Global Liquidity – January 2007

January 17, 2007

Dow Jones Average: 12,583
S & P 500 Index: 1,432


Global Liquidity

Equity markets around the world did better in 2006 than many had predicted. A pullback or low return year for stocks would not have been surprising, given the share price increases of the previous three years, the decline in housing prices, higher interest rates, the mid-term elections, and international events. The U.S. stock market was in the red through late July, at which point it reversed course and rose without interruption through year end. When stock valuations become high as they are now, many analysts attribute the rise to excess global liquidity ( lots of money floating around) chasing the existing supply of stock. The concept of a stock shortage gains credence when analysts are having difficulty explaining or justifying the level of stock prices.

Global liquidity grows as individuals and businesses increase the level of their assets and their debts. When interest rates are low, borrowers are able to take on more debt. The low interest rate policy of central governments in Japan, Europe, and the U.S. has helped fuel borrowing and asset inflation of stocks, bonds, and real estate. The steep rise in real estate prices in much of the world has put more equity onto the balance sheet of property owners, which has allowed those owners to borrow against the equity or sell their property for a high price. Changes in real estate values are immensely important, because the total value of real estate worldwide dwarfs the assets represented by shares of publicly traded stocks. The value of real estate in the U.S. alone has gone up by many trillions of dollars over the past six years. Americans have been extracting some of that gain and spending it on everything from college tuitions, Japanese cars, foreign oil, and a flood of products that are labeled “made in China”.

China now holds the world’s largest foreign currency reserves at 1.1 trillion dollars, with Japan in second at 750 billion dollars. The world is awash with U.S. dollars, as the borrow and spend policy of the U.S. government and the average American consumer continues unabated. The export driven countries, such as China and Japan, depend upon the U.S. market, and the U.S. needs low interest rate loans from them to finance the spending. In the business world, the practice of loaning money to a customer of the business is called vendor financing. Continually loaning money to customers who are financially weak is considered to be a risky, unsustainable business policy. As the years tick by and the balance of world economic power shifts, China may reassess its role as a low interest rate lender to the United States.

Going into debt by spending beyond the nation’s means seems to be helping America at the present time. The expansion of debt creates more money in the system, some of which flows overseas as Americans buy foreign goods. The foreigners save money, put it in their domestic banks, and the banks return it to the U.S. by investing in our bond, mortgage, and stock markets, which drives our financial markets higher. It seems to be a happy picture all around, but there is something wrong with it. The pressure of greater indebtedness and excessive generation of currency will eventually take its toll. The downside of excessive global liquidity is inflation and currency devaluation. The U.S. dollar is one of the most vulnerable currencies, because of the trade deficits. One measure of a nation’s wealth is the buying power of its currency in the world marketplace. A significant drop in the U.S. dollar would illustrate the fact that overspending has negative consequences.

p align=”left”>For the past few months stock market investors have greeted every bit of positive economic news with a great sigh of relief. Economic weakness in the U.S. could put the Federal Reserve Board in a very difficult position. The Federal Reserve Board raised interest rates seventeen times between 2004 and 2006. The effect on the U.S. dollar was neutral. Typically an increase in interest rates will produce a rise in the value of a country’s currency. Because there is a glut of dollars worldwide, it seems to take a higher level of interest rates in the U.S. just to keep our currency from moving lower. If the Fed is forced to cut interest rates to stimulate a weakening economy will the dollar collapse? Would the Fed have to push interest rates right back up to stop a slide in the dollar? Most countries that are deeply in debt and hostage to foreign investors have to make such moves to protect their currencies. The biggest risk facing investors in U.S. stocks and bonds is a Federal Reserve that is caught between protecting the economy or protecting the value of the U.S. dollar.


Current Strategy

Holders of capital earn lower returns when there is too much capital available for investment. It may seem that lots of capital hunting for investments would drive investment returns higher. Actually over a longer time frame, capital will be less rewarded when it is abundant as opposed to scarce. When capital poured into financial markets in 1999-2000 it set the stage for low returns over the subsequent seven years. In the midst of the buying frenzy of 2000, Warren Buffett cautioned that investors should be prepared for returns of about five percent from stocks going forward. Most investors thought that he was out of touch, because investment returns had been closer to fifteen percent per year for the preceding eighteen years. As it turned out even Buffett’s five percent forecast was too optimistic.

After a rebound from the deep lows of 2002, we believe that the market is once again perched at a level that portends lower returns going forward. Our proprietary stock evaluation system that we have used for 25 years indicates that stocks are generally overvalued. At the 2000 market high, technology stocks were insanely high and scored terribly on our evaluation scale, while other groups such as food, railroads, and homebuilders were under priced, and scored well using our evaluation methodology. As we enter 2007 we are faced with a market that is uniformly high. Over the past few years every stone has been turned over as investors have scoured the investment landscape searching for some undiscovered investment possibilities. There are few undervalued stocks left, outside of energy stocks that have declined due to the abnormally warm weather in the Eastern United States.

In high markets our strategy is to take gains and wait for buying opportunities to materialize at a later time. We think that the large flow of institutional money into hedge funds, private equity funds, and exchange traded funds is a sign that investors are becoming more aggressive and blindly throwing money at the market without considering equity valuations. This kind of behavior often correlates with market tops. Even though we are selling more than buying at this time, we continue to look for special situation stocks that can prosper in difficult market environments. Innovative companies in the medical and technology fields have often been able to defy weakness in the economy and the stock market. We intend to buy stocks more aggressively after a significant correction. The trigger for a downward move in stock prices could be a simultaneous drop in the U.S. dollar and the U.S. economy.

Our fixed income strategy has not changed in recent months. We are comfortable with U.S. Treasury bonds of relatively short term duration that yield about five percent. We have also purchased inflation protected securities that are priced to yield about 2.75 percent over the rate of inflation. We think that some protection against inflation is wise as governments have a history of favoring inflationary policies.

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