Conflicting Questions for Fed's Inflation Fighters
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By JONATHAN FUERBRINGER
wo economic reports released last week show neatly the quandary of the Federal Reserve and investors as both try to deal with the interest rate outlook, the economy and the stock market.
The first report, of a surprisingly strong 1.2 percent increase in August retail sales, suggested that the economy was not slowing, at least not yet, to a noninflationary pace that would make the Fed comfortable.
The second report, on the Consumer Price Index for August, showed a gain of 0.3 percent. The index is up only 2.6 percent for the first eight months of the year, suggesting inflation is still in check.
The surge in retail sales inspires this question: With the stock market still near all-time highs, and clearly powering the consumer spending that is fueling rapid economic growth, how can Fed policy makers avoid another quarter-point rate increase -- the third since June -- when they meet on Oct. 5?
The restrained inflation rate, however, begs this question: With prices still in check after four years of robust economic growth, why should the Fed raise rates again?
Lawrence B. Meyer, a Federal Reserve governor, grappled with the two questions in a speech earlier this month in Philadelphia.
Speaking about the impact of the stock market on the economy and on the Fed's decisions on interest rates, he said, "Most important, policy makers should reflect the higher value of equities in their forecasts for aggregate spending and adjust monetary policy as necessary."
While he would not say if he thinks the stock market is overvalued -- a view that is held by many analysts -- Fed policy makers still have to judge what an overvalued stock market, even a bubble, means for their strategy. But Meyer did say that deciding where an overvalued stock market was heading, and how it would impact consumer spending and the economy, wasn't easy.
On the one hand, he said, policy makers "could conclude that an overvalued stock market would decline on its own and add that assumption to their forecast."
"That would seem reasonable but could be a mistake," he warned, because "it could discourage them from tightening in response to robust demand, driven in part by past increases in market values." He also said counting on a correction was dangerous because its size and timing were always "extremely uncertain."
On the other hand, he added, "policy makers should be alert to the potential that a tightening of policy could have a disproportionate effect" on consumer demand and make the economy slow too much.
"This does not mean, however, that policy makers are trapped and cannot respond to robust demand and rising inflation risks," he said. "It does suggest that they should appreciate that there will be more uncertainty" about how much a rate increase will slow economic growth.
Meyer, of course, didn't say which hand he favors.
But in figuring what might happen on Oct. 5, consider this: Fed policy makers have indicated that they are more worried about too-rapid economic growth and the pressure that puts on wages than they are comforted by low inflation.
Alan Greenspan, the Fed chairman, has indicated that he is not worried about pricking a stock market bubble, as long as the burst is a result of an anti-inflationary policy and not an effort to rein in the market. In fact, Greenspan has said that "while bubbles that burst are scarcely benign, the consequences need not be catastrophic for the economy."
In this context, Fed policy makers are trying to decide how many of last year's three quarter-point interest rate cuts should be "taken back." They have already taken back two, pushing up the federal funds rate to 5.25 percent. Many investors think the Fed will not rescind the third, with inflation so low and fears of Year 2000 computer problems threatening market tranquility.
Still, given strong growth and the Fed's apparent willingness to face the consequences of a market tumble, taking back all three cuts seems likely. While the rate increase in June came after a surprisingly big jump in consumer prices in April -- 0.7 percent -- , the move in August came after that surge was shown to be an aberration.
And Fed policy makers won't really be hitting the brakes until the federal funds rate is higher than 5.5 percent, where it was just a year ago.
NEW YORK (Reuters) - A curious thing has happened. The bull market died in the spring of 1998 but Wall Street still hasn't been told -- at least that's what some experts say.
The headline-grabbing stock market indices -- the Dow Jones industrials, Standard & Poor's 500 and Nasdaq composite -- may be cruising at record highs, but the truth is that many stocks have not kept up.
In fact, a big number of stocks are below the highs made in the rip-roaring days of the 1997 and 1998 bull market.
''The overall market has been in a bear market since April 1998. Yes, that is right -- 1998,'' said Don Hays, chief investment strategist for Wheat First Union in Richmond, Va.
It's a smoke-and-mirrors market.
''With only four technology stocks making up 25 percent of the weighting of the Nasdaq and the media only concentrating on the indices, the 'Stealth Bear Market' is being ignored,'' he said.
''What do you think the headlines would be saying if the major indices were 19.7 percent under the mid-April 1998 highs?'' he asked.
The experts backed up their words with some strong stuff.
Ned Davis Research in Venice, Fla., says the average stock in its 7,736-stock data base has fallen nearly 20 percent since April 1998 -- a virtual bear market for a large number of stocks.
There's more.
Richard McCabe, chief market analyst for Merrill Lynch, found that 23.6 percent of the New York Stock Exchange's common stocks and 22.7 percent of the Nasdaq market's stocks are below their summer-fall 1998 lows.
''The uptrend in the major market indices is misleading because it does not represent what the majority of stocks have been doing,'' he said.
People have been buying the big-name stocks, such as technology and consumer growth companies, in the hopes that the sectors would stand up to the downward pressures on earnings from the economic problems in Asia and Latin America as well as the slowdown in Europe.
''Investors went for the rapid and proven growth companies and ignored the medium and small stocks, which have been underperforming for more than a year,'' McCabe said.
''It's created a new breed of 'Nifty Fifty' -- the group of stocks that did well in the early 1970s when the rest of the market was having trouble,'' he said.
The Nifty Fifty stocks eventually went through a nasty period and they joined the bear market that had been dogging the other stocks since the late '60s.
Was it the smart way to pick stocks?
''It was not the ideal investment,'' he said. ''A good, steady and healthy market is usually one where the vast array of stocks are doing well. But, when it's a narrow advancing market, the risk is the majority of weak stocks will ultimately bring down the minority of strong stocks.''
Some investors may be reacting to the warning signs.
The emotional intensity of the bulls has tapered off over the past few weeks. The proof: The rallies have not generated a lot of new buying interest.
Also, mutual fund investors have reduced their stock holdings at the fastest pace since December 1987. Back then, investors were still running for the exits after the October crash.
The downsizing of stock portfolios started this summer. In July, investors redeemed shares from mutual fund companies at an annual rate of more than 20 percent, according to the Investment Company Institute, a Washington-based mutual fund lobbying group.
And, at the end of July, Fidelity Investment's Magellan Fund, the nation's biggest mutual fund with assets of more than $100 billion, cut its stock holdings to the lowest level in three years at 92.2 percent.
''A reasonable case can be made that what has been occurring simultaneously over the last 16 months is a bull market in a minority of large-cap issues and a bear market in a majority of mid- to small caps,'' McCabe said.
Has the bull market been built on shaky ground?
''There is little doubt, even in those partying 'tunnel vision' minds, that this bull market is being carried by a small pocket of stocks -- mostly big-cap technology stocks,'' Hays said.
The good times have been rolling for the tech sector, which includes International Business Machines Corp., Intel Corp., Microsoft Corp., among others. In fact, the technology sector has jumped 32 percent so far this year, after soaring 72 percent in 1998.
And, while the overall market was off 1 percent in August, the tech sector climbed nearly 6 percent, which explains why the market, on the surface, appears to be in a bull mode.
During the days of the Nifty Fifty, investors concentrated on a select group of stocks with extraordinarily high price-earnings ratios of 40 to 80.
''Their philosophy was to find stocks that had been able to provide consistent annual earnings gains, with the statement that you could buy these stocks at any price and know that in the future, you would be bailed out because of those persistent growth patterns,'' Hays said.
How different are things from the 1970s?
Cisco sells at 70 times projected earnings and Microsoft is at 60 times future earnings.
Hays said tech stocks now make up a huge 24 percent of the Standard & Poor's market capitalization, which is up from 13 percent in 1997. In 1990, it was just 7 percent.
Technology stocks, particularly the Internet group, are in a new era and for that reason, Wall Street has no idea where the P/E limits should be for many of those companies.
After all, the limits of a stock's P/E are largely decided by investors' expectations of earnings growth and risk. In the case of the Internet stocks, the sky seems to be the limit.
America Online is selling at 200 times expected 12-month earnings.
''We believe the next two months will be very chaotic and take those perpetual grins off those who think the bull market is still alive,'' Hays said.
McCabe said the market sell-off could take place in October.
''It has the reputation of being a 'crash' month for stocks but October is also known as a 'bottoming' period because market weakness often sets the foundation for recoveries,'' he said.
''Then, there's the Y2K computer problem, which may provide the market with an excuse for a setback in the big-cap stocks as we get nearer to the end of the year,'' he said.
McCabe sees a correction in the Dow of 10 to 15 percent.
For the week, the Dow Jones industrial average fell 224.80 points, the Nasdaq composite index slipped 17.44 points, and the Standard & Poor's 500 index dropped 16.23 points.
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