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Pushing Stocks Higher

May 15, 2008 by  


By Bob Wood, MMNS

As a confirmed Bear in regards to the domestic stock market, I am as bewildered as anyone about how the stock market continues to move forward despite overwhelming evidence that it should not. The underlying fundamentals of our domestic economy are dreadful — and getting worse. So what’s behind investor enthusiasm for the stock market? I wish I really knew, though I do have some ideas that might explain it.

We have all been led to believe that, over the long run, the stock market always moves higher. For the most part, that is true when we look at long time frames, maybe 20 years or more. The Dow Industrials are near all time highs, which seems to argue that point.

Recently, I saw an interesting chart showing the real, inflation-adjusted rise in the value of that index for the past 100 years. It should come as no surprise that the stock market began moving higher in a consistent way after 1913, the same year the Federal Reserve was created by New York bankers. As we developed the means to inflate the country’s money supply and, thus, assured that the economy would avoid a depression or similar economic downturn, we also ensured that enough liquidity was available for credit creation and business activity.

Apparently Fed governors were too slow to be of much help when the stock market crashed in 1929 and throughout the subsequent depression years. Or, perhaps more accurately, they had done so much damage in ginning up the economy in the prelude to the Great Crash that doing more of what got us into that mess was seen as a dumb thing to do.

But this little trip down Memory Lane could put today’s economic scene in better perspective for us. Wasn’t it a runaway Fed, inflating the money supply and encouraging banks to extend massive amounts of credit to anyone who wanted it in the aftermath of 9/11 that helped boost the housing bubble? Parallels with the 1920s seem worth consideration.

Maybe the Fed believed it was working along the guidelines promoted by John Maynard Keynes as best for a soft economy as it used added liquidity to boost economic activity. What it forgot was the other part Keynes tried to impress on those who adopted his idea: this is a two-way street. When times were good, the Fed should have taken back some of the liquidity it infused into the economy during down times.

Instead, the Fed continued its long history of taking the easy way out by continually increasing the money supply, usually at the behest of a political party or business leaders. The courageous former Federal Reserve Chief Paul Volcker stands out as the lone exception in this double-dipping history.

The trouble with adding liquidity by money printing is that, at some point, too much money floats through the system looking for investing opportunities. The price paid for these investments seems less important to some than realistic valuations would imply.

Let’s face it, the more money you have, the less you watch over the pennies. If your net worth doubled tomorrow, you’d be much less inclined to shop only at clearance sales at your local mall. And many in politics and business believe that this process works well. Rising prices mean rising profits, and that gives the illusion that our economy is growing.

But rising prices, in and of themselves, do not necessarily equate to rising values. Looking at the currently rising price of food items like rice, corn or wheat gives us a wonderful illustration of this. Those commodities have risen sharply in price over the past couple years, but have the wheat, corn or rice benefited from strong improvement in quality during that short time?

Ah…nope! Prices are on the rise due to increased demand around the world, and, in part, to the rapid rise in the availability of money throughout the world. Which central bank is not printing money at a faster rate today than in previous years?

The more they print, the more money is available to spend, and the faster prices rise. Today, some Americans are expressing shock at paying $4/gallon for gasoline, coming from $125/barrel crude oil, and rapidly rising prices of food items. Yet has anyone expressed concern about rapid money printing over the past few years?

Here are the facts: if Americans had much less money available to them today, they’d be much more likely to spend it wisely. Frugality would creep into their spending habits, and that would curtail demand. Prices would begin to fall by some degree.

So now, along with rapidly rising prices for commodities, other classes of investments are also experiencing more cash inflow, as investors look for better places to put it. They attempt to offset the falling value of the dollar by acquiring those things that should rise in price to offset the dollar’s lost purchasing power.

Perhaps we are seeing some of that sort of buying now in the stock market, due, in part, to investors’ desire to offload their depreciating cash into something that they hope will rise in value and protect their purchasing power and real wealth. I cannot conceive of any other reason that the stock market is rising now — despite the mountain of bad economic data arguing against it.

For example, let’s look at the valuation of our stock market, with the S&P 500 now sporting a P/E of 21, while the case for investing in it, based on compelling buying opportunities, seems to be obviously absent. And the housing market worsens by the month, with inventories of unsold homes rising to dramatic levels.

Watching our biggest investment banks and brokers scrambling around the world, looking for infusions of fresh capital to fill massive holes in their balance sheets suggests that conditions are anything but rosy in our economy. And the outlook for new credit creation to fuel spending appears to be vanishing.

New job creation numbers are so bad that the Government has resorted to simply assuming additional job growth even though no new jobs can actually be found. The job creation number reported for April shows a loss of 20,000 jobs, which looked bad enough, until we saw that the Bureau of Labor Statistics added into the report 267,000 new jobs, which they couldn’t really find!

What would investors do upon hearing the real truth about these job creation numbers, showing a loss of 287,000 jobs in one month? Just a couple years ago, stock market promoters were appearing in the financial media almost daily, assuring us that the price of oil would surely fall back under $50/barrel, or some other level lower than its new high price. After all, it would have to go down in price, since each U.S. recession over the past 50 years was blamed on rising energy prices.

With average consumers already spending every last dollar on basic necessities, how could they possibly absorb rapidly rising energy costs? Obviously, they can not, and our economy is feeling the loss of discretionary spending power among the poor and middle classes. Yet stocks continue to power higher!

Perhaps another explanation is that inflation is raging, not just in the commodity sector of the world economy, but is also spilling over into other investment classes, such as stocks and bonds. But does make them compelling values? Or does it suggest that investors will look back in five years, remembering the great buys they made in stocks at 2008 valuations? Or is just too much money looking for a place to reside, with the hope of generating gains in excess of the true rate of inflation, now estimated by some astute observers to be running in the low double digits?

All that money has to go somewhere, and now that the housing bubble has burst, the stock market must seem like the best substitution. But maybe that’s what our Government and the Fed intended all along?

Have a great week.
Bob

Bob Wood ChFC, CLU Yusuf Kadiwala. Registered Investment Advisors, KMA, Inc., invest@muslimobserver.com.

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