| "The difference between false memories and true ones is the same as for jewels: It is always the false ones that look the most real, the most brilliant." |
| -- Salvador Dali |
ALLOWEEN CAME EARLY TO THE FINANCIAL markets this year. Starting in early summer, ghosts from the past were just about everywhere. For example, consider these haunting facts:
- Equity markets are falling a precisely the same time as last year's major corrections.
- Oil prices have crossed over $20 and show no sign of stopping, bringing back memories of the early '70's inflationary prices.
- Inflation fears are weighing on both the stock and bond markets, reminiscent of almost forgotten bear markets.
- The Fed is tightening interest rates, resurrecting fears of a reprise of 1994's devastating bond market.
Is all this concern justified or is it just so much market superstition? As any horror movie fan will tell you, things aren't always as they appear. Let's take a closer look.
Nightmare on Wall Street
All summer, the Federal Reserve was the focus of attention. The threat of higher interest rates hung over the market like an alien presence on an isolated spaceship. Presumably this resulted from the fear that inflation would soon return to wreak revenge on the economy for so many years of uninterrupted prosperity. It didn't help that Alan Greenspan was doing his imitation of the Chucky doll, popping up in unexpected places, even when you thought he was done in.Bond traders hung on every word, running around like the kid from Home Alone any time anything evenly vaguely negative was said. Were they right to worry, or was this simply some bad fiction?
On the face of it, it's enough to make you believe in ghosts. The Fed did raise interest rates twice -- once in June and then again at their next meeting in August. The last time this occurred, the last bond bear market followed. As a result, the yield on the 30-year Treasury Bond rose from 5.80% to 6.25%. Scary, isn't it?
And this isn't just a problem from the bond market. When interest rates rise, corporate profits and stock values fall. This is because it's more expensive for companies to borrow to finance new projects or ongoing concerns. Higher rates historically meant lower stock prices.
This is illustrated by the accompanying chart. It compares the Federal Funds rate -- the rate used by banks when they lend to one another -- to the 30-year Treasury Bond and the Dow Jones 
Industrials (plotted on an inverted scale). This is a pretty frightening demonstration, particularly when you realize the Fed has raised the Fed Funds rate by .50% in a mere six weeks.
But on the positive side, the Fed may be done. After their August move their announcement offered some hope:
"Today's increase in the federal funds rate, together with the policy action in June and the firming of conditions more generally in the U.S. financial markets over recent months should markedly diminish the risk of rising inflation going forward."
Indeed, aside from an occasional aberrant report and the price of oil, inflation does appear to be in check. The Fed's recent actions, should head it off should it heat up in the coming quarters. Even oil may head back down when OPEC countries start to act in their own self-interest by cheating on their spring accord. In addition, the Fed may be reluctant to take further action to disrupt financial markets as Y2K finally arrives.
And by the way, that chart is a little like the Wizard of Oz -- its appearance is at first frightening, but when you pull back the curtain, you find it's just a lot of smoke an mirrors. In this case, what lies behind the curtain is the correlation between the variables.
In short, correlation measures how one variable moves relative to another. Perfect positive correlation is 1.00 and means both variables move in tandem. Perfect negative correlation is -1.00 and means both variables move in opposite directions to the exact degree. A correlation of 0 means the variables have absolutely no relation to each other.
As you would expect, the 30 year Treasury Bond is positively correlated with the Federal Funds rate and the Dow Jones Industrial Average is negatively correlated with it. But according to data from Ibbotson Associates, over the past 15 years, neither correlation is particularly strong -- 0.6638 for the bond and -0.6134 for the Dow Jones. Sure, higher Fed Funds rates won't help the stock or the bond market, but it isn't Armageddon.
And you know what? Even if the Fed adds another .25% increase, Fed Funds will only be back at the level of last year at this time when the Fed started lowering them. Markets were doing pretty well then, so why should a return to that level spell doom now? In fact, last year when short-term rates were .50-.70% higher, the 30-year Treasury Bond was 1% lower. Unless you're a bond trader and genetically scared of your own shadow, you should realize that soon bond yields should be headed lower, probably back to the 5.75-5.80% level.
I Know What You Did Last Summer
Of course bond-fretting isn't the only thing affecting the stock market. There's a great deal of concern that at such high valuations, the market is priced for perfection. In fact, this has 
been the fear for several years now and has resulted in increased volatility.
Through August, the S&P eerily followed the same path as it had a year ago. Equity investors felt like they were in some cheesy '60s sci-fi movie having been transported back into the past and wondering what they could do to change the future. For the superstitious, this is even more important as we move through September and October. If you wonder why, just look at the graph.
Even more frightening is the longer-term comparison of the Dow Jones Industrials to the Nikkei 225. You probably know that the Japanese market had a tremendous run-up in the 1980s, only to crash into a 
seemingly inescapable funk for the entire decade of the 90s. What you may not realize is that the U.S. equity market is following the exact same path.
That's right. If you offset the two by 12 years (specifically 11 years, 10 months), the charts are strikingly similar. (Salomon Smith Barney has a version of this chart that goes back a lot further and is a lot more impressive. Check it out if you have the opportunity.) Some of the same "new paradigm/different this time" talk is occurring here that occurred in Japan during their market's ascent. You don't have to be overly superstitious to wonder if the next decade will be the U.S. what the 90s were to Japan. It's not a pretty picture.
Ghost Busters
But it's here that the parallels end. The ghosts from the past evaporate when you turn on the light and get a grip on reality:INTEREST RATES ARE LOWER NOW THAN THEY WERE LAST YEAR AT THIS TIME. Even if the Fed tightens another quarter point, we'll just be back where we started. In real terms, rates aren't rising.
FOREIGN ECONOMIES ARE RECOVERING, NOT IMPLODING. Remember the reason the Fed lowered rates last year wasn't because the U.S. economy was failing but to head off a potential liquidity crunch emanating from foreign shores. While this crisis may not be completely over, the world economy is in much better shape now than a year ago. That's a positive, not a negative.
VOLATILITY AND SELLING IN THE U.S. MARKETS OCCURRED ON THE LOWEST VOLUME OF THE YEAR. Ever since summer started, it's been the night of the trading dead. Traders took to the hills (for vacations we hope) and every little earnings disappointment and bond market jitter was vastly overblown in the thin market. Well summer's over now and volume should pick back up. You can't help but think this is positive.
SINCE THEY'RE SO FAR OUT IN FRONT OF IT, THE FED SHOULD HAVE POTENTIAL INFLATION UNDER CONTROL. Last year there was speculation that the Fed's easing may spark inflation. This year they're taking it back with no current signs of trouble. Presumably this action should serve as the clove of garlic keeping the inflationary vampire locked in its coffin for several more quarters. That's got to be good for the stock market.
U.S. CORPORATE PROFITS ARE AGAIN ACCELERATING. Second quarter earnings were as strong as goat's breath and third and fourth should follow suit. As Y2K comes and goes, pent-up demand will come back into the market -- an additional positive. In essence, equity fundamentals are as strong or stronger than they have been for quite some time.
The Exhort-cist
So what -- other than a sinister supernatural force -- is holding the market back? It's the interest rate goblin again. Although it's really nothing to fear at this point, investors are still scared of it. It weighs most heavily on the financial stocks, and those are the very ones that must lead if the market is to move forward.
Whereas there's only a weak correlation between interest rates and the equity markets, there's a strong relation between financials and overall market performance. Remember correlation
measures? Well the S&P 500 and its financial sector has a correlation of 0.9914. You can see the close relation in the accompanying graph.
As long as investors worry over the effect of higher interest rates on financial stocks, the market won't establish a strong upward trend. But once it becomes clear that the Fed has inflation under control and further tightening won't be necessary, the financials and the market as a whole will be free to move up. Strong third quarter earnings will only add fuel to the fire.
So over the short-term, financial stocks will be the omen. When they begin to strengthen, so will the entire market. In the meantime -- if you're adventurous -- you can find some real values in the sector. Hopefully the market ghosts and goblins will be long gone by Halloween.
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