| "If you go looking for trouble, you're bound to find it." |
| -- Mom |
S SUMMER 1998 CAME TO A close, Russia, Latin America, and Asia were all falling deeper and deeper into economic turmoil. The general consensus was that they would pull the U.S. down with them, ending one of the longest recorded domestic expansions.
In the autumn, with inflation still at bay, the Fed moved in three quick strikes to lower interest rates and inject liquidity into the market. Bond traders reacted quickly and favorably, sending yields briefly below 5%. In comparison, stocks again became attractive, finishing 1998 on a strong note.
But as 1999 unfolded, the fear of slowing corporate earnings and recession again surfaced. Analysts actually had relatively low (realistic?) earnings projections rather than the usual pie-in-the-sky optimism. In a pleasant surprise, earnings were up across all market capitalizations and the expansion lived on for another quarter.
As is often the case, investors turned 180º. Now the concern was that the economy was expanding too fast and was sure to ignite a debilitating bout of inflation. Instead of lowering, the Fed's next move might be to raise rates, perhaps even more than once. Bond prices immdiately jumped from 5.2% to 5.7%.
This sudden about face brings to mind Mom's old admonition, "If you go looking for trouble, you're bound to find it." Investors were obviously looking and even when they failed to find trouble in one place they looked in another.
OPEC Demands More Kopecs
Maybe they have it right this time. After all, just because you're paranoid, doesn't mean someone really isn't after you. Perhaps the best justification for the current inflation worry is OPEC's reemergence from the dead.Earlier this year, OPEC ministers reached yet another agreement to limit production in an effort raise the plummeting price of petroleum. In fact every time they meet they come to this conclusion. (Makes you wonder if they have a fill-in-the-blank communique they just complete at the end of each meeting.) This time, however, the price of oil actually reacted, jumping from lows around $11.00 to briefly trade over $18.00.
Inflation has been wonderfully low for the past several years, averaging around only 2%. The last great bout of inflation occurred in the 70's and was kicked off by sharply rising oil prices. That's kind of an eerie parallel, isn't it?
Well, no, not really. Other commodities (gold, lumber, grains) certainly aren't following suit. Unlike the 70's, the deflationary effect of higher productivity brought about by technology has kept wage inflation at bay.
Besides, there's little reason to believe the latest OPEC agreement will stick. Each dollar increase in the price of oil is additional incentive for the cartel's countries to cheat. While the price of oil was unsustainable at $11, it's equally unsustainable at $18. Your local gas station may have jacked up the price at the pump, but that's probably the biggest effect you'll feel. In a month or two, this latest OPEC agreement will probably go by the boards like all the other accords before it.
Bound Bonds
So what's up with bonds -- other than their yields? If inflation isn't a problem, why are bond prices down?
A lot of it is seasonal. The first quarter is usually the worst for the bond market. The economy gets and extra boost from early tax refunds and late bonuses. Japanese firms pull some of their investments out of the U.S. to dress up their balance sheets for their March 31 fiscal year end. The Treasury adds supply during the February quarterly refunding. To top things off, this year AT&T brought to market one of the largest corporate issues ever.
Since the first quarter jump in yields, bonds have fallen back into a fairly steady trading range (5.5 - 5.7%). 
While not exceptionally high, with inflation around 1.5 - 2%, the 30-year Treasury Bond's real interest rate (quoted rate - inflation rate) is still near the top of its 3.5 - 4.5% 10-year historical range.
As we move into the second quarter, some of the seasonal trends will reverse. In addition, U.S. bonds should benefit from government's attempt to pay down debt rather than financing the usual array of pork barrel projects. Weakening economies in Euroland, Japan's continuing reluctance to truly addess the financial industries' problems, and the flight to quality spurred by the Yugoslavian crisis will all tend to push up U.S. bond prices.
If inflation stays tame, the long-bond can easily move back into the 5.2 - 5.3% range, if not lower.
Inflation Rotation
So what do stock investors have to worry about? Essentially the same issues as bond investors -- plus a few extra.
As the year began, everyone fretted that the market was being led by a few high-multiple tech stocks and that market-weighted averages were distorting the real weakness in the market. Consider these results from the first quarter:
- Although the S&P 500 was up 4.6%, 278 of its stocks were actually down for the quarter. The average stock rose only 0.3%.
- Small and mid-cap stocks fell during the quarter, Relative to the S&P 500, the S&P 400 Midcap Index was off 11.3%, the S&P 600 Smallcap Index was off 13.8%, and the Russell 2000 was off 10.4%.
- Only 51 of the 113 S&P industry groups outperformed the index in the first quarter. Although this is an improvement over the 38 which beat the index last year, over half are still being left behind.
| Start | End | Months |
|---|---|---|
| June 1949 | August 1956 | 86 |
| October 1957 | December 1961 | 50 |
| June 1962 | February 1966 | 43 |
| October 1966 | November 1968 | 26 |
| May 1970 | December 1972 | 31 |
| October 1974 | November 1980 | 74 |
| August 1982 | August 1987 | 60 |
| December 1987 | July 1990 | 31 |
| October 1990 | Present | 102 |
| Source: Standard & Poor's Outlook | ||
Going into 1999, the main fear was that the slowing economy would cause the "nifty-fifty" stocks to stumble, taking the rest of the market down with them. With so narrow leadership, the bull's days were numbered. It is, after all, pretty long in the tooth.
Wrong again. Despite all the fretting during the "earnings confession season" in the last part of the quarter, fully 40% fewer companies pre-announced earnings disappointments. In fact, with 25% reported, first quarter earnings surprises were overwhelmingly positive in all sectors except energy.
Leadership also broadened out. As early as late February, oil and oil 
service stocks showed some signs of life. While this may have orginally been tied the latest OPEC accord, other cyclicals joined in April. In fact, smokestack stocks outperformed techs and financials in the latter weeks of the month.
What could possibly have caused this, so late in an economic expansion? It was worries, of course. Once fourth quarter earnings came in stronger than expected, stock investors (like bond investors) did a quick about face and began to worry that inflation was around the corner. If it were, no one would want to pay the high multiples demanded by growth stocks. Instead, the beaten down cyclicals were much safer and therefore more attractive.
Add to this the fact that value investors had missed most of last year's equity party and were dying to get in. As soon as value stocks showed some life, they jumped in with both feet. There was still plenty of liquidity to keep things going since over the past six months four times more cash went into money markets than into equity funds. At some point this trend had to reverse.
Wrong Again
But why would you buy cyclical stocks so late in an economic expansion? Usually they lead the way in the early years reaping the rewards of pent-up spending.Some believe that's exactly what's about to happen now. The only difference is, the anticipated demand isn't going to come domestically, but from recovering foreign economies. The underlying belief is that Asia (possibly including Japan) has hit bottom and is about to begin a powerful recovery. Cyclical companies that export a great deal of their products stand to benefit from this change of fortunes.
Well that's about half right. While it is true that recovering trading partners will increase demand for our exports, what do you think they'd be most likely to seek first, technology or heavy machinery? Computers or bricks and mortar? Coca-Cola or steel bar?
You get the picture, the companies that stand to benefit first and foremost from a foreign recovery are the very ones that have been leading U.S. stocks for the past 2-3 years. While it's nice to see the market recovering from it's bad breadth, let's not get carried away to the opposite extreme.
Fact is, there's plenty of room for all sectors and types of stocks to continue the move upward. It's not necessary to take all your money out of tech and buy basic materials (or vice-versa for that matter). The current economic environment can support quality companies with good products and steady earnings regardless of what industry they represent.
The broadening advance only means the bull has more room to run. The key is finding the right stocks in each sector. Focus on that and forget all the talk about "rotation" and possible inflation. After all, if you go looking for trouble, you're bound to find it.
Search this site! Just enter you key word or words:
Get current quotes or follow your own custom portfolio, courtesy of E-Line Financials:
| |||||||||||
| Homepage | Return to Top |
