April 27, 2005
As amazing as it seems, the stock market broke above
10,000 on the Dow for the first time in 1999.
This week, six years later, the market has had difficulty staying
above that same level.
Can it be true that large American enterprise has
created no added value in 6 years? Of
course, markets tend to reflect the forward hopes and fears of investors.
What are investors seeing on the horizon that bothers them?
Some U.S. industries clearly have lost value in the
past six years. The American
auto industry shifted from passenger cars, where they had been outmaneuvered
by Japanese producers, to SUVs. Now,
high gasoline prices are causing consumers to question the wisdom of owning
such fuel inefficient vehicles. General
Motors is a Dow component, and it clearly has lost value.
American fibers and metal production also have
struggled. Textile and apparel
companies are quickly moving to Asia, especially after a fiber quota was
discontinued at the beginning of this year.
Almost all steel producers have reorganized in the past few years,
though they have been earning profits with their new cost structures
A small piece of these struggling industries are
reflected in the Dow (Dupont still makes synthetic fibers, for example), and
they certainly have lost value. Some
technology companies, such as IBM, also have not added any value in this
century. Overall, however, I do
not accept that American enterprise is worth less today than six years ago.
So what is bothering the average investor?
The first comment is that the stock market remains overvalued.
Yet, if analyst estimates of earnings are close to the mark, current
prices value this year’s earnings at less than the historical norm of 16
times earnings. And interest
rates, the stock market’s closest competition, yields much less than the
6.5 percent that 10 year bonds averaged historically.
Two weeks ago, analysts began the week worried that the
Fed would need to raise the size of its interest rate increases to prevent
inflation from intensifying. Then
poor exports, retail sales, and housing reports suggested that the economy
was slowing more sharply than the Fed may desire.
That week ended with recession fears.
Then inflation measures were released this past week.
While many analysts believed the producer price index excluding
energy was modest, I worried about the 1 percent price increase for crude
materials other than food and energy. (That
is one of my leading inflation indicators that had been negative for several
months prior to March.)
A day later, a 0.4 percent price gain even after food
and energy were excluded brought back concerns about inflation.
However, despite all the headlines to the contrary, those
inflationary concerns were not reflected in investor decisions.
When inflation was first mentioned two weeks ago,
yields on 10 year government bonds were almost 4.7 percent. This made sense if the Fed needed to push short term rates
higher than originally expected. But
even as the stock market stumbled this week, those same bonds yielded less
than 4.2 percent. If the fear
is inflation, then why did those bonds rally so much?
In fact, the real investor fear is risk.
Energy prices could be unusually high because of speculative
interest. Two hundred forty two
thousand open oil contracts suggest that too much money is betting that
something will go wrong to spike up oil prices. If nothing wrong happens, oil prices could tumble at the peak
of the driving season (that is when commodity speculators know that enough
gasoline is available to meet the season’s needs.)
On the other hand, refinery capacity may be too low and
lines might form at gasoline stations.
People will react by making sure their vehicles are fully gassed up.
Ten additional gallons in 200 million vehicles certainly would create
a price spike.
Indeed, high oil prices may already be slowing the
world economy. Unlike last
year, when world production expanded 5.1 percent according to the
International Monetary Fund, oil prices this year are rising while the
dollar is relatively stable.
Furthermore, the Fed may raise overnight rates higher
than originally thought, or may not because oil is “doing the Fed’s job
In such time of increased risk, investors head toward safety and quality. That explains why government bond prices are firm while stock prices are weak. And if the risks do not materialize, investors will return to stocks, as I expect, later this year.