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Reality Check

October 9, 2002

As a rule of thumb, the higher up in an organization structure one rises, the more basic one needs to get in one's thinking in order to ensure that dumb decisions are not taken as a result of misplaced enthusiasm of more knowledgeable but less experienced executives down the line. It's called "applying a reality check".

The level of complexity that is being applied currently to economic thinking and debate is nothing short of mind boggling. The economy is/is not in a recession. It will/will not enter a recovery mode in the first/second/third/fourth quarter. The Fed must/must not lower/raise interest rates.

Let's apply our own reality check. Here are a few simple facts that even the brain of a 12 year old can grasp:

  • The Federal Reserve has cut interest rates (reduced the price of money) around eleven times in the past two years
  • Despite this, stock prices in the past two years have fallen.
  • On the other hand, house prices have risen.
  • Even though stock prices have fallen, the overall P/E ratio of the S&P 500 is still hovering around 30X. What this means is that at current levels of after-tax earnings, it will take approximately 30 years to get your capital back. Alternatively, it means that the market is anticipating rapid economic growth, which will facilitate a reduction of P/E ratios over time - assuming stock prices continue to hover at these levels.
  • The Producer Price Index is providing evidence that the supply armies' forces seem to be overpowering the demand armies' forces.

How can we apply a reality check to the above?

Here are two Tables which illustrate what could happen if interest rates on home loans are reduced:

Table 1 shows that the home owner will have more money in his pocket, provided he remains in his existing home and does not increase his mortgage

Table 2 shows that the home owner has leeway to increase his mortgage without increasing his monthly repayment

Fact: Home prices have risen dramatically over the past couple of years, evidencing that some people have opted to buy better houses (as opposed to increasing day-to-day consumption)

Fact: Fannie Mae recently announced that in cases where people raised their existing home mortgages and "cashed-out" to purchase something else, delinquency rates have risen.

So it would appear that reducing interest rates to stimulate the economy may not have been a good idea. People either tended to trade up or consume equity capital. People who chose to increase consumption have displayed unacceptable levels (to the lenders) of irresponsibility.

By the same reasoning as above, zero interest rate motor car loans have allowed people to trade up - as opposed to buy more cars. Yes, more NEW cars have been sold, but what has happened to the USED car market?

Where to now?

Unfortunately, further reduction of interest rates will probably not stimulate the economy given that lenders like Fannie Mae have recognised an increased propensity of some consumers to become irresponsible. It follows that any further cuts in interest rates will more than likely lead to increased savings than increased consumption - with a slim possibility that house prices could continue buoyant.

The following seems reasonable:

  • People who remain employed will either continue to trade up their houses or will use most of their additional income to repay existing debts. In either scenario, the economy is unlikely to expand significantly
  • Businesses, sensing that the economy will not be growing significantly from this point forward, will move to cut costs in order to increase profits. Unemployment will start to grow.

But P/E ratios are factoring in significant "compounding" growth in profitability. Cutting costs cannot give rise to anything more than a one-off increase in profitability.

Conclusion

Applying a reality check leads to the conclusion that the equity markets have nowhere to go but down, until the point where P/E ratios "normalise" at around 10 - 12 X earnings per share

Which begs the question:

What, other than rattling sabres on the international stage, and posturing for the media, are our political leaders proposing to do about all this? So far we have had two proposals:

  • Bring back Osama bin Laden "dead or alive", and wage war against all other terrorists until hell freezes over.
  • Wipe out Saddam Hussein

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