Here are some comments on current concerns and hard questions:
1. The trade deficit is eating us alive and is driving down the dollar.
Not entirely clear. In the first place, if we buy more goods from abroad – particularly productive equipment – than we sell abroad, that doesn’t mean that we’re actually draining greenbacks. The balance of payments does balance, so our overseas expenditures will in due course reappear here. Some will go into manufacturing plants that employ Americans and pay taxes in America. The Chinese see fit to send us attractively priced consumer goods in exchange for unattractive treasury paper.
The British balance of payments percentage deficit is like ours, and yet the pound has been extremely strong against the dollar. What actually does establish relative currency values is the return on treasury bonds. Our Fed is keeping interest rates low to stimulate the economy, thus weakening the dollar, which, by making our goods cheaper, further stimulates the economy.
When the crazy dot.com bubble collapsed, the Fed had to pump in liquidity to avoid a general turndown. That, in turn provoked a real estate bubble, since property prices are a function of how much you have to pay the bank every month and lower interest rates meant lower payments. Now, the housing market decline is provoking further stimulation.
2. There’s a rising oil shortage in the world, with America at the wrong end of it.
There is indeed. Our production has been declining for 30 years, and OPEC isn’t increasing production to meet increased demand, so we must continue to economize more and more: much more. Even then, we face the prospect of perpetual military involvement in the Middle East. Surprisingly, about the largest oil reserves in the world are next door in Canada: the Athabasca oil sands. Production there is rising fast, but at a high cost.
3. Americans aren’t saving enough.
The savings rate is badly calculated. Company contributions to corporate retirement plans aren’t counted, and yet they’re enormous. The Japanese have a seemingly high percentage savings rate, but wretched retirement plans. Capital gains are how many Americans save, since our companies reinvest most of their earnings (which puts stock prices up), but that isn’t counted. Then, our savings data are reduced by an odd “imputed rent charge,” representing what homeowners might have to pay to rent their homes from themselves. This figure penalizes our official savings rate by around $1 trillion, or 7% of GDP! On the contrary, the rise in house prices isn’t counted in savings. And the huge R&D investments made by our best companies are written off, although they are certainly to some extent savings. In a word, we’re saving much more than the raw statistics show.
4. Terrorism and avian flu are alarming prospects.
Terrorism and other calamities, even war, don’t seem to affect the stock market more than momentarily.
A major pandemic would be horrible, and should be planned for at the personal level, but can’t happen overnight and thus is not factored into the market. If it happens, we will be ill-prepared. For comparison, it costs up to $1 billion to get approval for one new drug. The world target plan to cope with all aspects of avian flu is $1.2 billion.
5. Aren’t Social Security and Medicare running out of gas?
Yes, but they aren’t absolute obligations. They can be strung out, at great pain to the recipients.
6. Is there a risk of deflating enthusiasm for alternative investments?
The blowoff period of every market cycle is characterized by that time’s version of a margin account, enough different from the last time so it’s not recognized as such. The takeover mania is very specifically a margin account, since you buy companies using borrowed money. As to hedge funds, the best are excellent holdings. Many, though, don’t justify the fees. The key thing will be liquidity in a downturn.
7. And in financial derivatives?
Nobody can estimate the danger to the system from counterparty failure in the financial derivatives market. Theoretically, derivatives slice up risk to permit everybody to own just what they want, and thus should have a stabilizing effect, but who knows? The entire derivatives market amounts to some $300 trillion, vastly more than the GNP of the whole world. Some slipped cogs could be catastrophic.
It can well be both that this hazard is reflected in today’s market prices, and that many less competent banks could risk a wipeout. Things don’t happen smoothly in this world: Occasionally there are anomalies, even if the whole picture seems rational. Witness Barings, after centuries done in by an enthusiastic trader in Singapore, or of course Long Term Capital Management.
8. Is it good to invest abroad?
Less than before. You could once find fantastic bargains, particularly in the emerging markets, but today these categories are quite efficiently priced, except in places like Zimbabwe, or previously Nigeria, that most people won’t look at. But I don’t see much undiscovered goodness in a lot of other countries now. The big American companies themselves invest massively and with great skill abroad, though, and many derive around half their earnings from overseas.
9. Does anything seem unusually attractive?
Among other things, some of the old blue chips, the “trustee” stocks, like Johnson & Johnson, whose earnings have grown 14% compounded over the last decade. Its market price got way too high some years ago, and has been flat ever since. It sells for about sixteen times earnings today, and American International Group, the world’s greatest insurance company, for eleven. The best Swiss bank, UBS, is selling for thirteen times, and Royal Dutch for nine. Wal-Mart, whose earnings have grown at 15% a year for ten years, is selling for sixteen times earnings. Even the stodgy old railroads are booming.
10. And the economy and the market overall?
The market is less keyed to the economy than generally believed, and anyway, the economy is so hard to predict that few eminent investors worry about that. I once asked Peter Lynch, of the amazing Magellan Fund, how much time he spent on economics. “A little less than fifteen minutes a year,” he replied. Part of the reason is that traditional linear economics doesn’t predict what actually happens. Why that’s so is in my opinion explained by complexity theory: too many variables.
That said, pre-election years are usually good for the stock market. The defending president pumps oxygen into the system to produce a rosy glow as the voters go to the polls. That’s politics though, not economics. ■