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Business Observer Friday, Jun. 4, 2004 14 years ago

Failure to Learn

If we don't continue to consume, our economy will crash. We are dependent upon the over consumption of goods and the consequent continued growth of debt.

Failure to Learn

If we don't continue to consume, our economy will crash. We are dependent upon the over consumption of goods and the consequent continued growth of debt.

Questions and answers beget more questions from readers, so here's a continuation of last month's Market Watch questions and answers.

The economy appears to be improving, so when can we expect the stock market to return and exceed its high of 11,700 reached a few years ago?

The good news is that cash flow continues to improve in our economy. The bad news is that the market is already selling at very high levels of value and the odds of the market reaching and exceeding 11,700 anytime in the next several years are very low, indeed. The huge loss in market values suffered over the last several years is only the beginning of the market returning to sane values. Such a return to reasonable values (price earnings ratios of 15 or under and yields of 4% or higher) may take years. Past market highs, like the one we just experienced in 2000, are usually not seen again for several years because those highs are built upon speculation and not value. The market has been over valued for so long that it will take years of increasing earnings and cash flow just for the economy to catch up to the extraordinarily high values currently existing in the stock market. An improving economy does not necessarily mean an increasing stock market as previously shown over the market's last 100 years of history. The market, at best, will move sideways until values catch up with current prices. Historically, however, the market has retreated significantly from levels like those existing today.

Inflation statistics are confusing. What is the real rate of inflation?

Nobody really knows the answer to that question because the statistical sample used to compute the rate of inflation is so distorted by the Bureau of Labor Statistics (BLS). In January the BLS stated that inflation was under 2%. In February it appeared to be up to 2.2%. The latest release of numbers indicated inflation at the rate of 6%, which has caused the Fed to indicate there might be a slow, gradual increase in interest rates.

BLS statistics are skewed in favor of the government. The government has two key reasons for keeping the rate of inflation down: (1) Most government welfare programs like Medicaid and Social Security are indexed. Each year the payout on those programs increases automatically based upon the rate of inflation as determined by the BLS. (2) The rate of inflation as determined by the BLS will influence the cost of money (rate of interest) as determined by the Fed. Both of these reasons can cause government expenditures to explode. The last thing the government wants is statistics that will automatically increase expenditures, but we consumers know that inflation is a lot more than what is published. Social programs and interest on the debt comprise 50% of the U.S. Federal budget of $2.3 trillion.

The good part of the year for the stock market is supposed to be from Jan. 1-April 30. How did the market do this year?

Not well. As of May 6, the market is 2% below where it was on Jan. 1, and that is the strongest four months of the year.

With the improvement in cash flow in our economy, can we expect the government deficit to go down as it did in the 1990s?

Perhaps, over a period of years. Right now, however, the government has estimated the total spending deficit to approximate just over $500 billion in this fiscal year. The last 12 months, government debt has increased by $681 billion, indicating, with only a few months of the fiscal year left, that the deficit will far exceed what was originally estimated. An increase in Social Security and Medicare expenses from indexing, and an increased cost of interest, could cause the deficit to remain very high for years.

There seems to be quite a lot of deception in government statistics and spending. How does the government get away with this?

Simple. No. 1, it is so complex that few people understand the magnitude of what is happening. No. 2, very few members of the press understand economics. No. 3, most congressmen, who vote upon the budget, have no clue about economics. And finally, many congressmen are more interested in being re-elected than in the well being of their constituents.

Former Congressmen Dan Miller said that the only way to ever get people to understand the complexities of our problems is to bring it down to the individual level. How do you do that?

See the chart below.

Why is debt so devastating to an economy?

Debt can be useful if it is fixed at a certain rate and financed over a period of years as with a home mortgage. Debt can be devastating, however, if the rate of interest payments fluctuate with interest rate increases in the economy. When interest rates are low, as they are now, and so much debt is financed short term, the cost of interest is relatively low. But it took 11 rate decreases over a period of only a few months for rates to become this low.

During the last 12 months the Fed has injected over $1 trillion of new money into our banking system which has made the banks flush with money to lend and has therefore pushed the lending rate of interest down. As inflation heats up, interest costs will increase. An increasing cost of interest means that a larger percentage of household's disposable income will be devoted to paying interest on debt. Therefore, less family disposable income will be available for other alternatives like vacations and other types of consumer spending. A slow-down in consumer spending equates to a reduction in our GDP. A falling GDP means less cash flow to service debts, which can lead to a dangerous downward spiral in economic trends and cause severe cash shortage leading to increasing bankruptcies.

Our economy is becoming more and more technical, so are tech stocks a good investment?

No. The following tech stocks sell at a very high volume every single day, and they are based on super optimistic evaluations that completely disregard classic measures of value. eBay has a price earnings ratio of 113, Yahoo 151, Nortel 37, Microsoft 31, Intel 32 and Texas Instruments 43. All of these stocks are under extreme pressure from competition both within and outside of the United States.

These price earnings ratios are high, but aren't they really fast growing companies?

They are fast growing companies under extreme competitive pressures. Price earnings ratios are based upon "future 12 months earnings," not upon past 12 months earnings. Merrill Lynch partner Richard Bernstein writes "projected price earnings ratios have been wrong 96% of the time over the last 35 years." He points out that the investor is really being duped most of the time into buying stocks at inflated values because earnings estimates have been overly optimistic.


Our current economic position in America is that we are consumer oriented rather than oriented toward being content with what we already have. And we are trapped. If we don't continue to consume, our economy will come crashing down. We are dependent upon the continued over consumption of goods and services and the consequent continued growth of debt. Our feelings of entitlement have created the situation and have developed a mentality within us of borrow, buy and upgrade. Debt enslaves. Our government has encouraged us to turn away from a free country and to become a country of people looking for a free lunch.

James Madison, Father of our Constitution, said, "History records that the money changers have used every form of abuse, intrigue and deceit possible to maintain their control over governments by controlling money and its issuance."

Such is Wall Street today. Simply witness the number of brokerage company and mutual funds' fines for trading violations.

Thomas Jefferson wrote to John Taylor in 1816: "I sincerely believe that banking establishments are more dangerous than standing armies, and that the principle of spending money to be paid back by posterity under the name of funding our government is but swindling futurity on a large scale."

Such is our Federal Reserve System and our Federal Government today. The only thing we seem to learn from history is that we don't learn from history.

The market continues to remain highly overvalued and very risky. The conservative investor position is cash and short-term, A-rated securities, and the proper investment attitude is patience.

Caveat emptor!

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

U.S. Statistics Per Capita & Per Family

ItemAmountPer CapitaFamily of Four

U.S. GDP$10.5 Trillion$35,000$140,000

Total U.S. indebtedness$33 Trillion$110,000$440,000

U.S. government debt$7.1 Trillion$24,000$96,000

This year's trade deficit$550 Billion$1,830$7,320

This year's budget deficit$650 Billion$2,165$8,660

(at least)

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