Copyright © 1998 by Norman P. Poire. All rights reserved.

THE NEW ERA

More and more these days we are hearing talk of a "new era" for stocks. According to this view, low inflation and falling interest rates have combined to produce a very powerful economic expansion that has carried stocks to record high P/E ratios and record low dividend yields. As long as we find ourselves in this not-too-hot-and-not-too-cold Goldilocks Economy, so the logic goes, historical comparisons to past stock markets are irrelevant. Therefore, the explosion in equity prices since 1994 is fully justified, with no end to the bull market in sight.

Undoubtedly, benign interest rates and a favorable inflationary environment have contributed greatly to the tremendous growth in equity valuations of late. And a reading of financial history makes it clear that, when viewed in the proper context, recent market action is normal and expected. The following chart shows the inflation adjusted S&P 500 index during the 1870s, 1930s, and 1990s. The index has been normalized to a value of 100 for the years 1877, 1932 and 1994.

As impressive as the last 3 1/2 years have been, they have nothing over the two prior periods beginning in 1877 and 1932. What all three have in common is that the economy was in the expansion phase of the 30 year cycle while in the down wave of the 60 year cycle . Where they differ is that the latest expansion was launched from a higher base than the preceding two. For that we have the massive investment of the Baby Boomers in a record setting spending wave to thank. And that is why current valuations are at record levels.

THE OLD ERA

But the more important lesson that can be gleaned from studying markets past is that a Goldilocks Economy can set a luring trap for unknowing speculators. Today's investors have become conditioned to believe that as long term interest rates fall, both bonds and stocks rise in value. That is because this relationship has been the norm for nearly 60 years.

As we shall see, though, stock prices can move opposite to bond prices; disquietingly, this situation tends to occur when inflation is most benign. And that means that just when the economy is functioning so smoothly that we are convinced it couldn't happen, a bear market in stocks can unfold before our very eyes.

There is no better example of this phenomenon than the greatest Bear market in the history of U.S. stocks. That infamous slide in equity values began in September of 1929, after long term interest rates had been falling for seven months and inflation was running near zero. Prices of stocks plummeted nearly 90 percent over the 33 months that followed, with interest rates trending lower over most of that period.

To understand how this could occur, we must explore the relationships between interest rates, inflation, and real economic activity.

ECONOMIC RELATIONSHIPS

Because bonds are fixed income securities, they are "hard wired" with interest rates. In order for a bond's fixed dollar return to remain competitive when interest rates are changing, its price must change inversely and proportionately. No other external factors enter into the equation.

Interest rates in turn fluctuate with changes in economic activity. For example, as the economy grows in real terms (i.e., adjusted for inflation), the appetites of businesses and consumers for borrowed funds rises. The increased demand for debt raises the cost of money which manifests itself as higher interest rates. The foregoing relationship always holds but can be quickly overpowered by changes in the general price level. The way this works is as follows.

When the economy is inflationary (a positive inflation rate), any further increase in nominal prices produces a rise in long term interest rates. That's because debtors are paying back loans with cheaper dollars so creditors in turn demand greater returns on future loans to compensate for the loss of buying power.

Conversely, when the economy is deflationary (a negative inflation rate), a further decrease in nominal prices (greater deflation) is required to produce a rise in interest rates. The reason is that falling prices and wages make it more difficult for debtors to service their debt. As the default rate on loans rises, creditors demand greater compensation for the added risk.

Up to this point, we have established the relationship between bond prices and interest rates, and between interest rates and inflation. The final missing puzzle piece to discovering how stock prices react to bond prices is the association between inflation and stock prices.

But stock prices are a proxy for real economic output, meaning the two tend to move in tandem regardless of other external factors. So to characterize the link between stocks and inflation, we need only understand the association between real economic growth and inflation.

For this we now turn to a body of historical research originated by James Paulsen, the chief investment officer of Norwest Investment Management. His findings were published in a July 28, 1997 Barron's article entitled What's Different Now.

WHAT'S DIFFERENT NOW

By analyzing economic data going back to 1926, Paulsen discovered that changes in real economic activity correlate strongly with changes in nominal prices. That a relationship exists between the two may not be surprising. But the nature of that alliance was quite unexpected. When the annual inflation rate is positive (inflation greater than +1.25%) changes in real economic activity move inversely with changes in nominal prices. In an inflationary environment, then, a growing economy yields a reduction in price inflation.

But when the economy is experiencing deflation (inflation less than -1.25%), prices change directly with real economic activity. In other words, a growing economy in real terms is accompanied by a rise in nominal price inflation. Finally, when the inflation rate is "zero" (between -1.25% and +1.25%), there is no correlation between prices and output.

Perhaps the most interesting aspect of this finding is that an economy experiencing real economic growth has a natural zero-inflation equilibrium point. Thus, as a general rule, an inflation rate moving away from zero signals an economy that is experiencing a slowdown in real economic activity. If the inflation rate is "non-zero", the slowdown should be accompanied by rising long-term interest rates; if it is "zero", interest rates should be falling.

STOCKS VS. BONDS

The above discussions can be summarized in tabular form as follows:

It is now clear that when the economy is dominated by inflation as it has been for the past 60 years, stocks and bonds tend to move in tandem. In that environment, periods of real economic growth increase stock and bond prices, while a falling real economic output forces these prices to decline.

As the inflation rate approaches zero, stock and bond prices are no longer driven by changes in general prices. Instead they are influenced by real economic growth alone. A growing economy increases loan demand, driving interest rates up and bond prices down. But stock prices, as always, follow the economy upward. Thus, the relationship between stocks and bonds must invert.

SAME OLD ERA

At this writing in April 1998, the inflation rate based on the Consumer Price Index is 1.4 percent and falling. Paulsen's research shows the bond-stock association inverting as inflation crosses below 1.25 percent. Our own analysis places the divide at 1.1 percent. At either rate, it would be prudent for investors to be alert to the possibility that the markets are entering a period unlike any they have experienced.

And that means not falling into the trap of believing that Goldilocks and the Bear could never meet.

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