Last Updated May 1998

---

OU MIGHT THINK FROM THE WAY the economy's been going that everything must be working in concert. That would not only include businesses and consumers, but Congress and the Fed as well. Well, you might think that, but you'd be wrong.

While businesses and consumers have worked together nicely, the economy's been hitting on all cylinders in spite of Congress and the Fed rather than because of them. The Fed has kept its monetary tools in the tool box, with the last rate increase coming over a year ago. Congress hasn't tinkered with its fiscal policy in quite some time. The Democrats are afraid to take any aggressive stances knowing that they can't count on support from a President caught up in Bimbogate. The Republicans are equally spineless, trying to avoid stepping on the electorate's toes between now and the November mid-term elections.

But don't misunderstand, this isn't a plea for bold interest rate moves (in either direction) or tinkering with tax policy. There does, however, have to be some middle ground between Keynesian futzing and Alfred E. Newman indifference. Currently, it looks like Congress, most businesses, consumers, and investors have all adopted the, "What, me worry?" attitude. Only Alan Greenspan seems the least bit concerned, but then again, he's the designated fretter.

Is there reason to worry? Of course there is. Regardless of how many purported experts tell you, "It's different this time", it isn't. The economy has ups and downs. No, it doesn't have to have sharp rises and declines. (Give the Fed some credit, they've taken it upon themselves to smooth out the path.) But the economy is cyclical and cannot perpetually move on an unimpeded upward path. Once everyone believes it will, it most certainly won't.

No, this isn't a prediction of doom and gloom. It is, however, a warning that there are storm clouds on the horizon. Let's start with inflation.

M2 is Not A# 1

More ominously, consumer spending (which has helped drive the economy) remains strong. This, coupled tightening labor market, poses the problem. Sooner or later (probably sooner now) businesses will find it impossible to absorb higher labor costs. Instead, they'll pass them on to consumers and you know what that means.

There's other warning signs out there, too -- for those who choose not to ignore them. Remember M2, the Fed's favorite measure of money supply? You used to hear a lot about it as a measure of inflation. The theory is simple, going back to the Economics 101 definition of inflation: Too many dollars chasing too few goods. If M2 (the money supply) grows too quickly when measured against the Gross Domestic Product (GDP), inflation tends to follow.

Because of this, the Fed used to closely track M2. Every week you'd see goofy cone-shaped charts in the Wall Street Journal, outlining the Fed's maximum and minimum range. Back in the good ol' days (the 80's, remember them?), the Fed would actually base their policy on this information. Now, if they look at it at all, they do so to see where the economy has been, not predict where it's going.

Throughout the expansion in the 90's, M2's growth and inflation have remained fairly stable or declining. But now that's changed -- M2 has recently accelerated. If this is predictive and it isn't "different this time", we can expect some renewed inflation. For those Non-Alfred E. Newman Economists, the accompanying chart doesn't lie.

Bottoms Up

If this were all you saw, you'd think it was great. The flat yield curve means bond investors aren't expecting any appreciable inflation over the next 30 years. If they were, they'd attempt to offset it by requiring higher yields for longer maturities. In fact, some folks feel that if the curve does steepen, it will be as a result of a Fed rate decrease at the short end.

But unfortunately the facts speak otherwise. Besides the strength of consumer spending, the growth of M2, and the tightening labor market, GDP continues to expand and the dollar is strengthening. This isn't an economy in need of stimulus. In fact, if anything, rates may have already bottomed.

Take a look at the 30-year Treasury Bond's yield. Over the past three years, it's moved from a high of just under 8% to a recent low of about 5.75%. As the technicians like to say, there's some pretty strong resistance around 6%. It bounced off this point in the winter of 1995 and is having serious problems moving below it this year. With the continued economic expansion and already relatively low rates, you could make a pretty good argument that rates have about bottomed out. That is, of course, if you care.

Shift Happens

OK, but maybe the trend isn't all that favorable. Rather than just bidding the market higher and higher, what if we take a look at a (relatively) reliable valuation model. (Yes, this is probably showing more concern than most investors, but then again, our initials are BTBS, not A.E.N.)

This chart comes from the March 16, 1998 edition of Barrons. It's based on the tradeoff between the yield on the 10-year government bond and the "earnings yield" (the inverse of the P/E ratio) on stocks (as measured by the S&P 500). Back in mid-March, the question was, "Why would you buy stocks with an earnings yield of 4.75% when you could get a 10-year Treasury Note yielding 5.6%?" This question has become even more compelling as the yield on the note has remained stable while the S&P has continued to climb. The chart compares the S&P's actual value to a "fair model" price based on the note yield. As you can see, on this model, stocks are currently overpriced.

Perhaps even more telling is the lower part of the graph. It plots the spread between the S&P's actual and fair value. As you'll notice, it was most overvalued in the fall of 1987 (remember what happened then?). It was also overvalued before the recession of 1990 and the brief pullback in early 1997. Currently, we're back to those levels. If the future is anything like the past, it will shift back to fair value. Are you worried yet?

Fear of Flying (Prices)

No, you don't need to sell all your equities and go to cash. And interest rates aren't going back to double digits -- at least any time soon. But you do need to be vigilant. It's extremely difficult to invest when conditions are as good as they'll get. Money manager Mike Rouzee summed this up in the April 13 Barrons:

People confuse price with value all the time. American business is priced at a level now that would argue that everything is perfect and will get more perfect, if there is such a phenomenon. My argument is that everything is perfect -- and generally, when everything is perfect, something goes wrong. And I think if something goes wrong, the price will change. That doesn't mean that Coke will sell any less Coca-Cola next year, or that it's not a good product. Or that P&G won't sell a lot of soap. It just means that the perception of the value of those things will change -- and that will be reflected in the price.

Right now, the prices of both stocks and bonds are fairly divorced from their true (intrinsic) value. (You knew it was going to come back to that, didn't you?) This isn't a good time to be an arbitrary buyer -- or even and arbitrary holder. In fact, with prices in the stratosphere, this might be a good opportunity to evaluate current holdings and take some profits -- if you can stand the taxes. If you're looking to buy, believe it or not, there are still some values out there, but you have to do some homework…

What's the best barometer for the short term? Probably corporate earnings. As the economy slows and/or inflation heats up, it'll be harder and harder to increase earnings. Companies that can do this may not outperform the momentum-driven indexes over the short-term, but will be best situated when the markets revert to the mean. Small to medium caps with strong balance sheets and niche markets probably offer the best opportunities.

Concern doesn't necessarily mean panic. In fact, when the economy proves it really isn't different this time, the Alfred E. Newman investors will probably be more prone to pathos. A little well placed vigilance never hurt anybody -- especially value-oriented investors.