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 recently. 

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 for it.”

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. 


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