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Musings on the 'new high' in the market & other thoughtsWilliam R. Thomson Unfortunately, in my view, the DJIA is a tragically flawed representation of the overall market and is one of the bigger cons foisted on the investing public. It is an arithmetic average of the prices of 30 seemingly randomly picked stocks that hardly reflect the 21st century US economy, let alone the global economy. Companies are inserted or deleted from the index at the whim of the Dow Jones Corporation, a company with a well defined extremist political agenda. Only General Electric remains of the original 30 shares. Iconic stalwarts from the past such as US Steel, Bethlehem Steel, Sears Roebuck and Westinghouse have been retired to the knacker's yard. Because it is an arithmetic average of only 30 shares it can be fairly easily manipulated by powers wanting to "paint the tape" and provide a false signal of prosperity, for instance. With the upcoming mid term elections, there could well be an element of that occurring at present. To digress for a moment, let us look at the average and some of the absurdities it throws up. American Express earns one tenth what Citigroup earns but they are equally weighted since their shares have the same absolute price, about $50. General Electric is twenty times the size of General Motors but they are also equally weighted for the same reason. GE also earns 6 times what Amex earns but Amex has almost twice its weight in the index. IBM earns less than General Electric but is more than twice as important in calculating the DJIA simply based on its share price. Altria is half the size of Microsoft but twice as important in the index. Finally, a company such as AIG, the insurance giant, is larger and more profitable than most of the DJIA constituent shares but is not included in the index. With the exception of Exxon, there are no resource stocks in the DJIA. Other indices give different results. The flawed NASDAQ index, for instance is still 60 percent below its all-time highs. Probably the broadest and fairest representation of corporate America is the S&P 500 index which represents the 500 largest shares in the NYSE and is capitalization weighted. It is still 13 percent below it's all-time highs achieved in 2000. So truth, to some degree, is where you find it. We should note also that profits in the US, largely as a result of globalisation and cost cutting, are at their highest ever levels in terms of GDP and this supports shares in the short term. The flip side is that the returns to labour are at their lowest and the US worker on average wages now earns substantially less in real terms than he did in 1973, thirty three years ago. First the working classes and now the middle classes are getting poorer as a result of the great labour arbitrage. It would seem quite possible, even likely, that this will eventually engender some form of a political protectionist reaction that will lower profits as a share of GDP at the expense of wages. That happened in the wake of World War I and the impact could hardly be neutral on share prices. In any case, any celebration of a new high is a result of money illusion. A dollar in 2006 is worth significantly less than a dollar in 2000 even using the politically manipulated BLS figures. The high of 11,700 in 2000 requires a 14,000 level today to achieve a new high in real terms. Gold is often seen as the only real money. If we were to use the price of gold as the determinant of the real level, we would require a price of 26,000 for the DJIA to reach a new high. How sustainable is the rally? Is this US rally the real thing or a sucker rally? The next few weeks will be critical but count me a sceptic over the next few months. The first part of 2007 in the US could be more difficult than the consensus expects but there will at some point next year be an effort to reflate the economy in front of the Presidential election in 2008 which, incidentally, is also the year Beijing will host the Olympics. The massive adjustments could even be delayed until 2009 with the new US presidential term and a further deterioration in the US budgetary imbalance as the first baby boomers start to collect their social security. But one should avoid being
overly US-centric. Excluding geopolitical upsets and that is
a huge caveat, Asia, including Japan, and now Europe, have their
own momentum and look set to continue their economic growth/recovery
stories in 2007. There is still excellent value in parts of Asia
and there are good pockets of value in Europe also. These technical adjustments do matter. Was it, for instance, a coincidence that Goldman Sachs - for whom Mr. Paulson, the US Treasury Secretary had recently been Chairman - sharply lowered the weighting of gasoline in its commodity index in August thereby precipitating ETF selling and sharply lower gasoline prices? How very convenient for the Republicans who are facing defeat in November's elections! Once underway, these reactions can become self fulfilling and go to excess in the same manner as the previous bull-run. Some funds have undoubtedly moved back into equities as portfolios are rebalanced. It is just the normal ebb and flow of the markets. But we need to keep the focus. We had a twenty years bear market in commodities from 1980-2000. History shows that the bulls that follow a long term bear are often of the same duration. The supply demand imbalances will take time to correct on the supply side whilst demand can be expected to remain strong. Even if the first wave of the bull cycle is over we should still have more on the upside after this corrective period is over. Has the decline commodity
prices been enough to keep interest rates from climbing further
and worsening the downturn in the US housing market? It will be some time before
we know the outcome. But, again, geopolitical events and possible
stagnation in Washington are factors probably not fully weighted
into the equation of the conventional wisdom. And, again, the
commodity story is not over. Stagflation - higher inflation and
lower growth - remains a possible, perhaps even probable, outcome.
Are funds deserting bond
markets because of a conviction that interest rates have peaked,
or because of fears of rising defaults in the bond market, especially
in the corporate sector? 11 Oct, 2006 |
