Monday’s Wall Street Journal asked, “Why Can’t Stocks Get on a Run?” Familiar but unlikely culprits mentioned for today’s market uncertainty were too much consumer debt and high P/Es, along with the “bull markets die of old age” theory that above-average stock performance from 1982 to 2000 made below-average performance from 2000 to today inevitable.
The Journal article noted the “high oil prices and world tensions” that laid the groundwork for the last “secular bear market” from 1966 to 1981. But the high oil prices cited were merely a symptom of the inflation engineered by the Fed during those years. Stocks loathe inflation, and they loathe monetary uncertainty in general.
Moving to today, other than a strong rally in 2003, stocks have been in bear territory for more than five years now. To the great extent that Federal Reserve policy impacts the direction of stocks, it seems fair to address the central bank’s role in what remains an uncertain environment for equities.
While it would be a reach to say the Fed is re-creating the major monetary mistakes of 1966-81, public statements suggest it has at times abandoned the monetary price rule that seemingly governed its actions in the first half of the 1990s. When asked in 1994 congressional testimony what he used to gauge inflationary pressures, Fed chairman Alan Greenspan mentioned three market-based indicators: gold, the dollar’s value versus other currencies, and the yield curve.
The price of gold up to 1996 shows the value of a price rule. Gold moved in a pretty tight range at the time; roughly around $385 an ounce. Since then the message from the Fed has changed, as have the indicators used to manage the dollar. Gold is rarely mentioned at all.
Indeed, with the economy and stock market sizzling in 1999, Greenspan’s message changed pretty dramatically. He worried about GDP rising “in excess of trends of potential,” and the possibility that the economy could “eventually overheat, with inflation and interest rates moving up.” Notably, 1999 was the year in which the price of gold hit a low of $253.75. The market indicators that used to guide Greenspan were screaming deflation as opposed to inflation, but the Fed chairman was moving in another direction. Higher interest rates and an inverted yield curve were the result.
“Bubble” theory is often used to explain what happened to stocks after 2000. More realistically, tight money initially makes stocks very attractive relative to commodities, and distorts the investment process altogether. The S&P 500 rose 78 percent from May 1996 to March 2001, while the CRB/Reuters Futures Price Index fell 18 percent.
Of course, deflation, much like inflation, eventually works its way through the total economy, and when it did, stocks were a casualty once again. The Fed’s role in the market carnage that began in 2000 cannot be underestimated. Easy money is often cited as a cause of the equity “bubble” towards the end of the millennium. Tight money is the more realistic culprit — first for having driven equities up and then for slowing the economy in a way that earnings and stocks ultimately fell.
Moving ahead to November of 2002, the notoriously lagging consumer price index had just begun to indicate deflation — the very deflation that began in 1996 and started to ease after 9/11. When Ben Bernanke spoke of the Fed’s willingness and ability to deal with deflation in November of 2002, gold was already trading in the $320 range — on the way to the $395 an ounce price that it would reach a year later.
Since the Fed ultimately controls the dollar’s value, it should be credited for the dollar’s exit from the 1996-2001 deflation. Still, its initial tightness caused the monetary phenomenon, and it must have puzzled markets that a senior member of the Fed’s open-market committee first acknowledged deflation a year after it ended.
In recent years investment distortions have moved in the other direction — this time toward commodities. Just as commodities do poorly during times of deflation, reflation and inflation favor that which is priced in dollars in the spot market. Since August of 2001, the CRB/Reuters index is up 54 percent while the S&P 500 is down 2 percent. The Nasdaq is even worse off.
The mention of inflation might puzzle people. According to the latest CPI figures, inflation is quiescent. Importantly, falling commodity prices today indicate that the markets feel the Fed is addressing the mini-inflation that it engineered. But the Bush administration should still be concerned. President Bush is 4 ½ years into his presidency. Increasingly this is his stock market, and since he’s been in office the Nasdaq is down 27 percent while the S&P 500 is down 12 percent.
As long as the Fed continues to ignore market indicators in favor of backward-looking and demonstrably false (growth causes inflation) indicators, the dollar (as measured in gold) will continue to bounce around. This volatility clearly distorts the investment process and in doing so makes equities less attractive over the long-term.
With Alan Greenspan set to retire in January, President Bush has a chance to take the mystery out of Fed policy. Yes, Greenspan has often hit the mark, but his misses have been near disastrous. Specifically, Bush should demand that the next Fed chairman adapt to an easily understandable dollar price rule that’s stable and will normalize investment. Stocks will rally if Bush marries good tax policy with good monetary policy. Right now he can only count on the former.
–John Tamny is a writer in Washington, D.C. He can be contacted at email@example.com.