What are the chances?

By Bob Wood

If you follow the stock markets closely, you have, no doubt, heard happy talk from the Bulls of the financial media about the great year 2007 will be for investors. Of course, on the other side of the coin are the Bears, who argue for anything but great things to come investors’ way in ‘07. The best thing an investor can do is consider what each side says and then decide how strongly to invest, based on which makes the most sense.

But if achieving success was that easy, everyone would have made small fortunes investing in stocks over the past few decades. It is quite apparent, though, that investing is anything but easy. After all, haven’t promoters in the stock market, big brokers and the investment newsletter industry been going strong for decades now?

Few of us can make a long list of friends and relatives who have become stock market winners over the long term. And how strange is that, now that we all know that the Dow 30, for instance, has rocketed to a new, all-time high? How is it that the stock market continues to rise over time, but so few have really prospered from buying stocks and mutual funds?

Maybe this is a good time to look at what is not so obvious. One thing to consider about higher Dow levels is that this index measures the progress of a very short list of stocks — 30 in all. What this index leaves out are the thousands of shares that never became part of its short list of names. So the fate of investors who have poured good money after bad into stocks like JDS Uniphase, Enron, Adelphia, InfoSpace and others simply fails to register on the Dow’s measure of investor performance.

So much money has been lost in stocks that never became part of this or any other index. Then, too, any company stock included in the Dow index that suddenly appears in danger of going out of business is simply removed from that basket of stocks and replaced with a more viable company’s shares. So survivor bias does inflate the performance of this index.

But this is stuff for the history books and doesn’t do much to help us determine the best track for 2007. So we do what we should: consider information and advice from multiple sources and, then, using our sharpest analytical skills, allocate our available funds into what looks like the best choices.

So what are we hearing from the Bulls to supports the case that stocks will go ever higher and investors will reap solid profits from taking stock market risks? One argument I hear repeatedly is that we will see ‘’P/E expansion.’’ How does that sound to you?

Now, it is true that one of the great drivers of stock market gains comes from bear-market bottoms, when stocks like those in the Dow or S&P 500 sell, on average, for less than 10 times earnings. At bull-market tops, history shows that average price-to-earnings ratios sit at or above 20. Much of the profits earned from holding stocks come from other investors who are willing to pay more for every dollar of profits. But this process also shows that investors become less attentive to risk and are more eager to ‘’roll the dice’’ on risky assets like stocks.

With the Dow now selling at 22 times earnings, how much higher will valuations go in 2007? We’ve already reached what history shows repeatedly as market-peak valuations. But will investors keep on paying ever-higher prices, on top of the premium pricing already evident today? Well, anything can happen, and the strong domestic stock market surprised me as much as anyone else in 2006.

Another argument for buying stocks comes from the folks whose job it is to keep you interested in them, and that focuses on our low-interest-rate environment. The Fed, they speculate, will almost surely lower short-term interest rates again this year, reversing the string of rate hikes that have brought those rates to the current 5.25%.

But just what would prompt the Fed to lower rates and bring down the cost of borrowing? Typically, this tactic works during slower economic times, as a measure to stimulate the economy. Wouldn’t that move infer, then, that the economy will slow and that lower consumer spending will threaten corporate profits?

Another argument for buying stocks is that corporate profits have been strong and will continue to grow. No one really knows how much of those growing profits have been created by tax cuts for corporations. But when considering corporate profits, consider what percentage of them is actually used in ways that shareholders would disapprove, if they only know what was really going on inside these company board rooms.

What about the executive pay packages of over $200 million awarded to Robert Nardelli of Home Depot and Hank McKinnel of Pfizer, who arguably failed in their jobs and cost shareholders billions in aggregate company value? Their payoffs bode ill for shareholders wondering how well managed our major corporations really are. And those two represent just the tip of the corporate pay scandal icebergs. Add to that insider selling, which is now hitting record levels. How confident are today’s managers about the future prices of their own shares? Why don’t many more of them buy shares, if the future looks so rosy?

A recent report claimed that, in 2006, the average employee at Goldman Sachs was paid over $600,000. Yes, that’s the average pay of all employees! According to Morningstar’s database, that company has over 19,000 employees. Imagine how some of that $11 billion in compensation might have been better utilized on behalf of shareholders, who are the real owners of the company. (Obviously, workers earning low pay made nowhere near that much for their share)

Was the allocation of many millions in pay the best use of the company’s cash? Were investors’ best interests taken to heart when those pay packages were doled out to the top people? In the cases of Nardelli and McKinnel, the obvious answer is “No.” Anyone could have done a “worse than average” job like those two managers.

Yes, strong corporate profits are a wonderful thing, when you can trust management to use them in the best interests of the company. That possibility seems a stretch these days, doesn’t it?

And what are the chances that stocks will sell at ever-higher premiums in price than they do now? Or that slower economic growth will turn out to be a good thing for profits? Or that managers will see fit to put investors’ best interests before their own? I’m not willing to bet one dollar on any of these happening!

Now for our look at the Bear’s side, I have excerpted a short section of John Williams’ latest monthly commentary from his excellent web site, www.shadowstats.com. He begins his year-end newsletter with this:

The U.S. economy and financial markets face significant peril in 2007, with the dollar sitting on the brink of a major collapse. The positive 2006 equity markets and reasonably tranquil credit markets belie the pending turmoil that already has been set in motion by a rapidly deepening inflationary recession and exacerbated by the de facto long term insolvency of the U.S. government.’’

His large concern is that the federal budget deficit for 2006 was much higher than the Bush administration admits. According to Williams, the federal budget deficit neared $4.6 trillion in 2006, which looks significantly higher than the estimated $250 billion number touted by Bush as proof that his tax cuts worked for all, not just his richest friends.

And where does Williams get this number on the deficit, so oddly different than that of the President? As it turns out, Williams’ number came from…the Federal government!

Again, in a short bulletin from his web site, he reports:

Yesterday, the U.S. Treasury published its annual generally-accepted-accounting-principles (GAAP) basis financial statement, signed off on by Treasury Secretary Henry M. Paulson, Jr. The consolidated statements show that the actual annual federal deficit for fiscal year ended September 30, 2006 was $4.6 trillion, up from $3.5 trillion in 2005. Total federal obligations at year-end were $54.6 trillion, up from $50.0 trillion in 2005.

The actual deficit number was nearly 19-times the size of the gimmicked “official” deficit for 2006 of $248 billion. Total obligations were 4.2-times annual U.S. GDP.

The above GAAP numbers include accounting for the year-to-year change in the net present value of unfunded liabilities in social insurance programs such as Social Security and Medicare. The Treasury notes that these liabilities are “not considered liabilities on the balance sheet.” While Treasury has pushed for such an accounting standard for the federal government, it would not have a choice as to reporting these obligations if it were a corporation such as General Motors.

The 2006 GAAP statement can be found on the Treasury’s Web site, under Financial Management Services at: http://www.fms.treas.gov/fr/index.html

So what are the chances that this bit of reality will turn out badly for the American economy, where piling massive amounts of debt and deficits on top of an already historically massive pile will, at some point, work itself out? Remember, if you have to borrow money just to pay interest costs on what you owe, you’re running a Ponzi scheme.

And don’t those schemes always work out badly? Yes, they always do, and all the happy talk from stock market promoters won’t mean a thing when the reality of our collective financial situation becomes a problem to be dealt with.

For 2007, I’ll again take my chances with the Bears. After all, if the bulls are right, we might see another 12% move higher in stocks this year. But if the bears are right, we could see a return of the bear market environment that saw the S&P 500 lose 48% of its value from 2000-2002. What are the chances, and what are the risks involved in either position being proven right, and how much of each do you want in your portfolio?

Have a great week,
Bob

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

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