This Much We Know

By Bob Wood

I have to admit, I am as surprised as anyone that the Dow is now reaching new highs almost daily. The only way I am saving face is the performance of my favorite overseas markets, which are doing even better than the Dow. My clients hold heavy allocations in those foreign markets, based on what I see as better fundamental cases for them over domestic markets. Apparently, therein resides the flaw in my thinking.

Imagine my surprise when reading The Financial Times recently to find how little fundamentals seem to matter. According to one news item, a poll conducted by Thomson Financial asked 93 U.S. fund managers with over $4 trillion in assets for their views on the economy and the stock markets. One statement, in particular, stood out among others. “More than three quarters of the respondents ranked equity market fundamentals, such as valuations and earnings, as the least important element in their investment decisions.”

You may want to read that again. I read it several times, looking for the word I may have missed that would change the meaning into something more believable.

What a shock for a quaint, old-school investor like me to wake up one day to discover that professionals who manage vast sums of money do not consider business fundamentals when selecting shares to buy. All I can say is, “Wow!” — as I recall the title of a book on investing by Bill Gross: Everything You Know About Investing Is Wrong.

Apparently, is it ever! So if the profit and business outlook for the foreseeable future matters not, then what does? Perhaps professional investors are technicians now, and chart patterns are all that matter. If a stock is going up, it’s a “Buy.” If a stock is going down, it’s a “Sell.” And investing is just as simple as that. Whether a company’s outlook is good or questionable doesn’t seem to matter anymore.

If a manager buys a stock and it doesn’t perform as expected, he can quickly sell it in favor of some other high-flyer. If you are right now enjoying the performance of your domestic stock mutual fund, it would be helpful to understand that this is the prevailing mindset of the manager of your high-turnover fund. Is this the investing process you thought you were buying?

I don’t know about you, but for me, this scenario seems eerily similar to the late stages of the secular bull market ending in early 2000. In 1999, we didn’t hear much about fundamentals; rather, we heard about those “new paradigm, new economy metrics,” endlessly spun into what sounded like valid reasons to buy stocks at whatever prices.

Only when the bear market began to spook investors a couple years later did a renewed appreciation for fundamentals, such as valuations and earnings, develop. And I wager that, when the current euphoria generated by a higher Dow subsides, the fundamentals will matter again.

Of course, there is much we don’t know about how fundamentals will look in future years. But there are plenty of things that we do know. And yes, they do matter now and will reassert their importance sooner or later. Before the bear market resumes, which might coincide with the slowing of money and credit creation now moving at record speed, investors should at least consider what we do know now.

One thing worth considering is the state of the housing market. This offers a viable place to start, given the boost housing has provided to the economy over the past five years. We know now that housing sales are slowing across the country. Especially hard hit is my home state of Florida, where sales declines in the double digits are now common in previously hot-selling areas.

With slower home sales come rising inventories, which now show about a seven-month supply nationally. What that situation does to prices is obvious, but the bear market in housing may be just beginning. If you live in the Detroit area, you’ve seen this happening for many months.

Perhaps the reason for that area’s becoming the first to slow in housing has much to do with the availability of jobs. Massive layoffs at the big auto makers, which generated so much economic activity in previous decades, make this kind of economic contraction predictable.

Adding to those woes are stories about the growing trend to outsource auto parts, with China becoming the preferred place of manufacturing. Bill Ford said in China this week that his company plans to double the amount of parts made and imported from China to values close to $3 billion annually. That $3 billion in parts will no longer be made in America, and that’s only a portion of the more than $20 billion in car parts we can expect from China by 2010, according to Goldman Sachs.

Another important consideration before buying any product is the fundamental idea of valuation, meaning how much we should pay for it. An old adage says that we make our profit when we buy something. The purchase price actually determines whether we’ll make money on it. With the Dow currently quoted as selling for about 23 times average earnings, we may need reminding that history clearly shows that paying so much for risky assets has never worked before. Never!

Another fundamental consideration that appears unimportant to today’s fund managers is the ongoing cost of the wars waged by seemingly incompetent leaders in Washington–with no end in sight. Each day, another $1 billion or more is thrown into the fires in Iraq and Afghanistan, which also create growing liabilities due to injured returning soldiers who may require very long-term care.

Besides burning over $1 billion daily in those wars, the U.S. must now borrow almost $2 billion daily from foreign lenders to finance our growing twin deficits, the Federal budget deficit and the insanely large trade deficit, now closing in on $70 billion/month. Consider the dynamics involved when nearly $800 billion goes from America to other countries’ banks in just one year! And this massive exodus didn’t start in 2006, but rather, about two decades ago. And nothing on the horizon promises to temper this number, as I refer again to the outsourcing of auto parts as one trend involved.

Another fundamental concern deals with the looming “budget-busting” effects of Social Security and Medicare spending. Now costing about nine cents of every GDP dollar, those costs are expected to rise to between 20 and 30 cents of every GDP dollar in the next 50 years. But our Government does not consider those liabilities real, since it seems to feel no obligation to pay those promised amounts to retirees. Those programs have been altered and adjusted in the past, we are told, so future Congress members may also reduce payments or raise taxes to help bring about the needed balance later. Yes, play out that scenario in your mind and see where it goes. The one sure thing I see now is that a conflict of sorts is coming, and painful adjustments will follow.

Now add to the equation some of the larger, geo-political considerations that former Treasury Secretary Robert Rubin believes are real enough — but unappreciated by today’s fund managers and other investors. Competition from China and India for oil supplies, the control of almost half the world’s natural gas supplies in the hands of Russia and Iran, and the widening disparity in wealth between the very rich and the rest of us promises the potential for ugly things to happen.

With today’s 23 times earnings for the Dow and about 18 times for the S&P 500, how many of these potential issues are factored into investor buying decisions? I think the answer for most is, “Very little.” You would have to be exceptionally optimistic to value risky assets at those prices, and you would have to assume that the rest of the world will become a simpler, more peaceful place where governments everywhere will join together for everyone’s mutual benefit. Do you see that coming, given today’s unsettled atmosphere?

Some things we know, and other things we do not know. But shouldn’t some potential for adverse events become a factor in investor decisions? Could the national debt situation worsen with predictable consequences to follow? Could the wars in Iraq and Afghanistan prove more economically destructive than they are already?

Could the loss of well-paying manufacturing jobs alter consumer spending for years to come, as is seen already in northern states affected by auto plant closings? And can the housing market endure the typical, average bear-market cycle of four years, and with what effects on jobs and spending?

Yes, some things we know, and some we don’t know. But it seems that what we do know argues strenuously against paying premium prices for domestic stocks. Call me stupid for missing the current rally in domestic stocks, but I still feel confident about the performance of my favorite foreign markets, where all those good jobs are headed. And I feel great about being the contrarian who doesn’t take the bait and buy stocks at premium prices for the lamest reason of all: they are going up!

This much we know: as in the recent bear market of 2000-2002, a time comes when investors regret having ignored the fundamentals. Will you be one of them?

Have a great week,
Bob

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

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