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 September 2006 History Lesson
For years stock and bond investments were viewed as long-term holdings. By their very nature with maturities out to 30 years or longer, bonds have traditionally been viewed as long-term commitments. The variability of stock returns also rendered them longer-term investments as well. But that changed in the 1990s when stocks jumped 1% or even 2% on a daily basis. Initial public offerings were considered failures if shares didn't double on the first day of trading. Companies were expected not only to meet analysts' quarterly earnings expectations, they were expected to exceed them. "Long-term" came to mean the current quarter at the most.
Despite all the lessons learned after the tech bubble burst, individual investors, professional money managers, and even economists still adhere to this short-term approach. They fret about the next dip or spike and search for something to gauge next month's or even next week's activity. There's always something in the daily news to spark ongoing concern. Yet this isn't rocket science. Investors have been making rational decisions for years -- often with less data than is commonly available today. What's changed is the ubiquitous short-term perspective. It's difficult -- if not impossible -- to predict what will happen in the market or the economy in the next week or month. On such a limited basis, daily news or market events can have a significant impact. But these short-term developments tend to smooth out over the longer term. Economic data that seem to be all over the map appear much more systematic when viewed over a longer period. Market cycles can't be discerned over a week or even a month, but they're much more obvious over a year or longer. While there's always someone willing to argue "it's different this time", it rarely is. The past is often the best indicator of the future.
This is still true today. Many of the most vexing questions troubling today's investors aren't that impenetrable when properly put in context. Although it may not be possible to get a handle on short-term expectations, the long-term direction -- what investors should be concerned with -- can be much clearer.
Look Back to Look Forward Yet things are much clearer looking back 1-1½ years. The green bars on Chart 1 show the past 20 years of GDP quarterly changes. Most are positive, but beyond that there isn't much of a short-term trend. That's exactly what today's short-sighted pundits are seeing. However, if you instead consider six-quarter rolling periods, it's much easier to discern the actual market cycle. That's what's shown by the red line on Chart 1. As it indicates, the low points in the most recent cycles occurred in 1991 and 2001, precisely when the economy last experienced mild recessions. The high points fell in 1997 and 2005, again right in line with actual economic peaks. It's also not too difficult to see from Chart 1 what's in store over the next year or so: The economy will continue to cool as the cycle trends downward. That doesn't necessarily mean a recession awaits, only that further slowing is in the offing.
Ongoing data supports this reading. For example, the housing market -- which has been instrumental in fueling the current cycle -- is clearly running out of steam. Sales of new and existing homes are declining while sales prices are also falling. In August, Toll Brothers, an upscale homebuilder who many had thought to be well insulated from rising mortgage rates, announced disappointing earnings as well as lowered forecasts for the upcoming quarters. Cooling housing trends impact more than just those buying and selling homes. As long as rising home prices and low interest rates prevailed, homeowners felt confident that increasing values and the proceeds from refinancing gave them the freedom to continue spending. In the process, savings rates fell to zero and occasionally, even lower. But with the demise of these favorable conditions, consumer confidence is waning, too. This doesn't bode well for the economy, at least in the short-term. The fear of inflation also weighs on consumer confidence. Once it becomes ingrained, the perception that inflation is out of control and that prices will be higher tomorrow than today causes the inflationary spiral to feed on itself. Breaking that cycle is arguably the Fed's most difficult task. History offers a lesson here, too.
More Art Than Science The Federal Reserve is charged with maintaining price stability, so it's understandable that inflation would be a bigger concern than economic growth. "I'm sure future policymakers will remember the lessons we learned in the past 40 years about what happens when you start down the slippery slope of trading inflation for growth," says Atlanta Fed Governor Jack Guynn. That's also why it stands to reason that until inflationary pressures cool, their bias will still be towards higher interest rates. As Federal Reserve Bank of Dallas President Richard Fisher put it, "If anybody tells you with absolute conviction that the Fed is done raising interest rates or with equal conviction that they have only paused and will raise rates more starting in September or October, remind yourself that at best -- and I'm being generous here -- they are only guessing. As a central banker, in terms of the genetic code, one's concern is always about inflation."
And that's as it should be. While the link between interest rates and inflation is at least somewhat proven, there's far less evidence that a powerful economy must lead to inflation. There's a much stronger relation between money supply growth -- something the Fed can influence -- and inflation. As a result, the Fed's decision to raise (or lower) interest rates should be primarily driven by the need to modulate inflation and protect overall price stability. On the other hand, that doesn't mean the Fed's not really finished for this cycle. In fact, history says otherwise. Looking all the way back to 1914, the Fed has never -- that's right, never -- simply paused when boosting rates. When they've skipped a meeting, it's always signaled the end of the tightening cycle. There's every reason to believe that will be the case this time, too.
Seasonal Signs During the past 50 years that's been good for stocks, too. In almost all instances, the S&P 500 has moved higher in the 12 months following the last rate hike, with growth rates nearly doubling. If the Fed is really done this time, that could again. Other seasonal factors favor stocks, at least in the short-run. For example, September has traditionally been equities' worst month. Although near-term lows are often achieved in October, that's usually the culmination of September's corrections. Mutual funds also contribute to the period's weak performance as many have fiscal year ends requiring tax loss selling to occur in September and October. While that's hapening, it pressures stocks, especially those with unrealized losses for the year. But when it's over, stocks tend to rally as funds move back into many of the same shares sold in the previous months. After October's bottom, stocks usually rally through year-end with November and December historically representing two of the best months. This year's mid-term congressional elections may enhance this pattern. The specter of congressional gains and possibly even democrat control hangs over the market as the election approaches. Investors typically view democrats as anti-business and pro taxes, neither of which is good for stocks.
As November nears, more and more press will be dedicated to campaign rhetoric and opinion polls. This is usually a poor environment for stocks. But as October ends and the outcome comes into better focus, stocks may begin to rise regardless of the projected outcome for no other reason than an end to the autumn's uncertainty. Economic data from September, October, and November will tell if the Fed has really achieved a "soft landing" with inflationary pressures declining while GDP and earnings continue to grow. If that's the case, the year can end on a strong note. Holiday sales are always the headliner after Thanksgiving and this year should be no different. Technology sales might actually lead the way. No, this isn't a throwback to the late 1990s, but it does follow a historical pattern. The last major wave of technology spending occurred right before the start of the current decade as businesses and individuals rushed to upgrade their computers before the dreaded "Y2K". In the following years, both businesses and consumers scaled back their tech spending and now find themselves with aging systems. With the first real upgrade in seven years for the Windows operating system just around the corner, there's yet another reason to return to the technology aisles. Falling prices for almost all related products -- especially LCD displays -- add additional incentives. Tech stocks, laggards since 2000, are also on sale. Now trading at realistic and even cheap valuations, it could very well be time to give them a second look. Financial shares are also poised to benefit from stable and perhaps even falling interest rates. When the yield curve returns to its traditional upward sloping pattern, banks and insurance companies will see margins begin to return to normal along with the spread. Of the group, only brokerages may suffer as it will be difficult to top the prior quarters' outstanding profit gains. These trends are all functions of economic and market cycles from the past. Although instability in the Middle East and oil prices factor into the equation, it's still the same equation. There have always been extraneous events with major short-term effects, yet the markets themselves have always recovered and followed the long-term cycles. Why should today's markets be any different? You can spend a lot of time and energy trying to figure out what will happen in the next week or even month, but if you're a long-term investor, your best guide is still years of history. With so much information available, it's easy to get caught up in the headlines while failing to see the long-term forest for the short-term trees. Don't make that mistake. If you look back over the past 50 or even 75 years, what you'll find is there were always short-term events that clouded perception of the market's direction. There was always a reason to think "it's different this time", but it never was. Odds are, it won't be this time, either. Search this site! Just enter you key word or words:
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HE 1990's LEFT MANY enduring marks on the investing world. From tighter regulation resulting from corporate scandals to the scars of the tech bubble, the impact lingers on. One of the most pervasive changes continues to influence investors' daily actions: The emphasis on a short-term perspective.
