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"For of all sad words of tongue
or pen, The saddest are these: "It might have been!" |
| -- John Greenleaf Whittier |
ITH THE ARRIVAL OF
THE YEAR 2000, there's been a lot of reminiscing about the previous century.
We've been reflecting, too, but on the recent, not distant past.
After all, 1999 was an eventful year. Most major stock indexes hit new highs -- again with double-digit gains. At the same time, many bond investors faced losses for the first time since 1994. The Federal Reserve was the focus of the markets' attention while IPOs -- especially internet IPOs -- were the focus of investor's dreams. Neither was rational.
All of this has us wondering, "What if?" What if some of these things didn't happen or what if others had instead? What if there are unexpected consequences? Specifically, consider:
WHAT IF THE FED OVER-REACTED IN RAISING RATES
3/4%?
Throughout 1999, the Fed openly worried about the dreaded return of inflation.
Not that the CPI or PPI indicated it, but rather because things were too
good. The economy was rolling along and unemployment was still drifting
downward. Certainly that must mean the economy was on the brink of overheating,
leading to a major bout of inflation.
In their zeal to be ahead of inflation, the Fed had three 1/4% rate increases. When they weren't raising rates, they were threatening to,
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 Source: Baseline |
In deference to Y2K, the Fed took no action at their December meeting. The bond market, however, has priced in at least one more increase, perhaps more.
But we're wondering if the Fed hasn't already gone too far. Sure, the economy hasn't noticeably slowed, but then you wouldn't have expected it to. It takes six to nine months between a Fed rate move and its effect on the economy. Given that, the first impact will be felt in the first quarter of 2000.
Without further Fed action, seasonal factors may further slow the economy. Any additional rate increases may change the concern from inflation to recession. At that point it's too late.
Those who believe the Fed is correct in fearing inflation, point to the remarkable rise in oil prices. In case you missed it, the price of oil has more than doubled from its lows earlier this year, so
WHAT IF OIL PRICES CONTINUE TO RISE?
Unlike the tenuous relation between unemployment and inflation, oil has a
history of igniting inflationary fires. Back in the '70s -- the last time
inflation took off -- oil was the major catalyst. If you remember (if you're old
enough to remember), the OPEC cartel was able to limit supply and drive up
the cost of oil. Here it is the year 2000 and they're at it again.
Of course gold, the other inflation indicator, continues to languish below $300. In the past, gold prices moved up with the inflation rate. As the
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 Source: Baseline |
But stagnant gold prices really don't offset the rise in oil. Unlike gold which is valued in and of itself, petroleum products are used in the production of a vast number of goods. Not only is this an inflationary threat from oil as a finished good, but for any product manufactured from petroleum products.
OK, that's the bear case, but it's probably overstated. First, OPEC quotas have a history of failure. Each increase in price is an additional incentive to cheat. Also, as prices move up, new sources of oil come on line. High prices make additional exploration and development more profitable and productive. Non-OPEC countries can use OPEC's self-imposed limits to their own benefit, even more incentive for cheating.
But most importantly, the U.S. economy has changed from that of the '70s. Back then, more of the GDP depended on manufacturing, now it's shifted to services. As a result, U.S. expenditures on oil have fallen from 8.5% as late as 1981 to less than 3% now. Rising oil prices will have an inflationary effect, but not nearly as dramatically as in the past. This is borne out by the relatively mild 1999 CPI and PPI despite the doubling in oil prices.
Without the threat of imminent inflation,
WHAT IF THE JANUARY EFFECT REALLY OCCURS IN
JANUARY THIS YEAR?
One of the few legitimate market anomalies is the so-called "January
Effect". Smaller stocks and to a certain extent, those that had been
laggards in the prior year, tend to start the new year off with a bang.
It's been speculated that this is the result of institutional money managers selling off losers and lesser known stocks at the close of the year to dress up their portfolios for year-end reporting. Individual investors also sell their losers in the closing months of the year. This allows them to lock in the losses for tax purposes. Once the new year begins, investors go back into the same names they just sold, giving them a New Year's pop.
In recent years, savvy investors have attempted to front-run the effect by buying late in the year ahead of everyone else. As a result, the January Effect has moved into December. But in 1999, Fed fretting and Y2K worries kept some investors out of the market. As they year ended, fund flows into money market funds far exceeded those into equity funds. While the equity markets moved up, the year didn't end with the usual rally.
But odds are, those folks who were willing to ride out the millennium in a money market, will be ready to jump back into equities in the new year. This, along with the usual seasonal inflows from bonuses and anticipated tax refunds, will fuel a January "January Effect".
Technology stocks will still be the momentum choice, but cap goods and basic materials may also shine. These latter sectors usually start the year with high expectations, only to fall back as time passes and reality sets in. Bargain hunters and value investors will further this effect. Watch these sectors in Q1 2000.
So if rising oil prices aren't overly damping GDP and the January Effect is still to come, why do we think the economy will slow in early 2000? Well, aside from the delayed effect of the Fed tightenings, we also wonder
WHAT IF THE REAL Y2K PROBLEM OCCURS IN THE
FIRST QUARTER OF 2000?
A lot of people spent the best part of 1999 fretting about what would happen in
the months leading up to January 1, 2000. Concerns ranged from a technology
spending "lock down" to something just short of the apocalypse. Now
that the fateful day's come and gone, we're wondering if the real effect of Y2K
has yet to be felt.
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  Source: Baseline |
Contrary to what was expected, U.S. GDP didn't slow in the third and fourth quarters of 1999. Sure, the Fed was concerned about this in regard to inflation, but there may be another problem here. For example, in early December when Solectron announced earnings, they indicated that revenues fell shy of projections because they were unable to secure enough components to complete existing projects. The implication was that other manufacturers were stockpiling components -- not only for projects in process, but as a precaution for Y2K.
What if other manufacturers are also building supply inventories, fearing disruption in their businesses if their suppliers aren't Y2K compliant? (Perhaps this is why the demand for petroleum products was so strong in 1999's fourth quarter?) In essence, this would push sales from Q1 2000 into Q4 1999. Inventories will have to be worked off in early 2000 before new supplies will be needed. If Q4 1999 sales (and earnings) were higher than expected, Q1 2000 will be lower.
The January Effect may carry the market for the first month or so, but if earnings really do slow, it will start to become apparent in late February and early March. If we're right, the March "earnings confession period" may be more active than usual. Look for the stock market to stall or even correct at that point.
If the economy slows and the market takes a breather, there's one other thing to consider:
WHAT IF INVESTORS START PAYING ATTENTION TO
THE FUNDAMENTALS?
Nothing can draw the focus back to fundamentals better than a few volatile down
days. Given that, more investors will start looking at the numbers in the latter
part of the first quarter.
This could also be the catalyst for another early year sector rotation. Investors might not be willing to pay so much for profitless (and pointless) dot.com stocks. By the same token, someone may realize that pharmaceutical and consumer staple stocks represent uncommon values. Whenever the Fed finally retreats back into oblivion, financials might see some interest, too.
If the economy slows and the stock market falters, bond investors might finally realize they've overreacted and bring the 30-year bond back to a more reasonable 6.00-6.25% range. We can only hope.
All of this isn't bad, in fact it's good. A slowing economy is just what the bond market needs. A return to fundamentals and a broadening of the leadership can carry the equity markets well into 2000 and perhaps even beyond.
But then again, what if we're wrong?
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