide to hold on? What happens if they decide to call it quits? Will we get another bank holiday, but this time in the markets? The last time we had a crash, which was in 1987, many large mutual funds closed their doors for as long as a week. The industry became overrun with redemptions. It could very well happen again. This time the markets could be shut down for a longer period of time. Market valuations are still at extremes with the true P/E ratio on the S&P 500 closer to 40 compared to a century average of 14. Even then you have to question that number in relation to the credibility of earnings. The 40 P/E ratio equates to an earnings yield of 2.5%. No matter which way you look at the markets, they are still grossly overvalued. If those earnings begin to slip even further, then the adjustment process has much farther to go. A better view of fair value for the S&P 500 is closer to 350 given the present state of true earnings. This would indicate that the S&P 500 would have to drop by over 60% just to get back to normal valuations, much less become a bargain for investing. The Dow would have to get closer to the 3000-3500 levels. Even then, it wouldn’t be a bargain
The insiders have already bailed out or are in the process of cashing out. What is remarkable to me is the fact that John Q. still holds on to his mutual funds, oblivious to their risk. It is indicative of the degree of ignorance of the investment public when it comes towards risk. They still have faith in the Fed, Wall Street and Washington that they will eventually be bailed out. The word "eventually" can encapsulate a very long-term time horizon. Those years of financial conditioning by the fund industry to buy and hold for the long-term are paying dividends to the industry. The Nasdaq is now at levels not seen since 1997 and the S&P 500 is at a level last seen in 1998. Another quarter like we just had and we will be back at 1995 when the real mania in stocks began.
Some Advisors Just Don't See it
his morning on the way into work I listened to a nationally broadcast financial show. A caller explained he had just taken a bath in WorldCom. He sold it at a loss in the hopes of using part of his $17,000 loss as a write off against income. The advice given was to sell his stocks and put his money in equity mutual funds. The financial advisor felt the caller would be much safer because of diversification. He would then avoid the problems of owning another WorldCom. If we follow this reasoning, the investor would sell off his remaining stocks and put them in stock funds, which have under-performed the markets, and on average just lost investors 14% in the most recent quarter. Under this line of reasoning, instead of losing 99.6% on WorldCom this year, he would have only lost 14%. Then we have to account for a loss of 13% last year, and another double-digit loss in 2000. Does that make financial sense? How about getting out of stocks, or shorting stocks, or maybe buy gold, silver, energy, or raw materials? Not a word of mention of any of these strategies. Instead you get the standard cliché of diversification, dollar-cost-average, and own stocks for the long run. No wonder John Q. has his money invested in stock mutual funds that continue to lose money. The advisors don’t see it, which means investors don’t see it, so they are still holding on. John Q. is totally oblivious to the fact that the floor underneath the markets is about to drop this year.
Bad Start to the Quarter
The new quarter got off to bad start with a bit of an aftershock from last week’s round of scandals. Bad news was everywhere. Biotech stocks took a hit after negative opinions from the Federal Trade Commission and the FDA. Volume was low with very little interest in buying. Most sectors were in the red outside of gold and select energy stocks. There is also a bit of hesitancy ahead of pre-announcements on earnings that go into full swing this week. There are also jitters over possible terrorist attacks. The FBI has issued a vague warning over threats this July 4th. Investors were also still recovering from the shock of WorldCom and Xerox. Wall Street added to the general sense of unease by downgrading targets for the S&P 500 this year. First Call warned that profit estimates for the second half of the year remain too high. In the last few weeks, estimates for the third and fourth quarter have been falling fast. First Call cited an ominous trend in severe cuts in capital spending budgets that doesn’t bode well for earnings or the economy.
It is normally when the news is this bad that rallies spring forth. Barring a terrorist attack, it is still possible for a small summer rally to take place this month. The pro forma earnings spin will kick into high gear by the second and third week of this month. This will be a short traders rally, and nothing more. I do want to emphasize the word "trading rally." After that, it will be time to go short again, especially ahead of the government’s economic revisions for 1999-2001 and the warnings for the third and fourth quarters. The key will be to keep your eye on the dollar and foreign investment in the U.S.
Volume was moderate with 1.4 billion shares traded on the NYSE and on the Nasdaq it was 3.4 billion. Volume on the Nasdaq included 1.2 billion shares of WorldCom, which fell from $0.83 to $0.06 for another loss of 93% for the day. WorldCom defaulted on $4.25 billion in loan agreements. Who knows--maybe WorldCom will now be considered a value stock.
Overseas Markets
European telephone and media stocks rose on speculation Vivendi Universal will oust its chief executive and the French government will buy France Telecom from the public. The Dow Jones Stoxx 50 Index of European shares rose 0.4% to 3073.07 on the first trading day of the second half. Four of the eight major European markets were up during today’s trading.
Japan's Topix stock index advanced for a third day, led by Sumitomo Mitsui Banking Corp. and NTT DoCoMo Inc., after a central bank survey showed business confidence had a record increase in the past quarter. The Topix added 0.4% to 1028.63, while the Nikkei 225 stock average shed 0.3% to 10,595.44.
Bonds Today
Bond prices fell on signs that stocks would gain ground Monday. The benchmark 10-year bond fell 6/32 yielding 4.82% and the 30-year government bond slipped 6/32 to yield 5.52%.
© Copyright Jim Puplava, July 1, 2002
