TAKING STOCK

Personal debt trumps worker productivity

Dear Mr. Berko: Considering the two interest rate cuts by the Federal Reserve why aren't you 110 percent bullish about the stocks in the Dow Jones and Standard & Poor's averages? Worker productivity has increased during the past 10 years and is still increasing, corporate profits have grown tremendously too and according to recent reports and lower interest rates they should continue to improve. I have a good long-term relationship with my broker. My broker believes the Dow will go to at least 16,000 this year. My broker, who has been in the business for 14 years, strongly believes that these rate cuts will tremendously improve productivity as well as corporate profits.  He also believes that the strong foreign currencies will make our goods and services cheap and he believes that it will continue to generate tremendous exports, which are great for corporate profits. And taking into account the $1,200 per family that Congress will put in the consumer's pockets this May, he now believes this could potentially push the Dow to 18,000. Doesn't that also lead you to believe that the Dow and S&P stocks will really soar?
S.T.
Joliet, Ill.

Dear S.T.: Believing something doesn't necessarily make it so. Meanwhile, if you will send me a snip of your broker's locks I'll have it tested and be able to tell what chemicals he's taking. Anyhow, the following will be dry but bear with me.

I'm mindful that worker productivity has increased. And as worker productivity increases so does the economy (without inflation) and so does our standard of living. According to the Bureau of Labor Statistics, worker productivity between 1997 and 2007 grew at a 2.6 percent annual pace, which is up from the 1.6 percent annual pace between 1987 and 1997. And according to the BLS, this 1 percent increase in productivity means that the gross domestic product is $1 trillion higher than it would have been otherwise. But therein lays the rub.

While the GDP increased by an extra $1 trillion in the last 10 years, the consumer took on and extra $3.5 trillion in debt, or an extra $30,000 per family. That's like getting a $1,000 increase in your paycheck, buying a $3,500 sound system at Circuit City and financing $2,500 of the purchase amount. As a result a good portion of that increase in productivity is illusory because demand was created by new debt, which in turn generates higher output and higher productivity.

But if the consumer is unable to continue borrowing at that rate than productivity and growth will melt like snowflakes in warm sunshine.
And yes, in the last decade this rise in demand has been a boon for corporate profits. In the early 1990s, according to the Bureau of Economic Analysis, corporate earnings between 1987 and 1997 averaged about 6.4 percent of GDP. However, the BEA tells us that in the last decade corporate earnings averaged 8.5 percent of GDP and it's this impressive increase that ignited the DOW, S&P 500 and the Wilshire 5,000 during the last 10 years.

The inconvenient truth is that 70 percent of this increase in corporate income was generated primarily from a single sector - financial services: banks, brokerages, insurance and credit card companies. And by contrast, the earnings of nonfinancial companies, during the same time frame, averaged a little less than 5.1 percent of GDP - almost exactly what it was between 1987 and 1997. And considering the "Strum und Drang" that has sullied this sector like a contagious disease, most of this growth will evaporate like raindrops in a Dust Bowl as the credit binge peters out.

Meanwhile, in a recent column I told readers that the consumer is tapped out; he's maxed his plastic, his mortgage exceeds the market value of his home, he's scrimping to keep his payments current with GMAC and Ford Motor Credit, Beneficial and Household Finance have him nailed to the wall and lenders are only making loans to people who don't need to borrow money. The $1,200 in alms that Congress is tossing to the consumer will certainly help but won't have a lasting effect while higher oil prices, rising medical premiums, higher home owner's insurance costs, increasing unemployment and a falling dollar are beginning to create an economic inflationary spiral

I'm not as enthusiastic in the Dow Jones as you and your broker are, but I am enthusiastic about many individual stocks, which I'm compelled to recommend for income/growth accounts. The 2,000-plus point crash in the Dow has created some rare values in quite a few issues. And as you continue to read this column it will discuss some of these opportunities; issues in which today's retail prices may be next year's wholesale prices. There are many exceptional income opportunities that justify some small nibbles even for risk adverse investors and the faint of heart.

Please address your financial questions to Malcolm Berko, P.O. Box 1416, Boca Raton, FL 33429 or e-mail him at malber@comcast.net.

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