TCS Daily

14,000 Reasons to Be (Mostly) Bullish

By John E. Tamny - July 26, 2007 12:00 AM

The Dow Jones Industrial Average's brief rise to 14,000 last week predictably engendered lots of commentary, including a Los Angeles Times op-ed by business writer Eric Weiner. Weiner's main thesis was that rather than a positive economic indicator, the buoyancy of stocks is rooted in heavy corporate takeover activity. While the latter is certainly a factor in the present bull market, Weiner chose to ignore various positive economic signs, along with the economic positives that result from takeovers themselves.

Weiner began by noting that, "Most finance experts agree that stock markets thrive during periods of steady economic growth and political stability." It seems paradoxical to him that U.S. shares could be rising amidst an economy "not clicking on all cylinders," not to mention a seemingly perilous geopolitical landscape.

On the economy, the alleged problem there doesn't so much have to do with its performance as it has to do with how the government measures GDP. Though trade deficits are simply the mirror image of capital surpluses, the fact that investment capital continues to flow our way regularly drives down GDP calculations. So while investment capital from around the world is bullish about US economic prospects, the latter works against traditional measures of economic growth.

The moderation of real estate prices has similarly shrunk GDP numbers, but despite the conventional wisdom, this is a bullish sign, too. Indeed, other than gold, real estate is arguably the safest asset category on the planet. Rather than an economic positive, periods when it outperforms stocks and other asset classes are times of a high degree of risk aversion on the part of investors. Booming housing markets are rarely indicative of booming economies; usually the opposite.

For proof, we need only look at numbers provided by the Office of Federal Housing Oversight (OFHEO). While the OFHEO Index continues to show year-over-year gains in home prices, it's certainly true that at least as far as GDP goes, moderation there has and will continue to impact the latter negatively. Still, there's potentially a silver lining here for equity investors.

Measured over thirty years, OFHEO statistics show that booming property markets are frequently bearish for stocks. Annual home-price appreciation since 2000 has averaged 8.96 percent. Over this timeframe, the S&P 500 has risen 28 percent. On the other hand, annual home-price appreciation averaged 2.9 percent during the 1990s, yet the S&P rose 317 percent. The housing market also boomed between 1972-74 and 1976-79, yet stocks were down during both periods. As housing cooled off over the past year, stocks rallied yet again, with the Dow up 26 percent since last July.

While the geopolitical landscape is unsettled as Weiner describes, he omits the happy truth that with a Republican in the White House and Democrats controlling congress, the political situation stateside is a market positive. Supply-side eminence Arthur Laffer once pointed out that President Clinton's scandals made him a market friendly president for his inability to do much in the way of passing laws. A similar concept is at work today alongside a Fed, which while it has surely mismanaged the dollar, is at least presently not harming stocks with more in the way of ineffective interest rate hikes.

But according to Weiner, corporate takeovers are driving the present bull market exclusive of the above, and that investors should look to the 1980s to understand what's happening now. The problem here is that his comparisons are provably false and contradictory.

Weiner says, "Takeovers became a big story in the 1980s because, much like now, cash was cheap and readily available." The latter is interesting because in the next sentence, Weiner asserted that much of the money that financed those takeovers "came from junk bond (my italics) king Michael Milken." Remarkably, he failed to note that junk debt by definition was and is expensive, rather than cheap. In addition to debt being expensive back then (the 10-year Treasury yield averaged 10.6 percent in the '80s versus 4.94 percent today), the dollar's value versus gold and other currencies skyrocketed in the '80s; much the opposite of today's weak dollar. The dollar was certainly weak in the '70s, but there's no evidence that a broad takeover boom or stock rally occurred that would bolster Weiner's view that inflationary monetary policy drives takeovers.

Weiner added that, "in typical Wall Street fashion, the good times ended with an orgy of greed an overreaching." Weiner cited Michael Milken's imprisonment as the final nail in the '80s buyout boom, but as University of Chicago Professor Daniel Fischel has noted about Milken, "He was driven out of business and forced to plead guilty to crimes that previously did not exist." And rather than a bubble that simply popped, the buyout boom ended in the late '80s when the federal government forced the savings & loans (S&Ls) to sell off their high-yield (junk) holdings; the latter at the time the most profitable asset class in S&L portfolios other than credit card debt.

Weiner asserts that just as it did back in the '80s, "rampant speculation" about takeovers has "helped push the stock market to record levels." Implicit there is the assumption that markets, rather than discounting the future, merely respond to present activity. In truth, if the markets felt companies were being bought just to be bought, stocks generally would be falling to discount a future of mismatched and mismanaged public companies.

And allowing for the fact that takeovers drive up the value of the company acquired, the unseen here cannot be forgotten. Takeovers are not only frequently positive for the acquired company experiencing a "streamlining" (Weiner's word) of its operations, but they also impact the vast majority of companies not taken over that aggressively right themselves to avoid a similar fate. In short, to comment that the present takeover boom is driving up equity prices is a tautological statement of the first order. Actions meant to improve the operational efficiency of firms would by definition lead shares higher.

Weiner concluded his piece with the thought that, "everyone cheering the stock market's historic climb might want to keep the champagne on ice for now." He's right, albeit for the wrong reasons. J. & W. Seligman president Charles Kadlec has long said that, "Bull markets don't die of old age, but do to policy failure." Much as government policy in the '80s ruined Michael Milken and ended the takeover boom, Sarbanes-Oxley turned a market correction into a rout after the '90s tech boom.

At present, Congress looms large with tax changes that could potentially impact the individual incentives surrounding takeover activity, while the Fed's misbegotten view that growth causes inflation means the dollar continues to be managed in a non-credible way. Geopolitically, problems in the Middle East could always potentially spill over here in a way that is inimical to economic growth and stock prices. So while this bull market could always end, it should be clear that policy mistakes and geopolitical uncertainty, rather than greed or hubris, will tell the story of its demise.

John Tamny is editor of RealClearMarkets. He can be reached a



And 36,000 to be (Seriously) Bearish
The approximate readership of The American-

The real reason why stock prices are up.
This is stupidly simple. Borrowers use money purchased now to buy stuff (including business capital stuff) and then plan to pay back the money when it is worth less in the future. This means that consumers are buying stuff and corporations are buying capital to make the stuff for consumers. This leads directly to increased corporate profits.

There is a red-herring in this plan that eventually borrowers will over-extend themselves and SLOW the borrowing. This will cascade through out the economy and is right now driving stock prices down.

it doesn't matter how many times eric has reality explained to him
he sticks to what he wants to believe

A quick question about GDP
Can anyone help explain this statement:
'the fact that investment capital continues to flow our way regularly drives down GDP calculations'


Let's work on that...
The author's full sentence was: "Though trade deficits are simply the mirror image of capital surpluses, the fact that investment capital continues to flow our way regularly drives down GDP calculations."

Gross Domestic Product (GDP) is composed of Consumption + Investment + Government Expenditures + Exports (Net of Imports).

Consumption includes spending for durables, non-duable goods and services.

Investment is into balance sheet, fixed assets and net inventory increases.

Government spending is net of certain transfer payments such as welfare (so it would not be double counted as consumption).

The Export component has Imports backed out. And this is where some confusion dwells.

Consumption, Investment and Government spending are direct measures of just that. What we have spent. The implication is that this is also what we have produced. But that is incorrect. What we spend is only an indirect measure of what we produce because some of what we purchase is imported and (therefore) produced by someone else. Never mind that those people mostly work for our own companies (and we earn most of the profit thereby)...the production itself is not domestic.

Great. Makes us look more productive and definitely makes us more profitable!

The one measure that such importation has the least impact on is the export number. Nevertheless, it is convenient to calculate the GDP with a Net Export component without breaking out which of the other components were thereby reduced by imports.

Another confounding element here is the fact that most of our companies with a global presence "capture a margin" in their offshore entities (to reduce their total tax burdens) by inflating the dollar value of the goods they import. These higher values make our importation measurments higher and thereby reduce our GDP numbers artificially. But that anomaly is not what the author is talking about here.

The author's actual statement is flawed in two different ways. In the first place he relies on the common assumption that trade deficits result in a pile of actual dollars that must come back to us in the form of investment into our debt liabilites or our equities. This is simply wrong. Virtually all of the funds tendered to a foreign entity to pay for imports are converted into local currencies by the foreign exporting entities, within their banking systems and at the prevailing FOREX rates. The daily trading volume at FOREX itself dwarfs any such underlying commercial activity. The electronic balances involved in actual trade are simply converted from one currency denomination into another whereby the original currency simply ceases to exist and a new currency balance is created by the bank. There is no mountain of dollars piling up out there. I know this does not seem intuitive...but that is how it does works.

If foreigners need dollars to travel here or to invest here then they go back to the bank and purchase those dollars at the prevailing rate.

The author is incorrect when he states that "trade deficits are simply the mirror image of capital surpluses". He can be forgiven because this fallacy is ubiquitous.

However, his statement that "investment capital continues to flow our way [and] regularly drives down GDP calculations" is patently wrong. Investments into financial instruments are not counted.

When foreign investors purchase our debt instruments or our equities there is no direct impact on GDP measures. When foreign investors own a company over here and purchase balance sheet assets for themselves (with money they earned or borrowed abroad) then this increases our GDP number. Similarly, if US companies have access to foreign capital much of that money underwrites purchases of capital assets or inventory builds. Again, positive. (Of course, when foreigners come here with dollars and stay in a hotel...positive impact!)

Insofar as excess foreign capital drives down interest rates our GDP should actually be stimulated.

And now regarding the FED. If any such excess liquidity (from abroad) became inflationary then the FED might need to do something about this. And that is indeed a tricky business.

The author further states that the "Fed...has surely mismanaged the dollar" but gives no evidence regarding what harm was done or the mechanisms whereby the dollar might have been mismanaged.

In fact the dollar is doing great and our inflation rates have been healthy.

That the dollar is weak and that the Fed is inept are commonly held, incorrect assumptions that lead to fundamental mistakes by some economists and confusing statements by many writers.

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