Sins of Omission

By Bob Wood

Oh, it is sometimes hard to be a Bear! While there are always two sides to every story, those of us taking the more realistic view of the markets have trouble finding listeners. Too many watch the financial media and come away thinking that all is well and stocks are bargains, regardless of their valuation. And that may sound true, until you look a little deeper — at what the Bulls don’t mention.

To me, being a Bear in today’s market is the obvious position. I am sure beyond any doubt that we are in the midst of a secular bear market that still has years to go. Perhaps the most obvious fact–that the major averages are lower now than they were six years ago–should be a clue to others. But Bulls always seem to find data or anecdotal evidence to ‘’prove’’ their case. And it would be easy to agree with them–if it weren’t for the sheer weight of contradictory facts. But that’s a real problem now; it’s too easy to get media information without doing any real research to find the truth.

How many investors were badly burned in the bear market cycle from 2000 to 2002? How many bought tech stocks at lofty valuations after hearing promoters like Larry Kudlow and Abby Joseph Cohen predict ever-rising stock prices yet to come? And how many of those same investors berated themselves after taking big losses on what should have been obvious: paying absurd multiples for stocks with no earnings?

History illustrates how taking the easy road almost always turns out badly. In 1999, while Bulls encouraged focus on growth, eyeballs and ‘’new paradigms’’ of “The New Economy,” Bears saw abundant evidence to the contrary, which, though unpopular, eventually proved correct. And now, nothing has changed! Investors still look for the easy road to riches without questioning any premise put forth by those who were dead wrong at the peak!

And what are they wrong about now? In my opinion, almost everything! Let’s look at my favorite source of truly bad information, CNBC and its story-teller-in-chief, Larry Kudlow. He seems anguished these days about a stock market struggling through another year of low returns. ‘’The economy is booming,’’ he says, calling it ‘’The greatest story never told.’’ And then he mentions the low unemployment rate.

Yes, I hear that point often–that the country’s “full employment” surely proves that the economy is humming. But where did information regarding the “4.7% unemployment rate” originate? Does anyone delve into the details, rather than just believing what they hear on television or read in the newspaper?

Most don’t really know the source of these employment numbers–or how to look them up. But you can, as I do, look for them on the first Friday of every month, after they have been compiled and issued by the Government’s Bureau of Labor Statistics to find the numbers on “new job creation.” And while the crowd and Kudlow beam about the headline number, few realize that it is a very small part of a much larger report. Buried deep into it is Table A-12, showing on Line U-3 that the unemployment rate really is 4.7%.

But another number, three lines lower on Line U-6 shows the unemployment rate at 8.5%. That line includes all people whose first choice is getting a full time job, if they could only find one! Isn’t Line U-6 the definition of unemployment we should use in making investment decisions, rather than the more politically expedient version appearing three lines above? And since wages and hours worked have barely budged in the past couple years, does it sound like everyone wanting work is finding it?

Let’s move on to the inflation rate, touted by promoters like Kudlow as almost non-existent and, therefore, little reason for the Fed to raise interest rates and slow the economy. For anyone taking the easy route analytically, simply listen to the announced number. But for those delving deeper into that report, some glaring omissions appear.

Today’s “low rate of inflation,” we hear, is around 2.5%, a calming rate showing stable prices. But that rate excludes food and energy costs! With the cost of energy nearly tripling in three years, does it make sense to exclude such costs when figuring the overall inflation rate? I read frequent articles in my local paper about the rising rates homeowners are paying for insurance and property taxes. Should that data be excluded from the overall rate of inflation?

Instead, the Government uses ‘’core’’ numbers. And which items are included in those ‘’core’’ inflation figures? I happen to have that data table right here, yet I wonder how many Bulls do! Furniture and bedding are included. Do you see frequent ads for sales at furniture stores? Most seem to have constant sales–with free financing for years after purchase. Major appliances are included, too. How fast do prices rise on products that have been commoditized due to over-capacity and imports from China? Of course, new cars are also a factor, but huge incentives coupled with “hedonic adjustments” show those prices as dropping steadily. The use of “substitution effects” also makes inflation look much lower than it appears in your checkbook register.

We hear, too, about the Federal budget deficit, now falling and well within proper guidelines for fiscal responsibility. Lower deficits are great for the markets. But the deficit numbers announced in the media are those seen when taking the easy analytical road; they exclude how the government spends excess Social Security payments, which should be segregated from normal operations. Also excluded are costs from two concurrent wars – and with no end in sight. And the Senate just approved another $65 billion for war costs, which must be borrowed, but that amount, too, is excluded.

Why, if the budget deficit is close to $350 billion for last year, has the national debt increased almost $600 billion for that same period? Economics Professor Lawrence Kotlikoff and Economist John Williams have reported that budget deficit numbers are based on the Government’s use of two sets of accounting books. Including rising liabilities for future spending for Social Security and Medicare would put last year’s deficit closer to $3.5 trillion! But that would mean using “real” accounting methods.

Kotlikoff makes the case that the U.S. is bankrupt, since we cannot possibly pay future liabilities for “entitlement programs,” now estimated at about $70 trillion. But The Wall Street Journal says we’ll grow our way out of this mess; since, while the national debt now totals over $8.5 trillion, asset values are also increasing. Kotlikoff adds back those annoying social program shortfalls and consumer debt of nearly $10 trillion more to paint the whole picture. What the WSJ omits is that $35 trillion in privately-held assets is far smaller than collective debt burdens of more than twice that amount. And since most of those assets are subject to value drops, such as in real estate and stock prices, those values are tenuous. The debt burden is not.

Another sin of omission helping the Bull’s case is a major reason for not raising the minimum wage. The Bulls claim a raise will cost jobs at the lower end, where those wages would apply. The problem is that when some – Bears, no doubt — actually tried proving this claim with facts, they found only one time in the past eight when raising the minimum wage caused job creation to fall, and that came after a dramatic rise in energy prices. In every other instance, raising minimum wages resulted in creating more jobs, report some Princeton researchers, who did the best work on this subject.

Of course, we hear that raising wages at the low end would be inflationary. But inflation is raging now, and the wage rate hasn’t been touched in eight years! So does one cause the other? But how could Bulls spin stocks as bargains if the unemployment rate was at the high end of the historic range? And if inflation is running hot, bonds would appear under- priced, making stocks prices too high. And those budget deficits would require drastic tax increases and sharply reduced government spending, which are not exactly bullish for the economy. And raising the minimum wage would help people at the lower end economically, at the expense of those at the higher end. And that provides a hint as to who gets hurt and why that matter is so egregiously spun away from the facts.

‘’The greatest story never told’’ is, in fact, the true state of the U.S. economy. If people knew the “real” facts, they would run from the stock market, and politicians pushing tax cuts for the rich at the expense of everyone else would be run out of town. You might like having your taxes cut, but simply pushing more debt onto your kids is the price to be paid. Is that really what you want to do?

I’ll admit that some Bears are more extreme than others. Robert Prechter of Elliott Wave fame calls for the Dow to drop someday to the…maybe I shouldn’t say it… Oh, OK, let’s look at it together, shall we? He’s calling for the Dow to drop to the 400 level. That’s not a misprint: 400! A more believable scenario might be Richard Russell’s prediction of Dow 3,000 soon. Bill Gross opined a couple years ago that the Dow would fall to the 5,000 level, or thereabouts. You can find his latest opinions at www.pimco.com where he says, “It will be next to impossible to borrow or sell our way out of this one.”

As for me, I don’t make these predictions. But I am sure that stocks will drop lower in the next five to 10 years and this bear market isn’t nearly over. But what about investors who bought into the incomplete picture painted by promoters? Will they say again that they should have seen it coming? Or that they should have seen that inflation was running much hotter than 2.5% or that Federal budget deficits were only showing a part of the true amount?

I think so. Once again, the sins of omission coming from promoters and major media outlets take the blame from those hoping to get rich in the markets without doing any analytical heavy lifting. The complete information is available, but you have to look for it, and that takes time and effort. You will not find it coming from those with an obvious agenda to get rich at your expense!

Have a great week,

Bob

Bob Wood ChFC, CLU Yusuf Kadiwala. Registered Investment Advisors, KMA, Inc., bwood44@tampabay.rr.com.

•