It Will Matter Someday

By Bob Wood, Muslim Media News Service (MMNS)

There comes a day in every investor’s life when what he or she has considered the best advice on where the markets are going turns out to be wrong. For today’s Bears, that day seems to have come. Yes, the Dow 30 average, which set new highs almost daily, has just hit the 14,000 level, an all-time high.

But here is one investor who remains as “bearish” as ever! I see this market rally as a simple case of large investors ignoring the fundamentals. At some point, fundamentals will matter, and then the stock market will react to facts that can no longer be ignored.

I see Wall Street as the greatest sales and marketing enterprise ever developed! Financial industry promoters seldom mention that economic facts do not align with their bullish forecasts. We saw this same pattern emerge in the late 1990s with huge runs in technology stocks and again, two years ago, in housing.

The fundamental underpinnings supporting those markets were weak, at best. Yet stock and then house prices rose despite growing reasons for the opposite. Since prices were rising, that was all that mattered! Of course, when those markets crashed, bewildered investors asked why and how it happened so fast.

Too many chastened investors wondered what warning signs they might have identified and acted upon –before their fast gains evaporated. Of course, market promoters assured them that such sudden drops in prices were nothing more than healthy corrections, since, in due time, those prices would resume their upward trajectories.

Today, no shortage exists of new warning signs for investors to consider. Once again, these signs don’t seem to matter much at the moment. But at some point, matter they will. Fundamentals eventually become relevant. They tend not to matter — until they do, and then they matter a lot!

Let’s take a closer look at the real estate market. In central Florida, for example, this Spring/Summer selling season has been a bust. Many optimistic property owners, waiting for better times to unload their houses or condos, are now facing the beginning of real estate’s slower time of year. That means buyers will have the upper hand, able to choose from multiple properties that fit their needs. In addition, new-home builders are adding monthly inventory, which is not being absorbed at expected rates of sale.

This may not be a bad situation for home owners not rushing to sell. But, what will happen in the last quarter of the year, when the surge in adjustable rate mortgages resetting to higher rates occurs? Owners of too many homes that are barely affordable now will see them become totally unaffordable very quickly. So what will this situation do to home prices, and how will it help stimulate consumer spending? Since consumer spending accounts for about 70% of all US economic activity, investors ignoring this growing concern are courting risk.

Add to this picture that the value of the dollar is falling in record-setting ways, with foreign currencies as far removed as the Thai baht and the Indian rupee looking much healthier by comparison. Once again, financial media promoters argue that this can be a good thing, so they urge us to load up on multi-national large cap companies to take advantage of the trend.

Our stock market and, even more astonishingly, the bond market seem oblivious to this concern. The fact that our currency is losing value is a fundamental consideration that should cause a sense of alarm among investors. The plummeting value of the dollar results, quite obviously, in our needing more of them to make purchases. Needing more dollars to buy everyday needs is commonly called inflation. And inflation is commonly referred to by economists as a reduction in lifestyle levels for those in economies suffering from rapidly rising costs.

As the dollar loses value, the appeal of interest-paying investments like bonds tends to wane significantly. Bond holders earning a 5% annual yield begin losing money in after-inflation or real terms. Foreign bond holders suffer even more, when their interest income later converts into their stronger, home currencies. This results in losses in nominal terms, even before factoring in inflation.

In normal times, this loss would matter greatly to those bond holders, but for some odd reason, they have continued to buy bonds. But at some point in the future, the losses will matter, and bond issuers like our Federal government will be forced to offer higher payouts for bond buyers. Can you imagine the effects of higher interest rates for our economy?

In past market cycles, high stock and bond prices resulted in low forward price rises, meaning that investors made little, if any, profits on their investments. Paying close to 20 times earnings for a stock or bond gives an earnings yield of about 5% in the first year. Buying risky assets that yield 5% has, as logic would suggest, resulted in small gains, at best, and big losses, at worst, for their holders. And that pattern is often repeated in the history of investing.

But for now, the markets seem oblivious. That stocks and bonds sell at premium prices doesn’t seem to matter at all, and the rally continues. But buying high has almost always proven a mistake for investors. And at some point, I am sure that lesson will be driven home once again. For now, few seem worried, but it will matter — sooner or later.

We have heard from our vice president that ‘’fiscal deficits don’t matter.’’ His contention is that the Federal government is virtually free to spend far in excess of what it receives in revenues. That excess just simply accumulates in harmless piles of debt. And as long as the economy is rolling along, faster economic growth will enable our paying interest costs on that new debt. After all, wasn’t this idea validated in the Reagan era?

But when Reagan was spending recklessly and piling up record amounts of new debt, the day of reckoning loomed far off into the future. Now, that day of reckoning is on the immediate horizon. Shortfalls in funding for Social Security and Medicare were not big issues then. But rapidly rising costs for those programs are now converging with rapidly rising interest payments. And they consume more and more of the Federal budget’s ability to pay.

This massive shortfall in funding, estimated now at close to $50 trillion, is fast becoming an issue that must be faced. Time marches on, whether or not we can pay those costs. Since we can’t pay them now, we’ll either need to print money even faster than today’s record pace, or simply give the bad news about social program shortfalls to a large group of people who tend to vote regularly. This issue matters now, but the markets continue to ignore it.

Losing two wars, with the Iraq War quickly becoming our most costly of all time monetarily, means even more borrowing and money printing. The big difference now is that, since no domestic pool of savings exists, foreigners, instead of American interests, will be buying these new debts. This, too, equates to even more interest payments leaving the national account and going into foreign coffers, further draining the country of treasure and future income. Yet this, too, seems to matter little.

And remember to consider the debacle in the sub-prime mortgage arena, with some hedge funds blowing up and their investors facing large losses. It amazes me that none of this seems to matter to stock and bond investors. They party on as if everything will simply work itself out — with no damage done.

None of this will matter — until it does, and then the game will change significantly. It’s not a problem until it is, and then it’s a real problem! So what is the timing for these factors to become issues in the markets? All I know is that they will, and the defensive investor will fare best. Someday these issues will matter greatly, and losing investors will be asking how they could have seen them coming. My response will be, “How could you not have seen them?’’

Have a great week.
Bob

Bob Wood ChFC, CLU Yusuf Kadiwala. Registered Investment Advisors, KMA, Inc., invest@muslimobserver.com.

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