National Futures and Financial Weekly

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Copyright 1997 by Consensus, Inc.
May 09, 1997 * * 1737 McGee, Kansas City, Mo. 64108 U.S.A. * * Up Dated Daily

Some foreign commentators might well be wondering if a large number of Americans are not suffering from a variant of mad cow disease that has plagued the British beef industry during the past two years. Investors wondering what is fueling the bull market in the past few months point to the mutual fund industry as providing growing support for equity funds. This is a normal expectation with the number of press reports advising young investors and baby boomers (the latter looking forward to retirement) to buy equities. Potential buyers are advised to purchase shares for long-term accumulation and not to give undue consideration to periodic spells of market weakness. This is good sound advice, in normal times, when values may be measured in a standard unit of account, such as an ounce of gold. Unfortunately, the latter proviso does not prevail in the closing years of the 20th century. Consequently, investors foregoing current consumption must place their savings in either tangible wealth or financial assets. In the past quarter century, financial assets, especially equities, have become the preferred method of accumulating savings for retirement. Since 1974, with fits and starts, and beginning in 1982 with a flight to equities, investors having grown enchanted with common stocks. In the aftermath of the dollar debasement, where the gold exchange value of the dollar dropped from 1/35 of an ounce of gold to approximately 1/350 of an ounce of gold, the flight to equities can be well understood. In fact, the massive price adjustment in common stocks was wholly justified by historically sound monetary factors. Now the questions becomes, when do we pass from the point of reasonable justification for the advance in equity prices and enter the zone of wild speculation that some characterize as similar to the South Sea Bubble, the John Law affair and other notable speculative frenzies that have afflicted the West in centuries past.

A Unit Of The Standard & Poors 500 Index

Adjusted for dollar debasement, a unit of the Standard & Poor's 500 index now trades at 2.34 ounces of gold. Using January 3, 1955 as the base period, the S&P 500 has increase from trading at 1.0 ounce of gold to 2.34 ounces. On an average annual basis, this represents an increase of 2.05% per annum. In real terms, this rise is not an unreasonably large one and probably is slightly less than the real increase in industrial production during the past forty-two years.

Nevertheless, the important question remains, how much higher might the S&P 500 go in the months ahead? Using gold as a barometer of valuation, we suggest the following gold anchored orders of magnitude as those most likely to prevail over the long term.

In September and October of 1967, a unit of the S&P 500 traded at 2.72 ounces of gold. This was the highest level recorded from 1955 through April of 1997. At the present gold exchange ratio of 2.34 ounces of gold for a unit of the S&P 500, the index is approximately 16.24% below the highest level recorded. Using this gold-related measurement medium in lieu of flat dollars provides a sounder perspective of what might come to pass in equity markets during the year ahead. Presumably, the S&P 500 could advance another 16% to 17% in terms of gold and still not establish a new record high exchange ratio.

Another method of looking at this matter is to say that equity prices, if they test the past record high in gold terms, could advance another 16% to 17%. A question investors must ask themselves (and answer) may be phrased as follows: Is the opportunity to gain another 16.0% sufficiently attractive to entice one to risk a loss of, say, from 15% to 30% of one's capital, in a reasonable market downturn? Because the range of the gold/S&P 500 ratio has ranged, on a monthly average basis, from 0.16 ounces in January of 1980 to a high of 2.72 ounces in 1967, the change from trough to peak was 2.56 ounces. We have currently recovered from the historic trough of 0.16 ounces to 2.34 ounces. Consequently, the S&P 500 in terms of gold has recovered approximately 90% of total difference from peak to trough, i.e., 90% of the difference of 2.56 ounces of gold.

The Bottom Line

There is no reliable method of predicting the future trend of equity prices, as AIC has long pointed out. Nevertheless, from a historical standpoint, equity price advances are usually carried to an extreme as well as the price contractions that follow periods of equity prices expansions. At this point in the cycle, AIC recommends that investors not risk more than 30% to 40% of their capital in equities in the hopes of gaining, at most, an additional 10% to 16% in real value by assuming undue risk. The possible gain is too modest; the real risk is too great.

Debt At A Glance...

Total Household Debt

Household debt continues to climb, albeit at a slowing pace. Total household debt for the fourth quarter of 1996 reached $5.44 trillion and is increasing at an annualized rate of 7.8%. This rate is down from 8.1% in the previous quarter and lower yet from the annual rate of 8.5% in household debt assumption during the second quarter of 1996. The year-to-year change in total household debt is decidedly lower. Prior to the country's last recorded recession in 1990, debt expanded at rate of from 13.5% to 17.0%. The annual rate of total household debt increase since the 1990 recession has been the weakest on record over the last 40 years. Perhaps the loss of high-paying manufacturing jobs since the last recession has curtailed many households from assuming a higher level of debt.

Employment uncertainties in the U.S. are much greater than the establishment is portraying, in our opinion.

Disposable Personal Income

The trend of annual changes in disposable personal income (DPI) has been clearly lower since the 19702 and early 1980s, although some years have recorded increases near the 7.5% level. DPI rose at an annual rate of 5.02%, to $5.70 trillion, in the fourth quarter of 1996 compared with a $5.63 trillion during the prior 3 months. The latest rate of DPI increase of 5.02% is the slowest rate since the first quarter of 1996. Downward pressure on wages is the primary cause and will remain a major factor in the years ahead. A helpful solution to the need for less workers in the workforce, due to increased productivity from technology, is sorely needed. The benefits from expanding technology, the common inheritance of the West, are now largely accruing to governments and corporations.

Labor has become less a factor in production and this institutional change has impacted the trend in disposable income.

Consumer Installment Debt

As the ten-year chart of net changes in consumer installment debt illustrates, the annual net increase in debt have been decelerating since early 1995. The net change (annual rate) in consumer installment debt in March of 1995 was $184.7 billion. As of February 1997, this rate of increase had fallen to $80.4 billion. Consumers usually pay down debt during a recession and assume debt as the economy improves. Since early 1992, consumers have been increasing their rate of debt assumption. However, since early 1996, consumers have become more restrained in increasing their rate of debt assumption.

May 5, 1997
Richard F. Maloney
AIC Investment Advisors, Inc.
440 South Street, Pittsfield, Massachusetts

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