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Business Observer Friday, Sep. 5, 2003 15 years ago

Ingredients for Upswing Missing

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George Rauch, a resident of Longboat Key, is a former investment banker on Wall Street and now owner of Bradenton-based General Propeller Co.

Ingredients for Upswing Missing

George Rauch, a resident of Longboat Key, is a former investment banker on Wall Street and now owner of Bradenton-based General Propeller Co.

Readers have asked us many questions about the market, its direction and values. Here are Market Watch's responses:

Why keep highlighting the Federal Reserve system and the creation of money, for no value in return?

Historically, economic value has been created from labor turning resources (anything produced by the land) into manufactured goods that have value. That good is sold for a profit. Profits are used to purchase more resources and more labor to turn more goods into profitable consumer items, thereby satisfying the demand in a society of increasing population. When money is made out of nothing, that money will be spent somewhere. It is unlikely that enough goods can be manufactured to keep up with an undisciplined increasing money supply, thereby causing an increase in pricing to satisfy demand, which we call inflation.

Is Market Watch's bearish skepticism toward stocks expected to change soon?

No. In an April 23, 1998, column, we wrote the Dow Jones Industrial Averages would reach between 10,000 and 12,000 by the turn of the century. Conditions then existed for a favorable increase in values because underlying increases in corporate earnings were excellent. The outlook for corporate earnings is not now favorable.

How long will this last?

Another three to six years. The bull market lasted from 1982-2000. The rule of thumb is that bear markets last one-third of the length of the bull market.

The market is being manipulated today by forces more powerful than ever before. The government's deficit has never been larger. The country's trade deficit has never been larger.

Over the past six months, the Federal Reserve Bank has been creating money, out of thin air, with no sweat or work behind it at all, equal to almost $1 trillion in new money annually in a desperate attempt to provide "controlled" inflation.

Despite the bear market, the secondary trend of the market lately has been up, while the primary trend is down. Should investors be taking advantage of the secondary trend?

A secondary trend in the opposite direction of the primary trend of the market is dangerous. It must turn around and match the primary trend sooner or later. If we were competent figuring out when secondary trends commence and end, we would all be richer than Solomon. This is a speculators' market. When we act in a market that has no value, we are acting on the "greater fool theory." We are buying securities hoping we can turn around and sell them to a greater fool in the future for a profit.

Why is the secondary trend of the market positive when the primary trend remains down?

The money supply. The M-3 (the large money supply) was $8.5 trillion on Dec. 31, 2002, and today it's $9 trillion dollars. Much of this new money is finding its way into speculators' hands. Speculation is increasing the market bubble. July insider selling was 32-to-1, which was the third month in a row it exceeded 20-to-1. With speculators driving up the price of the market, insiders are taking advantage of the opportunity to reduce their risk by redistributing their wealth into cash. Insider selling and buying has long been a barometer of the direction of the stock market. Judicious investors pay attention to insider behavior, which is why the statistics are published.

Personal bankruptcies are up 10% over the previous 12 months to 1,613,000 families, an all-time high. Does this have any bearing upon the stock market?

Yes. Like the unemployed, these are families that previously had money to spend. Bankrupt families and the unemployed represent a decrease in cash available for consumer goods. Our economy depends upon increasing consumer spending to fuel growth and meet debt obligations. A reduction in cash flow has a negative effect upon the economy.

Total state deficits this year would be at least $71 billion or 15% of the states' budgets. Does this impact the markets?

Yes. The states are going to try to make that up on the backs of property owners. Anybody in this area who owns property not protected by homestead laws recently received proposed double-digit tax increases. That money goes into the public spending stream and is unlikely to be used for consumer goods or capital investment. A further reduction in "productive cash flow" dampens the overall economic outlook. Government is an inefficient distributor of resources. Government distribution creates little value in an economy. A capitalistic economy requires efficient utilization of cash distribution to ensure an expanding manufacturing and job base.

What about all the smart people running mutual funds?

As a percentage of all mutual funds, mutual funds are actually going out of business more quickly than the percentage of families declaring bankruptcy. Mutual funds manage other people's money. There is tremendous pressure for their performance to "beat the Dow." Notice how any literature you get shows that "while the Dow was down 21% for the year, your fund was only down 14%." Most mutual fund managers' remuneration is based upon how their fund does as compared to indexes like the DJIA. They will never have the self-interest in managing your money they would have if they were managing their own money.

Why are good dividends so important?

A strong dividend of 4% to 6% represents a return of one's investment. Five years of collecting a 6% dividend represents a 30% return of one's investment. Over the last 100 years dividends represent more than 60% of the return investors received on common stocks. The current mania to build wealth on increasing stock values without the underpinnings of a good cash return represents a hope to receive a return without any underlying substance.

What fundamental economic changes are needed?

First, the dollar is too high, and until the dollar is recapitalized against other world currencies, we will not be able to rebuild our manufacturing base. Manufacturing is what creates value. Fifty percent of our manufactured goods are made abroad, up from 31% in 1987. Our manufacturing work force is 11%, down from 30% in 1966. In addition to our manufacturing business being exported, there is now a huge increase in the exportation of our service industry. This results from labor rates around the world being so much lower than in the United States and can only be addressed by the lowering of the value of the dollar.

Second, the U.S. economy is continuing to pile on debt at an unsustainable pace of about $2 trillion annually. Our existing future obligations are around $50 trillion and our current GDP is only just over $10 trillion.

Third, the Federal Reserve System making money out of nothing promotes continued speculative excesses and heightened financial fragility, which leads to deeper economic maladjustment and impairment.

Fourth, healthy economic growth depends upon three things: a high percentage of savings, a high percentage of investment of profits and a high percentage of profits. Currently, we have none of those.

Fifth, in the perception of the public, the stock market is coterminous with the economy, and this misperception can end up costing an investor a significant percentage of his portfolio. If the economy is getting better, the stock market can still have a huge downward adjustment in its values before the market establishes a base from which investors can enjoy successful gains.

Sixth, more than 50% of the incremental growth in earnings for the U.S. corporate sector is generated from financial services, not from manufacturing. Thirteen years ago only 10% of corporate profits were from their financial sector. It is frightening that all of GM's earnings come from their financial sector, and the car business is break even.

Is there any reason to be optimistic?

There is no doubt the rest of the world is economically worse off than we are. We have a currency that represents 80% of the world's money. In a country with a decreasing manufacturing base that represents only 4.5% of the world's population, the dollar's breadth is a huge benefit. The strength of our institutions, our military and our political philosophy has carried us through prosperous times. If we are patient with our current situation and are able to forestall our natural desires to invest (to "do something"), we may have opportunities in the future to make money that have never existed before. Such opportunities will only become available if there is a continued re-valuation of the dollar and a continued re-valuation of the stock markets. There must be a renewed increase in our ability to create and keep jobs in this country. The sooner the American public realizes what is really happening and can see through all the misinformation that exists in the press, the sooner we will force changes in our political institutions, which have driven us into these unstable and dangerous bubbles.

Are there any new investment recommendations?

No. The frugal investor is best advised to be sitting on the sidelines, primarily in cash and short-term paper. The market remains overvalued by at least 3,200 points on the Dow. Anxious investors might consider gold and silver, and gold and silver stocks. Dabbling with a modest percentage of one's portfolio in high yielding (4% and above), low price-earnings ratio (12 times earnings or below) stocks that are at least "A" rated can provide some income and upside market potential. Anything else is speculation.

Caveat Emptor!

George Rauch, a resident of Longboat Key, is a former investment banker on Wall Street and now owner of Bradenton-based General Propeller Co.

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