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Whether to put your money where your head or heart is

By Neville Bennett

Friday 20th June 2003

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I had a terrible head-heart dilemma before the last rugby test. As a patriotic Kiwi, I was fairly confident of attacking power of the All Blacks, but I was most respectful of England's defence and experience. My heart said bet on New Zealand. My head said bet on England.

Wall Street presents a similar dilemma. As a personal investor, parent and trustee I need shares to deliver a good return and I welcome bull markets.

I have some "value" stocks but shares are a small part of my portfolio. Should I switch some liquid resources into stocks now? Is it a good time?

The Dow Jones has surged 20% since March and no investor wants to miss the bus. The bulls are bellowing and enjoy heaping ridicule on the contrarians.

CBS Marketwatch is pointing the borax at three contrarians who boldly predicted the Dow would not surpass 9000. Marketwatch is busy making them eat their words.

Wall Street's most harassed figure is Richard Bernstein, Merrill Lynch's top strategist. He has stuck to his guns, insisting the market is overvalued and the rise is a bear-market rally. He warns the driving forces are tech stocks ­ the very area of the economy in which overcapacity is at its highest.

Surfing through think tank sites, I found my attention was arrested by Mises.org, which combines the qualities of dispassionate economic analysis with an Austrian School objectivity. Frank Shostak, chief economist at Ord Minnett Futures, Sydney, posted an analysis of the bull market on June 11. Dr Shostak asserts bull markets depend, in general, on a continuous increase in money supply. He associates this with a growing stock of real wealth and a growing percentage of businesses "making real profits."

There must be ever-expanding injections of money and rising profitability. If there are difficulties in maintaining momentum there will be oscillations. If businesses lose profitability, there will be a downturn in the stockmarket.

This is the kind of argument I encountered in the history of economics. It seems to assume the US is a closed economy and not subject to global capital flows. It is a novel point of view.

There is also some sleight of hand in the treatment of savings. But the emphasis on money supply is interesting, for Dr Shostak uses an unfamiliar measure of AMS (an Austrian definition of money supply) by which money supply fell 6.5% in January 2001 (setting off the bear market) and AMS rose 5.5% recently, underpinning the present rally.

He observes that "looser money can only reshuffle a given pool of savings;" if savings are stagnant, a stockmarket rally cannot be sustained. He then proceeds to a masterly exercise in which he demonstrates the stock of wealth is under pressure.

He believes consumer net worth has fallen 10% in the year and the ratio of financial debt to GDP has jumped to a record 1.965. Similarly, the income-to-consumption ratio has deteriorated.

The argument then switches to Dr Shostak's assertion that the US Federal Reserve's loose monetary policy has arrested the pace of liquidation of past excesses. Here the reader encounters some interesting ratios, including durable to non-durable goods and business equipment to durable goods.

The evidence is suggestive rather than conclusive but it appears to prove, without using the usual employment or GDP data, that there is no economic recovery.

The evidence is more appealing when it switches to the familiar P/E ratios, which stand at 34.5% ­ almost double the historical average of 18. The dividend yield on the S&P 500 is a mere 1.78%, in contrast with the historical average of 4.6%.

Given this situation, the only reason stocks are rising is that the Fed is pumping cash into the economy. The comparison with Japan is apt. The Japanese lowered interest rates to near zero but stock prices have trended down for 12 years.

The conclusion is the ability of business to generate more wealth is impaired at present. This precludes the possibility of a sustained economic recovery and thus "the emergence of a durable up-trend in stock prices." Does your head or heart still feel that this is the time to plunge?

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