Dow 10k: The Higher They Rise, The Harder They Fall

The Dow Jones Index Average (DJIA) closed above 10,000 yesterday. Unfortunately, hardly any American understands the reasons for the increase and bounce off the March lows.

Most DJIA companies receive at least half of their revenues from abroad. Coca Cola (KO), McDonald's (MCD), Procter and Gamble (PG) have been expanding overseas for decades. Even Wal-Mart (WMT)--unfairly stereotyped as a rural, "red state" store--has been expanding aggressively in Mexico, the U.K., and the EU.

Why are these international forays relevant? Over the past year, the American dollar has collapsed. The Canadian dollar, once the laughingstock of the world, is almost at parity (again) with the American dollar. Almost every major currency, except for the Mexican peso (FXM), has increased approximately 30% against the greenback. Thus, as a result of international sales, most DJIA companies will receive an artificial boost in earnings per share due to the dollar's decline. For example, let's say GE sold 1,000 widgets in Germany in February 2008 and made 1,000 dollars. If GE sells 1,000 widgets at the same price one year later, it will record approximately 1,300 dollars. On paper, GE appears to be making 30% more money; in reality, nothing has changed except currency values.

While the dollar's weakness has caused an artificial boost to earnings per share, the DJIA has also increased because other countries' currencies are strong or artificially depressed. For example, despite some barbed words between China and America, China continues to depress the value of its currency. China is smart to do so--its manufacturing sector is still booming (while America's is declining), and a weaker currency gives Chinese companies an advantage in exporting their products. In the meantime, the euro and yen continue to be strong. The ECB, unlike the Federal Reserve, has a singular mandate to maintain a stable/strong currency, and Japan's Finance Minister doesn't seem interested in devaluing the yen.

Where does that leave the United States? It leaves American companies in a stronger position to sell products to Europeans, the Chinese middle class, and the Japanese. In fact, I would not want to own any Japanese or EU-based stocks right now. European and Japanese companies now have to compete against American products, which will be cheaper because of the dollar's decline. Although American products used to have quality issues when compared to European and Japanese products, most American companies have closed the quality gap. Thus, I see American products cutting into "home-team" sales in Europe and Japan, especially with Germany being more willing to open up its markets to outside competition.

One exception to increasing American dominance will be European healthcare companies, because European governments subsidize healthcare. Thus, if you own Sanofi-Aventis (SNY), Roche, or Novartis AG (NVS), you may ignore this paragraph. Meanwhile, the Chinese will continue diversifying away from the American dollar by buying hard assets and commodities. The Australian and Canadian dollars will continue to benefit, and the American dollar will continue to look for support.

Why should American investors care about these currency-based developments? The DJIA has increased because companies and investors expect the weak American dollar to boost spending by Europeans, British and Japanese consumers. If the foreign consumers fail to buy, the market's gains may perish.

What about Indian and Chinese consumers? Although both countries have increased the size of their middle class, Indian and Chinese consumers tend to save money, not spend it. While this cultural predilection towards saving may change in ten or twenty years, it is naive to believe that Chinese and Indian consumers will spend enough now to return the world economy to its glory days. Although it is easy to imagine Americans (and Russians) spending like drunken sailors, it is more difficult to imagine Chinese and Indian consumers spending money they don't have. (Note: I said spending money they don't have, so please don't cite Indian gold-buying binges and opulent weddings, which are usually paid with cash or some other non-credit source.)

Why do I lack faith in the Chinese and Indian consumer? Currently, Chinese and Indian culture tend to focus on family and tradition, not individualism, which dampens unreasonable materialism. Of course, this is changing, but for now, I believe my hypothesis holds true. If I am correct, that means Mr. Market expects Europeans, Russians, and Japanese to spend enough to boost the world economy, and this expectation is already priced in the DJIA. God help the DJIA if this increased spending fails to occur.

There are other signs Mr. Market has gotten ahead of himself. First, look at the price of gold. Gold is an excellent barometer of consumer sentiment. Right now, gold is above $1,000 an ounce, which tells you that consumers are skeptical about any long-term economic recovery.

Second, don't forget the U.S. unemployment rate. It keeps getting worse, and the BLS numbers don't seem to accurately record people working multiple jobs or people who've given up looking for work. Also, as an employment lawyer in Silicon Valley, I'm seeing some unique layoff notices, which might disrupt any steadily improving employment numbers. For example. some major companies are informing employees that they will be laid off in six months unless they find another position within the company. (This unique form of notice is done partly to comply with the federal and state WARN acts.) In addition, a small business came to me yesterday for advice on laying off one employee. My limited personal experience indicates the unemployment rate is getting worse, not better.

Why does the unemployment rate matter if it's a "lagging indicator"? Without a lower unemployment rate, wages will stagnate or decline, and consumers cannot and will not spend. If American consumers do not spend, then businesses will not spend or hire. Surely, you see the problem: if the Europeans, Chinese, and Russians don't come through, and the United States continues to have a high unemployment rate, no one will be left with the financial capacity to boost the world economy.

What, then, is a conservative investor supposed to do?

1. Recognize that the DJIA's recent gains are due in part to artificial reasons, not organic reasons like increased sales or better margins.

2. Understand that cash is still king, even though it may not feel like it. I, too, grit my teeth over abysmal money market rates, but I also own foreign currencies (FXA, FXC, CYB) to earn more interest.

3. There is some debate about deflation versus inflation. I have hedged my bets by buying a seven year Treasury note paying 3% and also iShares Barclays TIPS Bond (TIP); T. Rowe Price Inflation-Protected Bond Fund (PRIPX); and Pimco 1-5 Year U.S. TIPS Index Fund (STPZ). Months ago, I added a GNMA fund (PRGMX) to earn a higher yield. Even with these investments, most of them in retirement accounts, I am still cash-heavy.

Mr. Market's recent euphoria--caused by currency fluctuations, expectations of foreign spending, and stimulus money--should subside in time. While everyone else seems happy to party like it's 2006, I will be ready to take advantage of opportunities in 2010. As the DJIA rises day by day, I am reminded of Shakespeare: "Only / Vaulting ambition, which o'erleaps itself, And falls on th'other..."

Disclaimer: The information on this site is provided for discussion purposes only. Under no circumstances do any statements here represent a recommendation to buy or sell securities or make any kind of an investment. You are responsible for your own due diligence. To summarize, I do not provide investment advice, nor do I make any claims or promises that any information here will lead to a profit, loss, or any other result.

Comments

[Highonlife:]

You talk about opulent weddings in India. Or at least people do. How much does it cost to have a full fledged church service, with caterers and everything in the US. Id say it goes beyond a 100 grand? in USD.
id say that the average indian wedding doesnt go beyond 25-40 grand USD.
And gold buying binges? Its an asset class. Buying gold is viewed as a form of savings and investment. Same with Jewellery.

Oct 15 04:50 AM

[Matthew Rafat:]

Correction/revision to article: Currently, Chinese and Indian culture tend on family and tradition, not unbridled individualism. Such a family-oriented, traditional approach dampens unreasonable or wild materialism."

Oct 15 05:32 AM

[Daniel Herkes:]

Thank you for the interesting article. The rally is mostly hot air, and the 10 000 mark is without value. I contrast this time to the early eighties when the interest rates were near 15%. Cash was king, and the seeds of destruction caused by the strong dollar were being sown.

Oct 15 06:23 AM

[174vishal:]

Dear Highonlife,

Difference is in the USA few people actually get married and few spend a 100k, in India most get married, and the fact that they buy gold, an asset class, means less consumption. Both facts which support the authors position.

BTW dowry alone will often surpass 40k. At my wedding we had 1500 for a sit down dinner. Friends who are better connected then I had 5000. And your prestige is based not on how many you serve but the quality of the food.


On Oct 15 04:50 AM Highonlife wrote:

> You talk about opulent weddings in India. Or at least people do.
> How much does it cost to have a full fledged church service, with
> caterers and everything in the US. Id say it goes beyond a 100 grand?
> in USD.
> id say that the average indian wedding doesnt go beyond 25-40 grand
> USD.
> And gold buying binges? Its an asset class. Buying gold is viewed
> as a form of savings and investment. Same with Jewellery.

Oct 15 06:37 AM

[Leftfield:]

The massive insider dumping into this rally and the facilitation of market manipulation via a couple of $trillion from taxpayers to Wall St., need mention.
Culturally, Americans have not only spent like drunken sailors but have invested aggressively in recent decades. While government and Wall St. lies have created an epic debacle already, culturally we still lust for a high return on capital even with the consequences of continued lies, and painful shoes to drop, imminent.
Government and Wall St. make out so well with this system that the protection racket and confidence game continues. There is yet value to kill in the dollar, that they can monetize during dollar descent. Investors, driven by negative safe yields, seem ready to believe and chase risk. Return OF capital has yet to become as important as chasing return on capital.

Oct 15 06:51 AM

[tripleblack:]

Timing the elevator is critical. I have now left the elevator, except for commodities, and am waiting for the down cycle to buy back in.

We will see how long the wait is. I do not think I will have to stand in line.

Oct 15 08:26 AM

[enigmaman:]

Good analytical article but I think you are giving way to much credit as to why investors are buying this market, most that are buying are doing so because its simply keeps going up and they dont want to be left behind, they choose to believe the less then good news we get is actually better then the expected news. Nothing really matters when your living in a world of make believe, I know the market can stay irrational longer then you can stay solvent or something to that effect but what it doesn't say is that it can do so forever, so one day it will be over but when is anybodies guess, when it does we will find out like we always do, long after the fact and the resulting carnage,

"The wiser person yields, but the donkey doesn't, and falls into the brook."

Oct 15 08:48 AM

[connorport:]

You have to also consider how the Government handles the credit markets and banks. They are pushing lending back out there and many people are like the author and have stockpiled a lot of cash. Many will spend and many will invest it. Of course we will see pullbacks in the market but if you look carefully you will see some great opportunities in many equities still left out there. GE has a ways to go but is on the right track while i believe GOOG and AAPL are hitting their top. The next ride down will pull hard on these stocks while leaving the fundamentally sound and quality dividend yielding equities intact or very slightly moved.

I would also have to disagree about investing in ASIAN stocks. Greentechs from asia like APWR are still my favorites. Merchandising is a different field and should be viewed by the volume of exporting they do.

Oct 15 09:50 AM

[finmah@yaho...:]

Very good article - it gets back to the decoupling argument of emerging markets - and you are right there is no evidence whatsever to support the inter markets pulling the US train at 25% of the world economy based on 70% consumerism. If you look at many stocks you will see little volume but a tickling of higher prices for many months. There is of course the buy and hold crowd still there and too big to admit mistakes invest crowd waiting for the eventual return they are not selling which allows this tickling of prices. But after a 40% rebound - well .

I was hoping you could be more aggressive in your positions - like selected stocks short if this is indeed a multitrillion dollar vapor bubble. Certainly you can find us something and yes timing is crucial but right now the majority of your cash and bond funds are losing 15-20% against other currencies.

Oct 15 10:42 AM

[User 434096:]

As a new investor, this bigger-picture view is very helpful. Reminds me I have to renew my courage to slog through Mr. Graham's tome.

Oct 15 11:37 AM

[Mr. Big:]

I think the real cause of this rally was due to tax payer's money going into the markets. Trillions of dollars went into the banking system to help boost lending and credit. But lending has not budged materially and in fact has reduced somewhat due to the tightening of credit standards and the bias towards savings.

So where did all that money go? Simple. Bank's had to do something with all that cash, so why not deploy that capital into the markets and buy up assets and depressed prices? And that's exactly what they did. The massive buying by banks and institutional investors (primarily using stimulus money) had the self-reinforcing effect of jacking up demand and thereby causing stock prices to go up.

Take a good look at Goldman and Citi results and see where their profit generation is coming from. That's right....trading revenues and asset price appreciation. Thanks to you....the taxpayer. So just imagine how happy you feel knowing that Goldman is set to pay a $20 billion bonus to its employees this year. Again...thanks to you...the taxpayer.

So....just imagine what happens when stimulus has to be pulled back. It ain't gonna be pretty. Especially when there are no real economic fundamentals supporting the current stock prices.

Continue to keep an eye on earnings and find out what the true underlying drivers are of the profits. And ask yourself if they are sustainable. My guess is, at this point in the economy, they are not.

Oct 15 12:29 PM

[chap08:]

You say that earnings are "artificially" increased by a weak dollar. Please justify this position. They are only artificial if the dollar's current level is artificial and the level 2 years ago, or whatever, was "right". What evidence do you have for that position? Given that the dollar has been manipulated upwards for years, it seems a very illogical position to take.

Oct 15 01:38 PM

[untrusting ...:]

enigmamman,
So who is buying the market?

According to a Morningstar article yesterday the net market inflows in 2009 so far are: stocks=$14.5 billion, bonds=$254.5billion, almost a 20x ratio of bond to stock purchases.

So retail investors are not buying stocks, they are buying bonds. Insiders are selling at near record levels, and insider purchases are almost non-existent. Corporate stock buybuys have declined dramatically and far fewer corporations are doing stock buybacks.
And finally, stock volumes have been weak almost since March.

So then where is the buying coming from and who is doing it?
The answer is pretty obvious. A MarketWatch article on Goldman Sachs showed the following: Trading Revenues: 2009Q3=$10.3billion, 2009Q2=$10.78billion, 2008Q3=$2.70billion
Note that GS has about a 400% increase in trading revenue from 2008 to 2009. As has been pointed out in many SA articles, as much as 50-70% of the entire US market volume has been due to prop. trading desks (GS, MS, JPM, etc.) and High Frequency Traders. Also as noted this tiny handful of connected big traders comprises less than 2% of market participants.

Draw your own conclusions, but to us it is pretty obvious that the so-called recovery rally is a "manipulated rally" based on: 1) massive Fed liquidty provided to large banks and prop desks, 2) ultra low interest rates, 3) intentional large dollar devaluation, 4) domination of trading volumes by a tiny minority of big traders.

If one thinks the above is grounds for a sustainable rally, then go ahead and believe that. We personally think none of those are sustainable conditions. Further, virtually no other metrics such as stock fundamentals, past historic recession metrics, hugh debt overhang, contracting credit, or virtually any other fundamental supports the so-called recovery rally and thus it is just a matter of time until a major sell-off begins again.

On Oct 15 08:48 AM enigmaman wrote:

> Good analytical article but I think you are giving way to much credit
> as to why investors are buying this market, most that are buying
> are doing so because its simply keeps going up and they dont want
> to be left behind, they choose to believe the less then good news
> we get is actually better then the expected news. Nothing really
> matters when your living in a world of make believe, I know the market
> can stay irrational longer then you can stay solvent or something
> to that effect but what it doesn't say is that it can do so forever,
> so one day it will be over but when is anybodies guess, when it does
> we will find out like we always do, long after the fact and the resulting
> carnage,
>
> "The wiser person yields, but the donkey doesn't, and falls into
> the brook."

Oct 15 02:46 PM

[untrusting ...:]

Well from a historical perspective, we have been following the Canadian dollar vs. US dollar relationship for over 40 years now. This is only the 2nd time in about 40 years that the Canadian dollar has approached the par level with the US dollar. Typically over the past 40+ years the Canadian dollar has traded in about the $1.25-$1.75 range, with on average probably about $1.50 exchange rate. So it certainly seems to us that arguements about the US dollar being "outside or on the low side" of historic trading ranges are pretty accurate to us.


On Oct 15 01:38 PM chap08 wrote:

> You say that earnings are "artificially" increased by a weak dollar.
> Please justify this position. They are only artificial if the dollar's
> current level is artificial and the level 2 years ago, or whatever,
> was "right". What evidence do you have for that position? Given that
> the dollar has been manipulated upwards for years, it seems a very
> illogical position to take.

Oct 15 02:59 PM

[chap08:]

Fine, but he didn't say "outside or on the low side of historic trading ranges". He said that earnings were artificial - implying an artificial level of the dollar. The reality is that the level of the dollar is a lot less artificial now than it was a few years ago - reality has caught up with us. What's more, reality will hit us harder and harder over the coming years - but at least foreign earnings will keep going up.


On Oct 15 02:59 PM untrusting investor wrote:

> Well from a historical perspective, we have been following the Canadian
> dollar vs. US dollar relationship for over 40 years now. This is
> only the 2nd time in about 40 years that the Canadian dollar has
> approached the par level with the US dollar. Typically over the past
> 40+ years the Canadian dollar has traded in about the $1.25-$1.75
> range, with on average probably about $1.50 exchange rate. So it
> certainly seems to us that arguements about the US dollar being "outside
> or on the low side" of historic trading ranges are pretty accurate
> to us.

Oct 15 03:13 PM

[enigmaman:]

totally agree with you, sorry I wasnt clearer but main street in not buying this market I understand that, this market IMO is incestuous between the same group that helped orchestrate the last two bubbles 1999 & 08, in other words the financial elites. Many may think Im negative, or a bear but I think Im just being realistic not to believe this market is anything but a bear market rally in a decade old bear market. when you look at many stats for the decade you see a steady decline, look at the charts for DJ30, S&P500 and Nasdaq, if you didnt know what they were but were asked to review the charts, applying the technicals you like, what would you come up with, Buy,. Sell or Hold.


On Oct 15 02:46 PM untrusting investor wrote:

> enigmamman,
> So who is buying the market?
>
> According to a Morningstar article yesterday the net market inflows
> in 2009 so far are: stocks=$14.5 billion, bonds=$254.5billion, almost
> a 20x ratio of bond to stock purchases.
>
> So retail investors are not buying stocks, they are buying bonds.
> Insiders are selling at near record levels, and insider purchases
> are almost non-existent. Corporate stock buybuys have declined dramatically
> and far fewer corporations are doing stock buybacks.
> And finally, stock volumes have been weak almost since March.
>
> So then where is the buying coming from and who is doing it?
> The answer is pretty obvious. A MarketWatch article on Goldman Sachs
> showed the following: Trading Revenues: 2009Q3=$10.3billion, 2009Q2=$10.78billion,
> 2008Q3=$2.70billion
> Note that GS has about a 400% increase in trading revenue from 2008
> to 2009. As has been pointed out in many SA articles, as much as
> 50-70% of the entire US market volume has been due to prop. trading
> desks (GS, MS, JPM, etc.) and High Frequency Traders. Also as noted
> this tiny handful of connected big traders comprises less than 2%
> of market participants.
>
> Draw your own conclusions, but to us it is pretty obvious that the
> so-called recovery rally is a "manipulated rally" based on: 1) massive
> Fed liquidty provided to large banks and prop desks, 2) ultra low
> interest rates, 3) intentional large dollar devaluation, 4) domination
> of trading volumes by a tiny minority of big traders.
>
> If one thinks the above is grounds for a sustainable rally, then
> go ahead and believe that. We personally think none of those are
> sustainable conditions. Further, virtually no other metrics such
> as stock fundamentals, past historic recession metrics, hugh debt
> overhang, contracting credit, or virtually any other fundamental
> supports the so-called recovery rally and thus it is just a matter
> of time until a major sell-off begins again.
>
> On Oct 15 08:48 AM enigmaman wrote:

Oct 15 03:23 PM

[iceberg17:]

"The Canadian dollar, once the laughingstock of the world, is almost at parity (again) with the American dollar."

While this may seem like a trivial point, it is very tiring to constantly read this type of commentary about the Canadian currency and for that matter about Canada in general. Unfortunately most if not all of it comes from the United States.

In the not so distant past when Canada, in addition to primary materials, exported considerable quantities of manufactured goods to the US, it was very much in Canada's interest to have its currency held considerably below the US dollar. Now that the word "commodities" is on everyone's lips, the secret is out that Canada's immense quantities of natural resources along with the lowest population of the planet in terms of territory make Canada a very interesting market to say the least. What is more, Canada does not indulge in the financial engineering that occurs south of the border. For a pertinent example take a look at the large Canadian banks that are not in the headlines: Royal Bank of Canada, CIBC, TB, etc... There is no need to go on at length regarding the fact that the US dollar has greatly benefited over the past 50 years from the fact it acted as a global currency.

Last, if the author wanted to pick a currency that was the laughingstock of the world, perhaps Venezuela, Zimbabwe or Italy prior to the Euro would be more appropriate examples.

I wonder who will have the last laugh?
Signed, a Canadian (of course!)

Oct 15 04:50 PM

[Albertarocks:]

On Oct 15 04:50 PM iceberg17 wrote:

> "The Canadian dollar, once the laughingstock of the world, is almost
> at parity (again) with the American dollar."<

I think that's just a wee bit of literary license gone out of control. If anybody was laughing, it was because they didn't understand Canada's understated and very sophisticated ability to reach an equilibrium that was very beneficial to both the United States and Canada at the same time.

The Australians were certainly never laughing at Canada's currency because they had the same innate ability to know how to best handle their own currency, and as such had a respect for, and understanding of, what Canada was doing. I dare say the Canadian dollar was the laughingstock of the United States and nobody else.

There... having gotten that little tidbit off my chest, I quite enjoyed Mr. Rafat's view of a market that's just a bit overcooked. Overdone as in the time I put a turkey in the oven, forgot about it and went to Greece for 10 days. That's the kind of "overdone" we're talkin' about here.

Oct 15 05:40 PM

[Rob_W_:]

The author also mentions that he has personally divested in foreign currency ETF's, but disparages corporate earnings (denominated in USD) that benefit from the same dynamic. Dynamic being the operative word. If the author believes that "cash is king", he is snubbing his nose at gains that represent a big move from the March lows. The market was oversold, period. This is not an opinion, it is an observation of recent history. Nimrods have been calling for a massive selloff since Dow 8000! The market may be overbought at current levels, but that is far from certain. This article is nonsense.


On Oct 15 01:38 PM chap08 wrote:

> You say that earnings are "artificially" increased by a weak dollar.
> Please justify this position. They are only artificial if the dollar's
> current level is artificial and the level 2 years ago, or whatever,
> was "right". What evidence do you have for that position? Given that
> the dollar has been manipulated upwards for years, it seems a very
> illogical position to take.

Oct 16 12:15 AM

[iceberg17:]

I agree with you...but you got to draw the line somewhere!


On Oct 15 05:40 PM Albertarocks wrote:

> On Oct 15 04:50 PM iceberg17 wrote:

Oct 16 07:40 AM