What’s Next for the Stock Market?

October 23, 2006 – The Dow Jones Industrial Average made a new record high this past week. It settled back somewhat on Friday, but still closed the week above 12,000, which was also a new record high for a weekly close.

I provided some inkling that a new record was coming. In my article of August 7^th A Fear Index Revival, I commented: “Recently the DJIA chart pattern has taken on an entirely different look. It no longer looks like a top. Rather, the two parallel red lines on the chart look like a consolidation pattern that will eventually lead to higher prices…[so] do not be surprised if the DJIA and S&P 500 climb to new all-time highs.”

We can see those “parallel red lines” on the accompanying chart of the DJIA. We can also see that the DJIA has now broken above those lines, scoring a new record high.

So one half of my forecast has now been achieved with the new record in the Dow. Will the S&P 500 confirm by eventually also climbing to a new high?

It’s a good question, particularly given that the S&P 500 index remains more than 10 percent away from that milestone. The Nasdaq is only one-half its 2000 record high (see the Qs chart on page 2). But for now, I will continue to stick with my same forecast – I expect that the stock market will move higher still, in time taking the S&P 500 into new high ground.

The reason for my forecast is simple, and centers upon the dollar. Specifically too many of them are being created. Just as importantly, too many of these newly created dollars are ending up outside the US. So my reason for expecting higher stock market prices should sound familiar to long-time readers of these letters.

For example, I provided my outlook for 2005 in Letter No. 357 published on January 10^th of that year. I noted therein that: “The Chinese…are sitting on $500 billion [$900 million now] because they cannot easily get rid of these dollars, though they are trying hard to do so by purchasing Noranda and other companies, like their rumored plans to purchase Unocal. Expect more of the same by them…I expect that it will become more clear that the Chinese and other big holders of dollars will increasingly look to exit from the dollar by purchasing North American companies (think big commodity producers like Noranda and Unocal). Therefore, what’s good for Chinese dollar holders is also good for all dollar holders – dump the dollar and hold instead the shares of quality companies producing essential commodities. It is a stock market play that is already underway, but it is one that I expect will gain significant momentum by the end of 2005.”

Those words were fairly prescient. More importantly, they continue to explain the major trend behind the stock market’s climb. But I was wrong in one respect; Chinese government attempts to purchase Noranda and Unocal were thwarted.

Those deals and the failed Dubai Ports deal were important nonetheless. They demonstrated the willingness of the US government to use protectionist measures to keep the flood of dollars it was creating from returning home and worsening domestic US inflation. Relatively less overseas money has gone into the stock market than would have otherwise been the case if those deals had been completed, but foreign money is flowing into US stocks nonetheless. Large overseas holders of dollars like China have learned a lot, and realized that they would have to make some changes in order to realize some tangible value for their vast holding of dollars.

Rather than purchase equities, the Chinese government is using its dollars where they are still accepted, for example, in commodity markets because commodities are still generally priced in and traded in terms of US dollars. Another change is that the Chinese government itself is no longer recycling dollars back into the US. It has continued to gradually ease its exchange controls, giving more freedom of capital movements to Chinese citizens.

So money from China continues to enter the US and the US stock markets, but it is coming from individuals, rather than the Chinese government. But the source of this money is largely irrelevant. What’s relevant is what is happening to these newly created dollars that are being used to fund the growing trade deficit – they are coming back into the US stock market. All this ‘hot money’ has the potential to launch (and probably already has launched) another stock market bubble.

Bubbles are the creation of central banks. In the absence of the discipline imposed on central banks by the classical gold standard, they just keep on creating more currency. There is a limit though.

Eventually so much currency is created that people no longer want to hold it. We have reached this stage already, and it is gaining momentum.

Instead of dollars, people now want to hold tangible ‘things’, like gold and other commodities. And they want to hold stocks because stocks are not dollar denominated. A lot of people confuse this point, so let’s look at Freeport McMoran as an example to explain my thinking here.

Substantially all of FCX’s assets are tangible goods, namely, its gold mine and the inventory it holds. So when you purchase stock in FCX, you are in effect buying an equity claim to your proportional share of those assets, and more specifically, the wealth that FCX creates by mining those assets. At the moment, those assets are measured in dollars, but they are not dollar assets.

So do you see my point? FCX will continue to mine gold and copper regardless what happens to the dollar. And if/when the dollar collapses and stops being used as currency, FCX will still be mining its gold and silver, but will measure the value of those assets in some currency other than the collapsed and totally discredited dollar.

Before you rush out and buy stocks, however, there is another side to the story. What happens to stock prices if there is a credit crunch in the US?

The last serious credit crunch occurred in the late 1980’s when banks stopped lending to real estate ventures. There was a liquidity squeeze, which hurt real estate prices as well as equities. But the example that I have in mind is October 1972, just before the election in which president Nixon was seeking a second term in office. Though this year is a mid-term and not a presidential election, the parallels are ominous.

Back then inflationary pressures were rising along with commodity prices. The economy was being pumped up prior to the election with newly created dollars, causing weakness in the dollar against other currencies and gold. Meanwhile, the DJIA was climbing toward its previous all-time high, and managed to eke out a new high in January 1973.

Eighteen months later the DJIA had lost over 40% of its value. A severe credit crunch caused liquidity to dry up. Stocks were therefore sold off with a vengeance as people tried to get liquid in order to meet their debt obligations. So the question becomes, what is the likelihood of a similar event today?

A replay is of course possible, but I think the probability is less than 20%. The reason is Ben Bernanke and his cohorts at the Federal Reserve. They will continue to pump dollars into the economy, particularly if they sense even the slightest possible hint of a credit crunch. But to get to the point I am making, Bernanke will end up destroying the dollar instead, much like the German Reichsbank destroyed the Reichsmark circa 1922-23.

In an environment of fiat currency and without any discipline on the money creation process, central banks will continue to create currency without end, until the currency is destroyed. Never underestimate the power of central banks to destroy the purchasing power of a national currency.

So to sum up, we are still on the same road that will in time lead to the inevitable collapse of the dollar. That collapse will come as a result of declining demand for the dollar, while at the same time the supply of dollars will continue growing in order to fund the ballooning US trade deficits. And this flight from the dollar will lead to ballooning stock market prices, particularly high quality commodity producers and defensive stocks.