Will the market return to bull mode?

When will investors get to recoup their wealth? Stay the course, this adviser says.

Issue: October 1, 2001

ByFred L. Dowd

Investors are worried about the market. They are worried about their net worth. They are worried about retiring in comfort after this current recession. More than $4 trillion of paper assets have disappeared over the past 2 years. How can investors get back some of those assets?

My suggestion to investors is to stay the course. Hold those companies that have real value and real assets to back the share price. There is no good alternative to our stock market for the creation of real wealth, and that fact has not changed.

I do not have a crystal ball, and I cannot promise my clients that our markets will begin to rally anytime soon. I cannot promise them that if they move to cash they won’t miss the biggest portion of our next rally. What I can do is show them why I am confident that our markets will return to bull mode and why I believe they can recoup wealth.

History lesson

Since the end of World War II the following statistics have proven true. The average bear market lasts only one third as long as the average bull market. Per this historical data, the average bull market is up 105% versus the average bear market decline of 28%. The average bull market has lasted 41 months versus the average bear market of 14 months’ duration.

My overall outlook for our markets is rather positive, and it is based on the mind-boggling inanity of our Federal Reserve. To understand why I think a strong recovery is on the horizon, I need to explain how I believe our economy and our markets got into this conundrum.

Nearly 2 years ago, on July 30, 1999, the Federal Reserve Board raised interest rates by 25 basis points (there are 100 basis points in 1%). I would argue that until this action and the chain of events that have followed, Alan Greenspan was the best Fed Chairman that our country had ever seen.

When the Federal Reserve Board raised rates for the first time, our economy was the strongest economy that the world had ever seen. Unemployment was at record lows, inflation was minimal, our markets were strong, sentiment was sound, and prosperity was pervasive. The United States was the most productive country in the world. That high productivity fueled the creation of wealth and produced profits that led to a dramatic increase in taxes paid into the U.S. Treasury Department. This increase in taxes collected led to a significant decrease in our federal budget deficit.

The Phillips Curve

However, operating on an obsolete economic model called the Phillips Curve, Mr. Greenspan and the Federal Reserve Board have destroyed the wonderful environment and economy that we had only 2 years ago.

Simply put, the Phillips Curve states that when there is low unemployment, an economy can grow at a maximum of 3% until significant inflation arises. This was true in a “smokestack” economy. When there was full employment, the only way a company could grow was to hire employees away from other firms, and the only reliable way to do that was to offer increased wages. This was inflationary in nature and always led to inflation.

Increased acceptance and adoption of technology inherently destroyed the accuracy of the Phillips Curve. By using technology, companies in the mid-1990s became more efficient and more productive with lower costs. For the first time, companies could grow at sensational rates without introducing inflation. Alan Greenspan refused to accept this and went on an inflation war that began nearly 2 years ago at a time when there was virtually zero inflation.

Economics 101

Economics 101 tells us that any monetary policy action takes 6 to 9 months to be felt by an economy of our size. So naturally, the first rate cut in 1999 was not felt immediately, and our economy continued to sizzle. On Aug. 24, 1999 and again on November 16, 1999 the Fed raised the Fed Funds rate by 25 basis points, bringing their total increases to a full percentage point. On March 31, 2000 the Fed raised rates again by 25 basis points. By May 16, 2000 the economy was beginning to show some signs of softness caused by the first few rate hikes, but the Fed ignored 1.25% of hikes still in the pipeline and raised rates by 50 basis points, shocking the financial markets. Over the course of 11 months, the Federal Reserve raised rates six times by a total of 1.75%.

This incompetence has been incredibly difficult to put into perspective, and the fact that our economy and equity markets were ruined on purpose has been nearly impossible to digest and accept. Nevertheless, it did occur, and now I believe that the Federal Reserve has done the exact opposite while lowering rates, likely making the same mistakes on the way down.

Raising and lowering

It became clear toward the end of 2000 that the Fed had absolutely paralyzed our economy with their rate hiking campaign. By December, when the final interest rate hikes were beginning to filter through our economy, it became apparent to both economists and investors that Mr. Greenspan had made several erroneous assumptions that needed to be corrected swiftly. With razor-thin liquidity and corporations cutting spending plans because of higher rates, the Fed began its attempt to reverse these horrendous blunders.

On Jan. 3, 2001 they lowered rates by 50 basis points in an inter-meeting move that portrayed their concern. It is a very rare occurrence for the Fed to change rates outside of their regularly scheduled meetings. Only 28 days later, they lowered rates again by 50 basis points. Waiting only two months, the Fed proceeded to lower rates by 50 basis points on March 20, 2001 and again on April 28, 2001.

As previously noted, interest rate changes always take 6 to 9 months to effect the macro-economic picture. Of course there would not be an immediate change from the downturn in our economy due to several hasty rate decreases, as the pain of the interest rate hikes from 9 months earlier were still circulating through our financial markets.

The Federal Reserve dropped rates again on May 15, 2001 by 50 basis points and again lowered rates by 25 basis points on June 27, 2001. We fully expect them to lower rates again at the meeting tomorrow, Aug. 21, 2001.

Numerous mistakes

Mistake number 1 for the Federal Reserve was fighting the inflation bogeyman that never existed. Mistake number 2 was the rapid manner in which the Fed raised rates. Mistake number 3 was lowering rates without accounting for the time that monetary policy takes to work, duplicating mistake number 2 in the opposite direction. Mistake number 4 is still in process, but hopefully will end at the August meeting with a statement declaring that rate cuts are finished. Mistake number 4 was the slow doling out of rate cuts that continues. When consumers and businesses realize that lower rates are in the pipeline, they hold back any large-purchase items to lock in the lower rates. This slows our economic recovery.

My take is that we will begin to see some signs of economic improvement beginning in September 2001 spurred by the first rate decreases of January 2001. Over the following 7 to 8 months, the other rate decreases should have the desired effect.

I have real difficulty understanding the wisdom of baby-step rate decreases with Fed verbiage to the effect that “more decreases will follow.” This retards spending for large-ticket items that require financing because buyers have been rewarded with lower finance rates by procrastination.

As of the writing of this article on Aug. 20, 2001 consumers continue to be rewarded for the procrastination of purchases for big-ticket items. As Mr. Greenspan continues to suggest the Fed will lower interest rates, both businesses and consumers are rewarded with lower financing costs by putting purchases on hold. Why not set a target Fed rate, move down to it, and announce that this is it for lower rates? This would return some real incentive to spend now, not next month or next quarter.

If and when the Federal Reserve announces the end to rate cuts, I think we will see the beginning of a substantial market rally.