In what many hoped would end with a long-term solution to our Nation’s fiscal woes, all the drama and fanfare surrounding Washington DC ended in a thud, again. Last week a "deal" was struck to end the government "shutdown," and for all the perceived relief it brought, details are sparse.
What exactly was agreed to? – What problem was solved? – How will it affect the economy?—and, What will it cost American taxpayers?
Since particulars are in short supply in the mass media, I figured I’d be the first to opine.
The most recent budget "deal" is really a legislative appropriation authorizing $1.2 trillion of government spending that will only carry the federal government until January 15th, 2014; it also suspends the debt ceiling until February 7, 2014 – at which time the Treasury will again "run out of money."
That’s not a deal – it’s an expensive delay!
The new Congressional pact, which trades three months for $1.2 trillion dollars, solved absolutely nothing and puts the annualized run rate for American central government at $4.8 trillion for the year – twice the amount of tax revenues it collects!
This fiscal dynamic dictates that tax hikes (a.k.a. "increased revenue" to government people) will be a major ingredient in the next budget "crisis" to be fought early next year. You see, government is slowly and gradually creating a crisis – just like they did with the housing-boom – where generations of taxpayers will again have to bailout poor government policy.
It is crucial to highlight that the next tax debate has nothing to do with fiscal responsibility and fair share payments by "rich people." Instead, the forthcoming "revenue debate" is just another way for America to get distracted while being divided by social class warfare. It’s a total ruse, for two reasons:
First, there is absolutely no way to raise taxes high enough to pay for this fiscal imbalance. American taxpayers simply cannot close a $2 trillion annual deficit. Higher taxes will only allow government to borrow more money, and waste more money, than it can reasonably afford. In the meantime it will also divide the country along Party lines, where those supporting higher taxes for the "rich" are pitted against small government proponents.
Remember, the American economy is already 100% leveraged. At the new rate of spending national debt will soar to 139% of GDP by the time President Obama leaves office in just three years ($25 trillion in debt against an $18 trillion economy.) This is an American disaster in the making; political party and social class should have absolutely nothing to do with it. To support this spending level is not just insane – it’s stupid.
This is not good for money and markets.
Second, higher taxes aren’t what the American Market needs to correct course. Higher taxes will only prolong and/or expand easy money policies, like quantitative easing, that are hurting the fiscal standing of the USA. At the same time, higher taxes reduce the incentive to profit in the private sector – the free-market side of the economy, where long term growth and prosperity derives.
This in no way helps the unemployment picture (which is still above 7% and way too high), corporate profits (a.k.a. return on investment), or the prospects of inflation and rising yields.
And that’s not good for the Real value of stocks.
In the near short-term, however, stocks prices will continue to benefit from a strong QE breeze at their backs. But that’s not the growing wind of free enterprise. It’s inflation. And that makes stock market investing much riskier and more volatile – a condition more ripe for correction and over-reaction.
While some impetus will most likely be required for that correction to ensue, it can essentially be anything: another major terrorist attack, escalating turmoil in the Middle East or Europe, a poor holiday shopping season followed by bad fourth quarter earnings followed by the next budget "crisis" – whatever the trigger, one of many possibilities can cause "the market" to dramatically sell-off.
The size of that correction, as with all corrections, is primarily driven by the amount of inflation residing in the stock market at the time the impetus presents itself. For example, more of a correction will occur in current conditions if the Dow is trading at 17,000 versus 15,000. That is to say that the severity of the correction, how steep the cliff, and how low the bottom, will be determined by the inflationary base and the nature of the impetus.
And since no one knows the actual motivation for the next stock market sell-off, it is impossible to predict its exact timing, behavior and trend-line movements.
However, it might be helpful to know that the stock market is valued 10% higher than it was at the peak of the housing-boom in 2007. Quite remarkable, if you think about it – because there’s no boom going on!
In ’07, the economy was averaging 6% growth for five years running. Today’s economy doesn’t come close to that, averaging just 2% per year for several years running.
There is absolutely no economic basis for the Dow’s escalated value. It’s purely inflationary; and as a result, inflation must be the first thing considered when determining the scope of the next correction.
At the present time there is approximately 3,000 points of inflation in the DJIA. Indeed, the Dow has recently made stock moves to bolster its performance. On September 23, 2013, the poorly performing trio of Hewlett-Packard, Bank of America, and Alcoa, which together had an average 5 year loss of 19%, were replaced with Goldman Sachs, Visa, and Nike, who averaged a 198% gain over the same five years. Again, the Dow’s objective is to indicate Nominal GDP, a level it has been unable to achieve or maintain since the last market top. See below.
The Dow needed to rearrange itself. Its performance has been too far below average for far too long (with Nominal GDP serving as the true market average in this context.) In the time period shown above, from October 2007 to current, Nominal GDP is up 14% compared to the Dow’s 9% advance – a pathetic return by any measure.
Stronger components will certainly make the Dow’s performance better from here on out; and it will also affect "the market’s" trend-line during the next correction.
But that doesn’t mean the Dow isn’t over-valued here. It is.
Below is a three-year chart showing the action zone ranges: irrational exuberance (high), fair value (where the Dow should be trading right now), and the hypothetical low (a safe entry point for investors.) The action zone is a good gauge to valuation when making your investment decisions. See below.
Because the Dow is trading above its average historical high doesn’t mean that it won’t go higher before correction. Stock markets have a history of over-reacting – especially when Wall Street is drunk on easy money (like: the tech-boom, the housing-boom, or the QE-boom.)
This also doesn’t mean that the Dow won’t bottom out much lower than the "low" indication noted by the blue line in the above chart. Free market trading is not finite. Inflation and speculation run wild during booms and busts. Average highs and lows are commonly breached. The action zone, therefore, should not be viewed as absolute, but rather a gauge based on average historical pricing multiples.
Additionally, it is worthy to note that a rise in the DJIA doesn’t mean that the economy is getting better, or stronger. Remember, the Dow is just a stock portfolio – one that has been recently restructured to produce stronger performance and better returns. The stronger portfolio should fare better from here to the next correction – but maybe not.
The stocks the Dow took out were already beaten up, and therefore low in valuation. The stocks it added were highly inflated. This dynamic could make the next correction very steep – and that might cause panic. In any event, "the market" has sent a prudent message to investors – all-time highs are a great time to rethink your portfolio, its components and allocations.
Some investors have already made their moves and have been defensive for a long time, and who could blame them, with just 5% - 15% in stocks. It is natural for them to feel as if they’ve missed something, especially if the Dow continues to move higher. Of course, that’s only true if objectives are not being met. If objectives are being achieved nothing is lost.
However, if more money must be made through investment than what is currently being made, more risk must be taken, i.e. a larger stock allocation. Only you can decide how much is right for you. But to invest now one must be convinced that "the market" will go higher from here and a safe and profitable exit can be reasonably had. It must be worth the risk of investing at all-time high valuations.
That said, I can easily see the DJIA moving higher from here (15,400), especially with all the QE money being handed out these days. For the Dow to achieve its Nominal GDP objective (and with a new, stronger portfolio that possibility has increased) it would have to trade at 16,168, a 5% lift from today. I can certainly see it getting there.
More government debt will breed more QE, and thus more money for the Wall Street establishment – those drooling to push the Dow higher. And should the Dow continue on and reach 17,000, defensive investors should care less. Let others play with fire. Stick to your plan.
My book, LOSE YOUR BROKER NOT YOUR MONEY, is a total guide to investing. Those who have read it understand these blogs better, and appreciate the superiority of 15-51 design. My market portfolio, the 15-51 Indicator, is a portfolio designed and constructed to indicate stock market strength. Its objective is to produce above-average stock market returns (where the DJIA indicates average performance) and it reliably does so.
The 15-51i portfolio has gained 87% since the ’07 top (compared to a 9% Dow gain) – and unlike the Dow, its stock components haven’t changed since its inception (January 2, 1996.) The complete portfolio layout can be found on page 162 of my book. Its complete performance track record can be seen by clicking the shield below.
Superior construction. Superior performance.
The road to financial independence.™