'Tis Only My Opinion!

January 2003 - Volume 23, Number 1

Aren't you Glad 2002 is Over?

Will 2003 be the fourth down year in a row?

Despite the predictions of the majority of the world's leading economists, the U.S. stock markets ended lower for the third year in a row.  True to form, many of these same academics and Wall Street voices are repeating the same refrain that we have heard for three years in a row. 

"The economy will recover in the second half of the coming year."

Cynics might suggest that eventually the economy will recover but will it be in the year 2003.  The answer to that question is important to investors.  Certainly, the results of the major indices as shown below for 2002 were enough to bring tears to those investors who still hang on the "Buy and Hold" strategy espoused by the Wall Street guru's and the mutual fund industry.


During 2002, the Gold sector was the place to be!

Yet, if you were listening to the Wall Street guru's, you would have barely heard mention of these two sectors which handily beat the major stock indices for 2002.

Gold bullion rose from $280 at the beginning of 2002 and closed at $347 for a 24% gain during the year.

The performance of the HUI (Amex Gold Bugs index) which is the un-hedged gold stocks was even better.  The following chart shows that performance versus the major stock indices.

The performance of the XAU (Philadelphia Gold/Silver index) which contains several hedged gold stocks like Barrick, Placer-Dome and Newmont also outperformed the major stock indices.  However, the HUI index gains were substantially greater than the XAU during 2002.

The following chart shows the weighting as of 12/31/2002 of the various components of the XAU index.

The chart shows that about 50% of the XAU index is composed of the major hedged gold stocks - -  PDG, ABX, and NEM.

The factors which we have stressed in previous 'Tis Only My Opinion! articles relating to fiat currencies and gold remain intact.  Hence, we would expect to see that the price of gold in forthcoming months will maintain its bullish trend.


The U.S. dollar remains vulnerable.

The continued monetary stimulus applied by the Fed, the increasing trade deficit, the reduction of capital inflows to the U.S., and the increased budget deficits being incurred by the federal government have been some of the factors that have pushed the dollar down during the past year.

The US dollar index has fallen from a high of 120 in January 2002 to close at 103 at year's end, a decline of about 17% during the year.  So despite the low interest rates which we saw the Fed continue to drop, the value of our dollar in world trade made the American investors dollar worth way less.  But according to the government, there is no inflation . . . what they are not telling you is that your dollars are deflating daily against the world's currencies.

Why is that important? Simply, it makes the cost of imports more expensive. But, of course, there is no inflation.

The Money Supply continues to expand!

The Fed continues to pour funds into the system in an attempt to turn the economy around.  The following chart shows the recent trend of M2 and MZM.

The increases in MZM during the late October and early November period were records.

M3 now stands at an all time record.

The percentage changes on a year to year basis as shown in the following chart underscores the desperation of the Fed in trying to turn around the economic wagon.


Lowering interest rates  is like "pushing on a string."

The following chart shows the federal funds rate for the last few years.  In its quest to revitalize the economy, the Fed has relied on cuts in the federal funds rate as a primary mover.  The only problem with that approach is that in the current economic situation, it has only a minimal effect.

Since the Fed began lowering interest rates in 2000, the economy has continued to falter.  What the Beltway economists fail to understand is that this economy suffers from an over-abundance of capacity and a lack of demand.

Until product demand picks up, lowering interest rates further is an exercise in futility.  The end result will be the U.S. joining Japan in economic malaise.

Another big factor which will affect the U.S. in coming years is the destruction of the wealth producing manufacturing jobs.  It is estimated that during the past year, over 1.5 million high-paying jobs have left the U.S.  Although the service economy continues to grow, the vast number of those jobs do not pay ordinary workers the same wages as the skilled manufacturing jobs which have left.

Since early 2000, corporate loans by banks have continued to fall.  Also, as credit ratings have been downgraded the number of non-financial institutions that are able to obtain funds in the commercial paper market has dwindled.

The following chart indicates the reduction in commercial and industrial loans by U.S. banks during the past 20 months.

During this period, banks have not only tightened up their loan policies but have seen their charge-offs skyrocket. 

Until corporations begin to increase their loans, the economy will be mired in the "muddling through phase" or worse.

The Housing Sector continues to amaze.

Low mortgage rates have helped the economy by refinancing higher rates and have allowed the housing sector to remain strong during 2002.  Both new and existing home sales have benefited from the reduced interest rates.

During 2002, new homes sales were the strongest sector of the economy.  Yet, recent sales data indicates that home starts are slowing and that existing home sales are under pressure.

Recent changes by Fannie Mae and Freddie Mac in their loan policies should make the housing sector less attractive in 2003.

The CRB index suggests that inflation is coming.

Since October 2001, the CRB index has been increasing almost monthly.  It would appear that since the cost of materials is increasing, and companies have very little  pricing power that either corporate profits will continue to be weak or inflation will be in the cards.

Since the major stock indices will have a difficult time until corporate profits turn up, I would expect that the inflation scenario will show up in 2003.

Where will the indices go from here?

As we stated in the beginning,  2002 was the third down year in a row for the major indices.  So will 2003 be different is the question.

Let's look at valuations.  Stocks are still high by almost any historical valuation measure, P/E ratios, dividends, Price to Book Value, and any of the more recent hype ratios.

Many analysts are suggesting the operating earnings for 2003 might increase by 7%  in 2003.  Unfortunately, it is after-tax and interest earnings that count to this investor.

For those who think the market will not be down for a fourth year in a row, the following from John P Hussman, PhD.,  might be of interest.

  • The bullish views lean heavily on two fallacies.
    One is the notion that the market can't decline four years in a row, since the only other time it has done so was during the Depression, and we're not in a depression. The difficulty is that the decline from the 2000 peak began at a price/peak earnings multiple fully 50% higher than the valuation that existed at the 1929 peak (or any other bull market peak for that matter). Valuation multiples based on other fundamentals such as dividends, book value, revenues, and replacement values were even more extreme in relation to prior bull market peaks. Even today, the S&P 500 price/book ratio remains above 4.0, which is beyond anything seen in prior market cycles.

    The second fallacy is related, and is based on the notion that the P/E doesn't look so bad based on forecasts of future operating earnings. But basing stock valuations on such forecasts runs into the problem that

    a) they're forecasts, and have a history of outlandish unreliability, and

    b) stocks are not a claim on operating earnings, which include items such as interest payable to bondholders and taxes payable to the government.

    Moreover, given that the portion of operating earnings represented by debt and tax service is now the highest in history, it's not at all clear that the P/E multiple attached to those operating earnings should be anything close to the historical multiple attached to them.

When confronted  by the valuation problem, and beset by the problems generated by a declining dollar, dollar outflows and an increasing trade deficit, it is hard for me to buy the argument that the 2003 market will be strong.

About the only positive factor that I can see is that the President may opt to change the tax laws of the United States.  The initial thrust of that change might be to reduce or eliminate the double taxation of dividends.  But at best, a change in dividend taxation can only be marginally helpful to the market.  Only a major improvement in corporate profits will change the current bear trend and  that does not appear likely.

Negative factors facing the U.S. markets.

The following are a few of the major factors that will negatively impact the U.S. markets in the coming year.

  • The War on Terror will increase the uncertainty facing the markets as Iraq and the Middle East become military involved.  Also, the situation with North Korea will add further uncertainty to the mix.

  • Lack of demand will reduce pricing power for domestic manufacturers and deflationary pressures will continue to make the U.S. dollar index fall.

  • China will continue to increase its manufacturing dominance and in order to strengthen its long-term political strength will continue to maintain its currency at low levels relative to its trading partners.  While the Yuan/dollar ratio may be slightly increased, China is now the country with the second largest foreign exchange reserves in the world behind Japan and gaining rapidly.  China's leadership anticipates a four-fold growth in GDP over the next 20 years.

  • The U.S. trade deficit will continue to increase and as a result, capital outflows from the U.S. will become positive.  Since foreign capital will no longer be available to finance the trade deficit which will probably exceed $500 Billion in 2003, the Fed's only recourse will be to continue to run the printing presses.

  • Technically, the markets continue in a bear trend.  As a result, it is highly probable that the recent lows for all major indices will be tested.

The Political Environment

The newly-elected Congress will find a myriad of problems from the budget, social security reform, health care initiatives, and immigration to tackle upon their return to Washington.

A new Senate majority leader may be able to work closely with the administration to push through the President's agenda despite the slim majorities in both houses.  The power sharing arrangement brokered by Senator Lott while Senate majority leader will be scrapped.

Many Democratic Senators, e.g., Edwards, Kerry, Daschle, and Lieberman will be seeking the political spotlight in order to garner attention as the front-running Presidential candidate for their party.  How this will affect the agenda is unclear. However, following the drubbing in November, the Clinton factor has probably been reduced.  Hillary Clinton has declared that she will not be a candidate in 2004 for President . . . but just wait until she is drafted.

During the current Congress, the President is expected to fill most judicial openings in the first few months.  There is also some speculation that the President will have one, possibly two, Supreme Court nominations to advance this session.

Now that the Homeland Security bill has been passed, many changes will start that will find opposition.  The all-inclusive data banks will cause privacy to totally disappear. In 2005, the government will be able to track cell phones anywhere in the U.S.

A task force in Oregon has just proposed a law that will require all motorized vehicles to be monitored by GPS devices and satellites.  The purpose is to raise revenue for roads on a "more-equitable basis" than the current gas tax.  The task force argues that the variation in miles per gallon used between vehicles is inefficient.  Welcome to George Orwell's vision of 1984 . . . just 20 years late.

Can we trust the government statistics?

The extent of revisions in most government statistics is beginning to cause many observers to question the usefulness of government statistics.  During the past year, the reliability of initial estimates has become suspect, particularly, the employment and unemployment data.

Now we have the situation where the BLS cites budget considerations (when was the last time you heard that) as a reason to drop the mass layoff statistics which were produced monthly.  Guess that when you don't want negative information to upset the citizens, you just cite budget considerations as a way to stop providing that information.

What trading strategies will be effective in 2003?

The "Buy and Hold" strategy will continue to show poor results during the coming year. Whether a conservative investor should even be in the market is a  toss-up.  Putting a portion of  one's liquid assets in foreign currencies, e.g., the Euro and/or the Swiss franc, and/or gold bullion/coins is probably a good strategy based upon the U.S. market and the pressures upon the dollar.

Sector rotation trading might continue to be effective during the coming year.  However, this will require considerable effort to determine the sectors and to find the leading stocks in that sector.

Portfolio bias should continue to be on portfolio safety. 

Aggressive investors will continue to go short and swing trade to maximize their gains during the coming year.  It will be a while before anything other than a bear market rally appears to change the direction of momentum.


2003 will be a year of contrasts and emotional upheavals.  As such, it will require a level head that steps back from the crowd, looks dispassionately by the underlying factors, and then makes decisions based upon facts, not emotion.

While the shock of terrorist acts can move markets immediately,  astute  investors will realize that long-term trends are  more important in investment decisions.

But then - 'Tis Only My Opinion!

Fred Richards
January 2003

Corruptisima republica plurimae leges. [The more corrupt a republic, the more laws.] -- Tacitus, Annals III 27

This issue of 'Tis Only My Opinion was copyrighted by Adrich Corporation in 2003.
All rights reserved. Quotation with attribution is encouraged.
'Tis Only My Opinion is intended to provoke thinking, then dialogue among our readers.

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Last updated - July 6, 2008