JAPAN ASIA INVESTMENTS
HOW NOW DOW?
March 27, 2006
Donald Dross
Sid Klein has been writing for a very long time that wealth, dominance and power have been and are migrating from West to East, as part of a massive cycle shift - bravely toward a truly new world. Through this process, he has argued, gold would end up in the hands of Easterners, while Western currencies would survive for the time being on the basis of their symbiotic relationship with the world's reserve currency-the US Dollar.
As a result, gold finally broke out against all currencies in 2005, within a massive secular bull market. The March 5, 2006 SKC report played along with the bullish fantasy of printing money that could support the Dow, since it is the same phenomenon (stimulus) that has caused the breakout in gold. Accordingly, Sid suggested that we look at the Dow average as priced in gold. In that report, he presented a catastrophic Dow chart (denominated in gold) that would put today's Dow average around 6500 (if still denominated in Dollars)!
Since I do not dispute Sid Klein's compelling logic, I have scratched my head wondering why the Dow has not plunged to its normalized value of 6500. My best guess is contained in this essay. But the reason I give is based on ephemera, not logic. It is the kind of ephemera that can vanish the moment you turn your back to go into the kitchen to get a cup of coffee.
To Whom Are American Equities Attractive?
The New York stock market these days seems to floating like a hot-air balloon that has found thermodynamic equilibrium. Any day, the chartists tell us, it will go into free fall. But that day keeps getting postponed. The market does not seem to have a care in the world. No news is good news, good news is bad news, bad news is not news.
Not only do the chartists tell us that the market will soon plunge like a basketful of balloonists, but fundamentalist observers are also looking skyward in grave apprehension. They tell us that equities are currently overpriced from a historical viewpoint. They point out that the future projected earnings stream runs the gamut from Discouraging to Dismal. The present dividend return is minuscule. Why should anyone want to buy these things? And yet, somebody must be buying them, or else gravity would have kicked in.
If neither technical nor fundamental analysis can help us, perhaps we should heed Sid Klein's advice and look at macro money flows. Follow the big bucks. Macro-analysis, by its nature, is inherently imprecise. It will not tell you what the market will do tomorrow or next week. But it does seem to govern our puny earth-bound movements over the longer term, like tectonic shifts that move continents in barely perceptible increments.
So let's start with a big number: the trade deficit of the United States. It currently stands at $805 billion. This means that Uncle Sam has exchanged lots of green pieces of cheaply engraved paper for clothes, sneakers, television sets, computers, automobiles, food, and just about everything you can find in a Wal-Mart. Pretty fiendishly clever of the Old Man! If the American consumer wants more stuff, he instructs the Fed to print more greenbacks to purchase it. He is running the world's best con game because he plays it out in the open. There is no con that beats transparency. The countries that sell us goods in exchange for our paper are dupes by their own volition.
Let's continue following the money. We have the $805 billion in foreign hands. What do they do with it? If nation L tries to convert it into its own Leeks, the Leek would rise so much that it would choke off L's foreign trade by making L's products prohibitively expensive. Most foreign currencies, like L's, are thus held hostage to the US dollar. The Swiss Franc is an exception because Switzerland does not raise the majority of its money from selling goods abroad. This is a major reason why our view at SKC continues to be to recommend that investors keep 25% of their net assets in Swiss Francs.
Another alternative for L is to use its stash of US dollars to buy oil from an oil producer like Saudi Arabia. This is a reasonable alternative, but it then leaves Saudi Arabia with an excess of dollars, so our money trail has not ended but rather has taken a brief Saudi Arabian detour.
An excellent alternative is for L to use its dollars to buy gold and then horde the gold in its own vaults. Until very recently, central bankers have been selling gold, not buying it. But maybe they are now waking each other up. More and more of them are deciding to add to their gold reserves. Although they are proceeding with a caution that under the circumstances seems excessive, the practice is bound to catch on-with spectacular consequences for the future price of gold.
At the present time, most of the $805 billion dollars in foreign hands has, at least until last year, been converted into US treasury bonds, primarily the ten-year bonds. This has helped provoke the infamous inversion between the interest rates on the ten-years compared to the two-years. But as more and more foreign holders realize that the interest they earn on US treasuries falls below the real rate of US inflation, they see little point in buying those bonds. Last year, the big creditor nations, including China, cut down drastically in converting their US dollars to US bonds. China and Japan still buy Ginnie Mae mortgages, which offer a considerably higher interest, in the perhaps mistaken belief that the US Fed will not allow Ginnie Mae to go bankrupt.
Is Uncle Sam Selling Out His Industrial Wealth?
Let's pick up the trail of the $805 billion. We have noticed some of it going into oil, some into gold, some into mortgages on private property in the US, and some of it (just out of force of habit) into US treasuries. But the bulk of it has not yet been accounted for. It will not go into the overpriced US real estate market. After the Sony experience, it won't go into buying Hollywood movie studios. Where will it go?
Into US equities. Right? In order to see why, we must look at the dollar not the way we normally look at it, but the way a foreign government or central bank looks at it. The foreign holder, for the reasons above given, really doesn't have much use for the dollar. Let's say, to oversimplify matters, that the foreign holder looks at a dollar as if it's worth 70 cents (in US currency). He may do so, to the extent that the foreign entity seeks board influence and/or eventual control. That point of view makes US equities very attractive to the foreign holder of dollars at current nominal prices.
Country L is willing to pay, out of the stash of dollars it is holding, 1.43 times as many dollars for Google or Southern Pacific Railway or Pfizer or even General Motors, than an American is willing to pay for those stocks. For example, if Google is selling for $350, to an official of state L who can pay in the US dollars it holds, it is as if Google is selling at $245 per share. Or in any given average stock on the Dow, what to American investors is a P/E of 20 looks to a foreign government like a P/E of 14. Thus, to the foreigner, the US stock market looks like a bargain, more so because he views his ownership as providing an economic asset that may lead to greater trade or business opportunities.
Let's pull a few numbers out of the air. Suppose the Dow were at 7,000. Then it would probably be reasonably priced to an American investor. But at 11,000, where it is now, it is only reasonably priced to a foreign government which has to park its dollars somewhere. If all foreign investors suddenly were to agree to a six-month moratorium on buying US stocks, the Dow would probably collapse to 7,000. It can also plunge, if there were an extraneous event that makes every foreign government skittish at the same time.
But, you might object, if American stocks look cheaper to a foreign holder of US dollars, then the same would be true of American bonds. Since bonds provide a higher rate of return than stocks, why wouldn't American bonds look even cheaper to foreign governments?
Indeed, that's exactly how foreign governments have been seeing things. US bonds have been more attractive to them than US equities. But then a funny realization set in: although bonds provided a high rate of return in interest, that interest was paid in US dollars which would then simply be turned over into more bonds. Thus, by holding bonds, you get more bonds. By holding more bonds, you get even more bonds than that. You become a bigger and bigger holder of US bonds. But all during this time the Fed is inflating the currency. Thus you may be holding more bonds, but their buying power might be declining. Eventually you realize that buying bonds is like running on a treadmill: you run as hard as you can but you haven't moved ahead.
The story is entirely different if nation L buys stocks instead of bonds. Stocks represent equity interests in corporations, whereas bonds only represent debt interests. If L buys enough shares in General Motors, L can wind up owning General Motors. But no matter how many US Treasury bonds L buys, L will never end up owning even a tiny fraction of the United States. Instead, if squeezed, the US can pay L back by printing even more money.
When we look at recent corporate transactions outside the stock exchange, we find that foreign governments are indeed willing to pay a lot more for American equities than their market price. This fact confirms the present thesis that American equities are more attractive to foreign holders of US dollars than they are to American investors. For example, in June 2005, China offered to pay a premium of two billion dollars for the American oil giant UNOCAL. But Congressional hostility to the deal was so immediate and strong that UNOCAL instead took the US Chevron offer at two billion dollars lower than the Chinese offer. In February 2006, the United Arab Emirates bought a British company whose assets included contracts to manage six major American ports. Again the howls from Congress reverberated through the country, with the result that the UAR backed off the deal.
If, instead of buying US bonds for the past three decades, Japan and China had used their dollar surplus to buy US equities, they might have accomplished by stealth what they now seek to accomplish in sporadic and controversial purchases. If, for example, UNOCAL were by now 55% owned by China through its purchases on the New York Stock Exchange for the past couple of decades, then China could have bought the remaining 45% of the stock by floating a tender offer to the remaining shareholders. This might raise some Congressional eyebrows, but it would be difficult for Congress to conceive of legislation that would bar a majority shareholder from making a tender offer for the rest of a company's shares.
To be sure, an objection to this line of reasoning could be made that in the long run the stock market will discount the long-term future of the equity in a manner that would result in the same price no matter who the purchaser. In that case, why are foreign governments different from individual investors? The answer was provided by Ludwig von Mises long ago. The value of money varies according to the time perspective of the holder. A person who desperately needs cash might feel the need to go to a loan shark and pay exorbitant interest for it. His short-term perspective requires him to place an extremely high value on money. At the opposite extreme, nations outlast us all. Their time perspective is measured in centuries. Thus, for this reason as well, the foreign nation that uses US dollars to purchase US equities is willing to pay more dollars for it than the individual investor.
Empirical support for the present thesis is the fact that over the past twelve months, when foreign countries have been shifting their dollar surpluses from bonds to stocks, we haven't experienced a single day when the Dow has gone up or down more than 1%. In fact, most days it fluctuates less than one-tenth of 1%. This kind of sideways movement is evidence of massive unhurried accumulation. For instance, nation L every year runs a huge dollar surplus in its trade with the US. It decides to purchase a basket of 100 leading American equities. Through a US broker, it places bids across the board on all these stocks. It never "reaches" for the asked price, but is content to wait until its bid prices are hit. If one of the stocks it wants happens to shoot upward, L's broker will back off rather than chasing it with increasing bids. If the stock were given a couple of months to settle down, maybe it would come back to its original price. If not, then the foreigner could increase the bid to the new level that the stock has achieved.
This kind of steady buying will make it increasingly hard for hedge funds to earn a living. Hedge funds thrive on volatility. But the slow and steady accumulation of US stocks by foreign countries places a "floor" under the stock market. And, when particular stocks spurt up, the foreign buyer backs off. Thus, rallies quickly lose their momentum. An artificial "ceiling" has been constructed over the stock market, simply by dampening bull-market enthusiasm. As a result, we would remain for weeks and months, where even a change of a half per-cent in the Dow could make the headlines.
So, at last we've come to the end of the trail. The money Uncle Sam causes the Fed to print in payment for imported goods finds its way, through a winding route, into the US stock market.
What if this process continues without stopping? Then all American corporations will eventually be majority-owned by foreign banks and governments. In effect, what the Fed is doing is keeping the American economy pumped up by the stealth sales of ownership interests in American corporations to foreign countries. It's a brave new world. Until reality sets in.
*Donald Dross is an associate of Japan Asia Investments; articles also appear under Sid Klein.
This letter has been offered into the public domain and may be freely copied or quoted.
DISCLAIMER: This market letter is intended to assist in the dissemination of information to private subscribers. The information contained herein represents Messrs. Dross's and Klein's best efforts in good faith to advance knowledge to SKC clientele, but there can be no implied guarantee as to its accuracy or completeness. The information is given as of the date appearing on this market letter, and Messrs. Dross and Klein assume no obligation to update the information or advise on further developments relating to the information provided herein. No solicitation to buy or sell securities is intended, and none should be inferred. Investments are inherently risky, but investment risk itself is a function of individual preferences. Thus any opinions, recommendations, or judgments expressed in this market letter are of necessity abstract and general. They must be modified, accepted, or rejected by individual subscriber/investors whose risk averseness cannot be known to either Mr. Dross or Mr. Klein.
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