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The Big Picture

(November 16, 2003)

I am going to discuss the big picture here, and I mean the really big picture.  I came across this quote last week, and I would like to share this with my readers:

"I place economy among the first and most important virtues, and public debt as the greatest of dangers to be feared. . . . . To preserve our independence, we must not let our rulers load us with public debt. . . . We must make our choice between economy and liberty or profusion and servitude." (Thomas Jefferson)

A prosperous society has never maintained its status by consuming more than they have and living beyond its means.  Think of the Romans, the various imperial dynasties in China, and 20th century Britain.  Think of the typical American household and your household.  What happens when your credit cards are maxed out or when your living expenses are beyond your income?  Why, you cut back, of course.  Take a look at the following chart from Comstock Partners, Inc., and it is obvious why I think America is on his way to a collision course not dissimilar to the ones taken by the Romans and 20th century Britain.

Total Credit Market Debt (All Sectors) As % of U.S. GDP

The total credit market debt (government, business, and households) as of the end of this year's second quarter is $32.9 trillion, which would put it at over 300% of GDP - a figure never seen before in modern American history.

My grandfather passed away on the 1st of this month and his funeral was held last Saturday on the 8th.  In the eulogy that I delivered, I praised my grandfather on his ingenuity, admirable worth ethic, his philosophy of self-dependence, and his financial conservatism.  He never lived beyond his means, and yet he still lived a comfortable life.  He was also very happy, spending the later years of his life with his family here in Houston.

His belief of financial conservatism was shaped by events early in his life in 1930s and 1940s Hong Kong - when mortality was high, food was scarce, and government assistance was non-existent.  He led a hard life as a business owner specializing in metalwork but he was a free man - free because he was his own boss, free because business in Hong Kong was not overly regulated, free because of low taxes, and free because he had no business or household debts so he had no creditors to answer to.  His philosophy of economy also allowed him to save a huge cushion of money for use in a "rainy day" - enough money to build a few apartments during those early days.

Hong Kong prospered after World War II because of people like my grandfather.  The opportunities were there and people were encouraged to pursue them.  People did not seek security because there was not any.  Saving and investing was greatly encouraged - and the payoffs were huge.  Not working hard was generally frowned upon -- people worked seven days a week under harsh conditions.  There were no such things as 30-year (or for that matter, any n-year) mortgages or financing your car purchase.  People did not consume today.  Instead, they saved and invested, hoping for a better tomorrow. 

The story is different today, here in America and in Hong Kong.  The above graph is a prime example of a society that has enjoyed too many years of stability and prosperity and living well beyond its means.  Like I said to one of my friends, peace and stability has bred mediocrity and laziness in nearly every one around me (myself included).  Aside from your typical immigrant from a developing country, what you have here is a huge number of people who have always enjoyed life and who cannot deal with economic adversity.  We rely too much on other people to look out for us.  Some of us work hard but are unprepared for changes.  Every one of us is encouraged to seek security and study a "safe major" in college such as business or engineering.  We may work over 50 hours in our job every week but we fail to keep track of and to prepare for the bigger picture.

Our consumption of material goods have also grown exponentially.  Instead of 2,500 square feet houses, we live in 5,000 square feet houses.  Instead of driving Camrys and Tauruses, we drive Hummers and Lexus.  And instead of saving and investing time in our families, we put everything on our credit cards and bet our retirements with speculations in the stock market.  Make no mistake - the S&P currently has a trailing P/E of 30 and a miniscule dividend yield of 1.7% -- if you're putting money into the stock market today, you're purely speculating.  That is all you are doing.

Just like Thomas Jefferson "predicted," most of us in society today have been enslaved.  If you hold a 30-year mortgage in your house, you have become enslaved to your house (or in other words, enslaved by the banks).  Likewise, if you have college loans outstanding, you have become enslaved.  If you are currently working for someone else and have no ambition of starting your own business, you have probably become enslaved forever.  The typical American today does not have any chance of being able to retire at 65 and to maintain his or her current standard of living for all the reasons I mentioned above, and the fact that Social Security will need to be cut back in the next few decades (unless we can tolerate much higher taxes or much lower defense spending).   It is also interesting to note that if Jefferson was alive today, he would probably be calling for "revolution" once he sees what kind of taxes we are paying. 

If your typical household or business was run like the United States of America, it would have gone bankrupt a long time ago.  Or worse, members of that same household or business would have gone to jail.  It is not unlike the "wealthy household" with lots of farmland but which spends 105% of its income every year from its produce and rack up huge debts with its creditors.  Or for that matter, Enron.  Sooner or later, this huge "house of cards" will tumble, taking everyone down with it.

My opinion is that in the next five to ten years, the typical American household will be handed a harsh lesson in financial conservatism and in independent thinking.  Globalization has given the world a more level playing field - America has now totally lost its comparative advantage in virtually everything from manufacturing to software development.  50% of the world's population lives on less than two dollars a day and you can bet that countries like China and India will be flexing their muscles on getting what they want.  Current demographic trends also suggest that Western Europe and Japan will decline in relative economic power.  No longer will America be able to dictate terms at will.  In the worst case scenario, the U.S. dollar will lose its reserve currency status and if that happens, the current standard of living we have enjoyed over the last 50 years will come down drastically.

I will discuss the stock market in more detail next week but to sum up the current situation: I do not like this market at all.  Breadth has been getting narrower and on a relative strength basis, the biotechs have been lagging since July.  To refresh one's memory, the biotechs also lagged before the start of the decline in May 2002 and it has not happened again until now.  Walmart also missed earnings (and stated that they did not see the recovery that most of us are "seeing" out there) and Applied Materials had a huge reversal after they released earnings and told everyone (for the umpteenth time) that the recovery was finally here (you can read more about AMAT here).  The Nikkei in Japan has now broken 10,000 as I am writing this and it looks like it has completed a huge heads and shoulders pattern.  The four-week average in mutual fund inflows as of last Wednesday (per www.amgdata.com) was at a 30-month high and even that failed to move the market in any sort of meaningful way.  M-3 also declined last week again.  The fact that gold rallied to a seven-year high is also another red flag for the stock market.

My conclusion: I still believe the market will not top out until sometime early next year but in the meantime, the stock market may correct at any time - especially given that we have not had a meaningful correction in eight months.  Even if the stock market does not top out until next year, any upcoming rallies should be narrower in breadth - so anyone without superior stock-picking skills should probably think of selling their holdings in the next few months.

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