May 2004 The Long and Short of It "If you need the government telling you what inflation is running at, you have no business in financial markets." --Bill Fleckenstein, Hedge Fund Manager as quoted in the Wall Street Journal   HEN THE ECONOMY FELL INTO RECESSION in early 2001, corporate earnings had already been slowing for about a year. Word on the Street was that neither the stock market nor the economy would improve until businesses returned to profitability. Earnings finally stabilized in early 2002, and were it not for the impending crisis with Iraq, stocks probably would have followed. As it was, they waited until U.S. troops were finally engaged before moving up. But despite 2003's sharp equity gains and other strengthening economic signals, investors feared that without a substantial pick up in job creation, the recovery would falter. That cloud hung over the economy until March's employment report revealed the creation of 308,000 new jobs, more than double the prediction. The last remaining question regarding the recovery's sustainability was now answered. But investors are a fretful bunch. There's always something to worry about. As soon as the March employment report was released, the concern turned to interest rates. And it looks like that's the fear that can carry well into the summer when worries about a change in the White House can take over. The 1% Solution It's been almost a year now since the Federal Reserve lowered their benchmark interest rate to 1%. This easy money policy has been credited with limiting the impact of the recession and possibly even speeding its conclusion. True to their word, the Fed has kept rates at this generational low for "a considerable period" of time. But everyone knows rates can't stay at these level indefinitely. As soon as the economic recovery shows definitive signs of being self-sustaining, rates will again return to normal levels. The Fed acknowledged this in the statement following the April FOMC meeting and Fed governors have been echoing this theme in subsequent public appearances. The real issue isn't whether rates will rise, but when and how much. Investors took March's employment report as the final piece of evidence that a lasting recovery was finally underway. FED FUNDS RATE 1985-2004 Source: Baseline Rather than rising, stocks and bonds both had a tough April. The stronger the economy, the sooner the Fed will have to move and the greater the inflationary threat. Investors -- especially bond investors -- didn't want to wait for the Fed. Bond prices fell in the first few weeks of April while their yields which move in the opposite direction, rose over 1/2%, a substantial move for an entire quarter. Stocks marked time, with major indexes moving between positive and negative territory for the year. Although rising interest rates and their negative effects on both stocks and bonds are the immediate cause for concern, the real culprit is inflation. The Fed doesn't wouldn't raise rates without reason but rather to head off inflation. Up until mid-April, the Fed was purportedly equally concerned about inflation and deflation. But that's recently changed. For the first time in a long while, Mr. Greenspan acknowledged that inflation was coming back to life when he noted in his congressional testimony that "It's fairly apparent that pricing power is gradually being restored." He went on to add that "Threats of deflation, which were a significant concern last year, by all indications are no longer an issue before us. But clearly it is a change that has occurred in the last number of weeks." There are two important points here. First, investors took the decline of deflationary pressures "in the last number of weeks" as signifying a sense of urgency to begin raising rates sooner rather than later. This, of course, sparked the almost immediate bond decline. Secondly, this was taken as an attempt by Mr. Greenspan to lay the groundwork for the Fed to change their "bias" to a tightening policy. If inflation's on the way, tightening is inevitable. Under Mr. Greenspan the Fed has tried to telegraph moves well in advance in an effort to avoid disrupting the market. Fed watchers speculated that the bias will "officially" change following the May FOMC meeting and the first increases will occur no earlier than June but probably no later than August. So are these the conclusions correct? Investors certainly acted like they were. Not only have both stocks and bonds suffered, inflation has now become the prevailing concern. Yet Mr. Greenspan himself contradicted the first conclusion by downplaying the current inflationary threat. In his words, "As yet, the protracted period of monetary accommodation has not fostered an environment in which broad-based inflation pressures appear to be building." Does that sound urgent to you? The second conclusion may have a little more validity. A number of indicators are suggesting inflation is again on the rise. You Knew It All Along Last year the CPI rose only 2%, well under the historical average of 3%. Earlier this year economists were predicting it would fall as low as 1.5% in 2004. CONSUMER PRICE INDEX (CPI) 1982-2004 Source: Baseline But March's CPI surprised on the high side, increasing by .5%. The so-called "core" CPI rose .4%, its greatest one-month increase in two and a half years. Since the core doesn't include the traditionally volatile food and energy components, its jump wasn't attributable to soaring oil prices. Instead, it must actually be showing signs of inflation. But you and every other consumer already knew that. Even some of the folks in the government who compile these figures have been questioning how accurately CPI actually measures inflation. CPI and SELECTED COMPONENTS 1-Year Percentage Change Data Source: Baseline Low interest rates and their effects on housing costs have certainly restrained reported figures. Housing costs -- essentially rent -- currently represent about 40% of the costs measured by the CPI so their stability has had an inordinate impact. While housing costs are a major part of consumers' budgets, for most they're relatively fixed. It's the rising costs of food, energy, healthcare, and education that you feel everyday. The home refinancing boom helped damp their effect on the overall CPI, but that's about run its course. Prices at the producer level are rising, too. The CRB Commodities Index has been on the rise since late 2001, only slowing briefly in 2003 just prior to the Iraq conflict. It's been on a steady climb since then, mirroring the acceleration in the domestic economy. That's the usual pattern: Demand for inputs (and their prices) rises when economic activity picks up. And it's not just the U.S. driving up demand, Southeast Asia, led by China, is also spurring the increase. While off-shore outsourcing and cheap imports may hold some prices down domestically, the U.S. is importing inflation at the producer level. Investors saw this, too. That's why bondholders were so quick to sell. Higher inflation cuts the price of bonds while eroding the value of their income stream. Equities suffer as well since higher prices crimp profits and while raising the costs of borrowing. This is ultimately reflected in lower share prices. Short-Term Reaction, Long-Term Cycle Bond investors spent April trying to position their portfolios for the coming higher rate environment. Equity investors took profits from some of their more speculative holdings (especially on the Nasdaq which ended April down for the year despite its big early run-up) and considered more defensive choices. At times there was almost a panic as if rates would suddenly jump to double-digits and stocks were on the verge of another bear market if not an immediate sell-off. Portfolio changes had to be made now before it was too late! But neither market nor economic conditions changed overnight. The Fed may move to a tightening stance, but they won't throw caution to the wind. "It's going to be important that we wait at least a little longer to see if the improvement in March data will be persistent, and I'm hopeful that it will," said Alfred Broaddus, President of the Federal Reserve Bank of Richmond. "We need some confidence these numbers are telling a longer-term story, and not a short-term story." Indeed, while the Fed may soon abandon its easy money policy, interest rates have a lot to rise just to get back to average. If you need any convincing, just look back at the first chart on this page. Even when they do move, a little tightening may go a long way. As Mr. Greenspan put it, "There is an implication that once we start [to raise interest rates], we continue for a protracted period. ... That is not the case." Under his guidance the Fed has preferred numerous small moves rather than a few large ones in an effort to fine tune the economy -- at least to the extent that's possible. They will certainly be on the lookout for any negative impact on the recovery. Inflation has a way to go, too, before getting back to its historical averages. In fact, many market watchers believe it's actually good to have a little inflation to provide businesses with a degree of pricing power. That's not been the case for most industries so far in the current recovery. Which brings up the point many short-sighted investors are overlooking: So far this recovery has pretty much followed the course of previous economic expansions. That includes the pick up in corporate earnings, strong consumer demand, and yes, even rising inflation and interest rates. Historically small companies and their stocks are the first to benefit as the country emerges from recession. That's precisely what happened in 2003. As the recovery takes hold and becomes self-sustaining, more sectors benefit and the gains are more widespread. That's what you saw in the strong fourth quarter profits from last year and even stronger earnings in this year's first quarter. As the recovery moves into its second year, some of the early cycle stocks become overvalued and leadership moves towards more fairly valued issues. This has already begun to happen as large cap stocks are now showing some strength relative to small and mid-caps. Now with the threat of rising interest rates and the return of even moderate inflation, investors are selling some of their appreciated speculative stocks and are seeking the safety of more defensive issues. This again is a normal occurrence at this stage in the recovery. Consider the Alternative What comes next? History can again be a guide as to what usually happens in the late second year and early third year of an economic recovery. The Fed will begin to tighten monetary policy, bond yields will rise, inflation will pick up, and corporate earnings will slow. That's not a doomsday scenario. At least it doesn't have to be. Many economic expansions have gone well beyond their third year. Look back no further than the decade of the 1990s which, for the most part, was a decade of expansion. Rising yields will certainly put an end to the bond bull market, but if done gradually enough, they don't have to spawn a bear market. Again, if the Fed moves as it has in the past with concerted small increments, rates can rise without causing real damage. The same is true for inflation. Just a few short years ago many economists felt 3-4% annual inflation was ideal. Well folks, that's 1.3 - 2.3% higher than last year. Like higher interest rates, if it comes slowly, it doesn't have to be damaging. Indeed, if food, energy, education, and medical costs could be held to 3-4%, it would be an improvement. As far as corporate earnings are concerned, you know they have to slow. Just as interest rates can't stay at rock bottom levels forever, profits can't continue to expand at the torrid pace of 2003-2004. The biggest improvements always come at the beginning of a recovery when earnings again turn positive and comparisons are easy. After almost two years of expansion, that time has passed. That's not to say that profits should fall, just that they won't be growing at such a rapid pace. The nearby chart shows the four-quarter moving average for earnings on the S&P 500. As you'll notice, they're projected to continue growing through 2005, but at a slower rate. That's what usually happens in the later years of an economic expansion. S&P 500 EARNINGS 4-Quarter Moving Average Source: Baseline Contrary to what some of the recent market action may imply, none of this is horrible. In fact, it's the alternative that's worse. By this point in the recovery there should be inflationary pressures, rising rates, and slowing profits. If not, the recovery wouldn't be self-sustaining but instead still dependent on external stimulus. If there was no pressure on interest rates, deflation would still be a viable threat. Isn't it better to face higher interest rates than Japan's decade-long deflation debacle? And what's wrong with steady but slower profit growth? Did anyone really think they could indefinitely set new records each quarter? Maybe they did and perhaps that's the problem. Over the past decade investors have become more and more focused on the short-term rather than seeing the big picture. That's why corporations have had to do everything in their power to show quarter-over-quarter profit growth or risk seeing their shares pummeled by a 1-cent miss. That's why investors panic at the latest economic report, selling first and asking questions later. That's why they expect market conditions to change overnight and are then surprised when they don't. That's why they intently watch CNBC hoping that a talking head will give them the next hot stock instead of truly building portfolios. All of this makes for good drama, but not necessarily good investing. Yes, it's hard to focus on the long-term when there's so much short-term noise, but it's well worth the effort. For those who do look beyond the latest economic or financial report, the current situation looks a whole lot better. It is time to take some profits in highly valued early cyclical or speculative stocks but that doesn't mean it's time to leave stocks entirely. Instead, the historical leaders at this point in the cycle are companies with proven cash flows like integrated oils, major pharmaceuticals, beverages, and materials. There's little reason to believe it will be different this time. There's no need for bond investors to panic, either. Yes, it's probably a good idea to shorten the durations, but bonds still belong in most portfolios. At this point, inflation-indexed Treasury securities known as TIPs are good alternatives. There's no denying that market and economic conditions are changing, but there's also no reason to ignore the lessons of past cycles. The best returns over the long-term come to those who take a long-term view. It may not be as dramatic as the short-term alternatives -- unless, of course, you get excited over better returns. E-mail your comments. Search this site! Just enter you key word or words:   Get current quotes or follow your own custom portfolio, courtesy of E-Line Financials:   Search:TickerName Company DataQuickQuote     Homepage Return to Top