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, McDonald's, Proctor and Gamble have been expanding overseas for decades. Even Walmart--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 seek 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 unbridled individualism. Such a family-oriented, traditional approach dampens unreasonable or wild 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 anticipated 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..."

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Gold in National Geographic

National Geographic Magazine's January 2009 issue has an article about gold:

http://ngm.nationalgeographic.com/2009/01/gold/larmer-text

While investors flock to new gold-backed funds, jewelry still accounts for two-thirds of the demand, generating a record $53.5 billion in worldwide sales in 2007. For all of its allure, gold's human and environmental toll has never been so steep. Part of the challenge, as well as the fascination, is that there is so little of it. In all of history, only 161,000 tons of gold have been mined, barely enough to fill two Olympic-size swimming pools. More than half of that has been extracted in the past 50 years. Now the world's richest deposits are fast being depleted, and new discoveries are rare.

I cannot understand why people and central banks are willing to pay so much for gold. It has less utility than platinum and silver. Most items that rely primarily on scarcity to attract consumers eventually lose demand and their high value. With gold, however, consumers can't seem to get enough. At least gold's value is not artificially inflated, as with diamonds (See DeBeers litigation). Still, I cannot think of another product whose attraction has such little correlation with its utility.

With platinum and gold selling at similar prices, I would probably go for the platinum. For now, my only precious metal is silver, which I own through a silver trust ETF (SLV).

Update: the print edition of the National Geographic has two charts on page 42 and 43 that are worth a look. One is called, "What it's worth," and the other is called "How it's used." If readers find a link to the charts, please let me know or please post a comment.

Bonus Round: Steve Forbes on gold.

Bonus Round 2: from the Italian Job, about gold: it "is our only refuge."

Update on 12/23/08: here is a comment I posted on seekingalpha.com, in response to other comments:

I appreciate all of your comments, but the only one that makes sense to me is Albert Ling's. He says that expensive products are expensive precisely because of their lack of utility. Although he doesn't expand on his hypothesis, he makes sense. The low utility of certain products, including gold, reveals an important trait--namely, that their buyer can afford useless objects, confirming the buyer's high disposable income, and therefore status.

I don't disagree with the ultimate end of the gold bugs, which is to establish a hard currency. Once most central banks moved away from gold and into fiat currency, gold no longer qualified as an agreed-upon unit of currency. Only if we return to the days of hard currency will gold have value because of its utility in determining currency. Until that day, its value seems to be linked to consumer demand and perception rather than utility.

Other people argued that almost no other products have prices relating to their inherent value, citing beachfront property; Mona Lisa; and Apple stock. Those examples are somewhat inapt.

1. Beachfront property has value because it is something that is necessary--shelter. It can also be used every day. Gold is not necessary, while shelter is required for most people.

2. The Mona Lisa has value because it is a unique historical artifact. Unique historical items tend to be valuable, despite their lack of utility, because history has value to most human beings. Therefore, I have no logical hangup with a historical painting connected to Leonardo da Vinci and the Renaissance having value. The Mona Lisa's value is inherent in its existence, which links it to a specific time period that will be studied as long as human beings exist.

Other paintings, however, especially so-called modern art, may have no value in the future. I would never buy a MoMa painting.

3. Apple stock is a harder one to analyze. It has no utility at first glance, because it does not pay dividends. (Many value investors avoid non-dividend paying stocks, because they don't see any definite return.) Yet, Apple stock has utility because it is easily traded, like currency, for other things, which do have utility. Gold is not easily traded for cash all over the United States. Apple stock, on the other hand, once liquidated, will buy a farmer in a rural area as well as a NY banker in a big city immediate utility. Therefore, its utility lies in its quick, convenient conversion into a unit that confers utility.

Gold

From the film, The Italian Job--prescient words from a gold bug?

INT. COIN & BULLION STORE - EVENING

Yevhen is 50 and like many in the gold trade, there isn't a conspiracy theory that he doesn't embrace. As they make their way to a back room, he keeps his mouth in overdrive --

YEVHEN:
All those poor bastards out there putting their life savings in banks and S&Ls and mutual funds. What do they think -- that when the collapse comes they can depend on the government? I don't think so.

Governments are nothing more than puppets on the strings of the Trilateral Commission with their twisted gods.

I mean, it's so obvious that in a world where NAFTA can overturn the Supreme Court, not to mention Microsoft's nefarious financial machinations, this, is our only refuge: gold.

I definitely get the part about feeling like a "poor bastard." Sigh.

Steve Forbes on Gold and the Fed

Steve Forbes, in November's Commonwealth Club magazine, says ignore the Fed and look at gold prices:

How do you know whether this thing [market situation] is getting better or not? Don't listen to the Federal Reserve--they speak what sounds like the English language but is designed to leave a fog of confusion. [Instead] Just look at the commodity markets, particularly the gold price. This has worked for 4,000 years; it'll give you a good indication whether they're doing it right or wrong. Right now, gold has come down a little bit, but it's still high, $870 or $880 an ounce. If it stays in that range, expect that more strange things will happen. If it comes down to the $600, $500 range, and they keep it there--don't let it fall below that--we'll be okay; we'll get out of this pretty quickly. Just watch the commodity markets, not what these folks [at the Fed] say.

Snarky. And probably true. As of October 29, 2008, gold was between $740 and $750 an ounce.