The Bear is Dead, You Say?
A Look at Interest Rates vs. Stock Prices
The gall and temerity of the financial press at certain times never ceases to amaze me. For example, an article published in SmartMoney Select on 6/13/03 was entitled, "Ding-Dong, the Bear is Dead!" The article states, "The lows of last Oct. 10 have proven, so far, to be The Bottom....But is the rally sustainable? Yes. Was Oct. 10 the bottom? Yes."
Right here I have to interject that this pronouncement came right at the same time in which investor sentiment hit a 16-year high and also at a time when the percentage of bullish advisors far outnumbered bearish advisors. In other words, this is a classic psychological indication that once again the investing public is being set up for a huge fall later down the road.
Back to the article. The author, Donald Luskin, seems to base a large part of his argument in favor of a new bull market on the correlation between stock prices and interest rates. He points out, "Since March 2000, long-term Treasury yields have marched lower in lockstep with falling stock prices," adding that "This reflects the fact that long-term yields embody more than a discount rate to be applied to a given amount of future earnings." Cutting through all the jargon, the author goes on to make the case that rising interest rates are actually better for stock prices than falling rates, an assertion which doesn't always match the historical record. After all, interest rates peaked in the early 1980s while stock prices were bottoming, while in the 1990s interest rates declined while stock prices rose. That fact is that at different points along the economic K-wave interest rates and stock prices sometimes align and sometimes travel in inverse correlation. It all depends on where we are in the K-wave, so trying to base an argument on a static correlation between rates and stock prices is untenable.
So where are we now along the K-wave in terms of the interest rate/stock price correlation? Since we are in "K-wave Winter," also known as "runaway deflation," the K-wave bottom is nearing its end and interest rates can be expected to remain low, overall. It is possible that rates could actually bottom a year or two ahead of the K-wave itself, perhaps even rally a bit, but they should remain low overall over the next couple of years. But here's the kicker: stock prices are extremely sensitive to interest rate fluctuations in late runaway deflation, and indeed there has been a noticeable effect on stock prices -- both up and down -- whenever interest rates change direction, short-term.
For instance, from 1996-1999 stock prices and interest rates took diverging paths, with rates trending downward while stocks trended upwards. There was a conspicuous peak in stocks with a corresponding bottom in rates around early 1999 which was followed by a near perfect correlation between stocks and rates from 2000 to 2003. All of that changed recently when rates and stocks again took conspicuously opposite paths with rates spiking to a 45-year low while the Dow Industrial index raced off its lows for the year to an impressive spring rally peak above the 9000 level. Have we now entered another short-term phase where stock prices and interest rates will again be inversely correlated (i.e., opposite trends)? If so, the latest market action is certainly instructive. The yield on the 10-year Treasury Note has risen sharply in recent days while the Dow is beginning to turn down. I need not remind you that in late runaway deflation almost everything is highly sensitive to interest rates, including and especially real estate!
With all of the hoopla surrounding the generational low in interest rates I would not be surprised if we've just witnessed a significant bottom in rates, at least for the intermediate-term. If so, then the road ahead is likely to become very rocky as interest rates gradually creep upward between now and 2004-2005, a time where a number of major long-term cycles are due to bottom which should produce a nasty 2004 and possibly extending into 2005. Oh and by the way, next year should guarantee that George W. Bush does not get re-elected for President. I've heard a few media pundits proclaim that "W" stands an excellent chance for re-election, but based on my reading of the dominant market cycles I believe he'll be kayoed by the same rough economy that killed his father's chances for re-election back in 1991-1992. Only this time it should be even worse.
Getting back to the SmartMoney article, the Luskin writes, "The Fed has indicated in the strongest possible terms that deflation-fighting is its highest priority. And beyond that, the statement from the most recent Federal Open Market Committee meeting could be interpreted to mean that its worry about deflation -- which indicates that the Fed isn't worried about inflation -- gives the Fed scope to try to stimulate the economy by means that would ordinarily be unacceptably inflationary." Luskin then goes on to assert, "The correct monetary-policy response to higher anticipated economic growth rates resulting from the tax cuts is to provide additional monetary liquidity to the economy -- and so far, even if it's for other reasons, that's exactly what the Fed is doing by keeping the overnight rate low." This statement assumes that the Fed has ultimate control over interest rates, when clearly they do not. They can only follow the trend and trajectory set by the natural forces of the free market (as determined by the K-wave and other market cycles), and even Greenspan himself has admitted in words to this effect that this is so. So this commonly-embraced idea that the Fed has ultimate control over the state of the economy by merely pumping money into it is patently false.
Indeed, pumping money into an already over-pumped, debt-ridden economy can only result in economic implosion (or explosion, depending on how you look at it) at some point. Just as a balloon can only be pumped so much before it pops, so too the economy has limitations as to how much liquidity it can withstand at any given time.
On a related note, here's an interesting statement from Harry Schultz, printed in the 6/23/03 issue of the HSL newsletter:
"Are you under the impression that Central Banks -- especially the U.S. Fed -- are pumping money and credit? That's a logical assumption, because their biggest guns tell us so. I thought so too, until I looked at the data. It's relative fiction. Increasing money supply somewhat, yes. Compared with the historic past, yes. But compared with recent past, no. Compared with their promises, no. Compared to the needs? Absolutely not!"
Schultz goes on to point out that the actual money supply numbers, looked at cold, do not amount to much until you have something to compare them to. He states that rate of change is all that counts, and I agree as this is something I've been preaching for years. I keep up a monthly chart of M3 money supply shown from a 10-month rate of change (ROC) standpoint. (See the online BMR page for the latest update to this intriguing chart). You'll note that M3 is in a significant downward trend as the overall money supply continues to lose momentum. As Schultz states, "When the rate of change declines you are shrinking at an increasing rate. What is not rising via rate of change is, by definition, shrinking -- the Accelerator Factor, an axiom of economic understanding!"
He adds,"To make it worse, not only is money supply shrinking lately, but the velocity of money is dangerously low," pointing out that this is the same pattern the Fed followed in 1928-1929, which of course led to the Great Crash and eventually to the Great Depression. "If this hesitancy [to increase money supply] isn't stopped fast, we're headed into the same trap," wrote Schultz.
Steve Saville, of the Speculative Investor, recently added to this observation, "...the year-over-year change in the total supply of U.S. dollars (M3)...while...still reasonably healthy by historical standards, it has plunged over the past 15 months. Furthermore, if the trend in money supply growth continues for another year then the money supply will start to contract (the U.S. will experience genuine deflation)."
To this end, the following quote from a recent Elliott Wave Financial Forecast newsletter adequately sums up the growing threat of deflation in the U.S. economy:
"The reason the Fed didn't use the word [deflation] is that it recognizes that deflation is a self-reinforcing psychological process. Once it gains a small place in people's expectations, it will feed on itself as consumers and businesses have no choice but to respond in ways that foster its development. The barrage of headlines over the last three weeks signals that deflation is truly at hand. In recent days, the Wall Street Journal has followed with stories noting that the underlying inflation rate is at a 37-year low and a special IMF task force assigned to study the deflationary risks in the world's 35 largest economies has found that there is actually some risk of it outside Japan. The IMF now says Germany, the United States, Singapore, China and 15 other countries could experience deflation. Now that deflation has its foot in the door, the only logical response is to take defensive action."
To this I can only add that the 1-2 years ahead should see extraordinary deflation across the stock and real estate sectors, as well as in the general economy, and "defensive action" is indeed imperative.