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October 12, 2006

Musings on the 'New High' in the Market and Other Thoughts
by William Thomson

Is the new high for real?

The financial media, especially CNBC, aka Bubblevision, have been trying to stoke up excitement as the Dow Jones Industrial Average struggled to a beat its previous all-time high set back in 2000 at the height of the tech boom. But does the DJIA really have any relevance to the health of the overall market?

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 since 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 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?

The markets reflect the high present levels of global liquidity, the high level of profits and the best three or four years of global expansion since before the oil price explosion of the 1970s. They are projecting the status quo forward and discounting the negatives such as the global imbalances, geopolitical threats such as North Korea and Iran, the slowing US economy and a likely rebalancing of power in Washington next month and the gradual withdrawal of excess liquidity.

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.

Does the sell off since May mark the end of the road for commodities including oil and gold?

The efficient market theory simply does not work on a short term basis. In the short term fear and greed and technical considerations can overwhelm purely rational theory. That, I am sure, is what happened in the first half of 2006. The flood of money from hedge funds and into exchange traded funds (ETFs) drove commodity prices up too far, too fast. A reaction was inevitable within the context of a long term commodity bull market for which the fundamentals, I believe, remain in place.

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?

The official line is that the US housing market will reduce US growth by 1-2 percent in the first half of 2007. Certainly, Australian and the UK have managed to defuse their housing bubbles without a severe reaction in their economy to date and that could also be true for the US. But the US might also have a much severer reaction. The full impact of adjustable rate mortgage re-settings will fall next year on already heavily indebted consumers. Mortgage equity withdrawal will no longer be the same prop for consumer spending. Some local markets in the US have seen massive price declines already on new built property which, in turn, affects the resale market. That could spread nationwide.

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.

Is the recovery in equities a result of funds flowing out of the housing market (in the US especially)?

I strongly doubt that the retail punter, having lost his shirt on flipping condos, has any spare cash for shares. We are looking at institutional and global funds going into equities as part of the great recycling effort. In addition, with the unexpected weakness of the yen, the carry trade is back.

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?

I find the premise hard to accept. Funds were flowing out of bonds early in the year based on a fear of rising inflation and better opportunities elsewhere. Since May there has been a recovery in bond prices as these fears were reduced. Volatility, a measure of risk, hit its all time lows in the spring and then spiked up sharply with the commodity/ emerging markets sell-off in May/June. It has since returned to levels close to the record lows. Complacency once again rules the roost. Emerging market bonds have also largely recovered although there is now greater discrimination between those countries with good fundamentals in terms of current account surpluses etc. and those with poor fundamentals supported merely by high interest rates and the carry trade, for instance Iceland and Hungary.

William R. Thomson
Chairman of Private Capital Ltd.

William Thomson, Chairman of Private Capital Ltd., an advisory company in Hong Kong. He is also a senior adviser to Franklin Templeton in Hong Kong and Axiom Alternative Funds in London.

Mr. Thomson is not a registered advisor and does not give investment advice. His comments are an expression of opinion only and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity or any other financial instrument at any time. While he believes his statements to be true, they always depend on the reliability of his own credible sources. Of course, we recommend that you consult with a qualified investment advisor, one licensed by appropriate regulatory agencies in your legal jurisdiction, before making any investment decisions, and barring that, we encourage you confirm the facts on your own before making important investment commitments.

Copyright © 2001-2008 William R. Thomson

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