DOES ANYONE AGREE WITH ELAINE?....read on"...it seems like every time (the CIBCR) index upticks for four consecutive months, the Fed has tightened.
"And it's been rising for four months. "
Elaine Garzarelli
What's driving the market?
Garzarelli: Well, I guess what everybody wants to know right now is, is inflation really dead, or is it heating up a little bit and will Greenspan have to tighten again, and what would that do to the stock market? I think that in terms of inflation, the producer price index and CPI came out benign the last month. However, that's last month, and I think that in the future we will see a little bit more inflation show up.
And the reason I say that is that I look at a very interesting leading inflation indicator, which is something that Greenspan looks at also. It's called the Columbia University Leading Inflation Index, the CIBCR. And this has eight different components. And it seems like every time this index upticks for four consecutive months, the Fed has tightened. And it's been rising for four months. Right after the last indication of an increase, the Fed did again hike rates.
The most recent rate of change in this index is 6.8 percent, which seems fairly high. This index is not as good in telling you how high inflation will go, but the direction. Some of the components that were really strong were the National Association of Purchasing Managers Survey Diffusion Index, the percentages of purchasing managers reporting higher buying prices and longer delivery times. The Journal of Commerce Materials Price Index was also included, and that shows that the deflation of industrial materials prices is slowing.
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Updated:
7/29/99 1:44:02 PM ET
Inflation leader
So just about every component, those being the major ones, have gone up in this latest reading in June. Now, we'll get the next reading when the employment report comes out, but my feeling is he's going to tighten again. And I think that not because of the way inflation looks at the CPI level or at the producer price level, but because of this indicator, which tends to lead inflation by three to six months.
Now he did tighten in 1988 four times. And again, this was preceded -- this tightening followed the four upticks in this index. And it was interesting in 1988, '89, after the four hikes, the short rate rose 130 basis points, and the long bonds stayed nearly flat. So it's not always that when the short rate goes up, the long rate goes up as well.
During that tightening the S&P corrected only 8 percent. And I think one of the reasons was that the market was 17 percent undervalued at that time, based on our interest rate model. This is similar to the Fed's interest rate model. But we have another model that looks at the market based on inflation, rather than interest rates. And at that time, the market was 70 percent undervalued, based on inflation. That's for the S&P 500.
The second time they tightened in the last 10 years was in February '94 to April '95, and they tightened seven times. At that point, the short rate -- the Fed funds rate rose 300 basis points, and the long rate rose about half that much but still went up dramatically. And even with all that, the S&P only corrected 9 percent. Again, during that period, the market was undervalued based on interest rates and inflation rate models, by 13 percent on the former model and by 90 percent on the latter model.
The long bond
And then the most recent tightening before this one was in 1997, from March '97 to August '97. Then it was only one tightening, I think because in August we started to have the problems in Asia, starting with Thailand. But the interesting thing is that, as the short rate rose 40 basis points, the long bond fell by 140 basis points.
So the correlation has been throughout history, the Fed raises short rates, and long rates go up at the same time. But as you can see in two of these three periods, either rates stayed flat, or the long rate came down as short rates went up.
CBS.MW:
"Is the stock market really undervalued?
Garzarelli:
"It really is. Yeah. "
And, you know, most recently, with this 25-basis-point hike, bonds had already risen by 130 points from its low on Oct. 5th. So I think that most of their tightening, even if there are another two tightenings, that it's in the bond market. So I don't think bond yields are going to go much higher than where they are, and they are a little over 6 percent now, because I think that's been anticipated.
The stock market, at this point, based on interest rates, is 30 percent overvalued. However, relative to the inflation model, it's still undervalued by about 30 percent. Isn't that interesting? There have been a pretty big divergence, I think, in this period, more than any other period, because real rates are so high. And inflation being at 2 percent, we really shouldn't have 4 percent real rates with a budget surplus the way it is.
Is the stock market really undervalued?
Garzarelli: It really is. Yeah. And I don't think the interest-rate model is a good one to use anymore because eventually, interest rates should go down to where the level of inflation is plus about 2 percent, or 200 basis points.
So our model suggests that the long bond, because of the continuing budget surplus and inflation maybe at 2 (percent) -- maybe it goes up to 2.5 percent inflation, the bond yield really should be 4.5 (percent) to 5 percent. It should not be 6 (percent).
So this is temporary. And I think the stock market is seeing that and knowing that this is a temporary rise in the long bond, and that's why stock prices continue to rise.
CBS.MW:
"Will the Fed raise interest rates in August?"
Garzarelli:
"Yeah, I would say they'd probably raise another 25 basis points..."
Will the Fed raise interest rates in August?
Garzarelli: Yeah, I would say they'd probably raise another 25 basis points -- I don't think they'll go to 50 -- until it starts to show up in the CPI. And, you know, if the economy begins to slow, I think they'll do it gradually. But if we get another industrial production number or leading indicator number on the economy that's very, very strong, I mean, they could go a little bit more. But I think they'll do it in 25 basis point moves.
Would that be bad for the market?
Garzarelli: Well, I don't think this is all that bad, actually. I think that if he doesn't do this it would be worse. What he's doing is nipping everything in the bud. He's, I think, doing exactly the right thing. We are growing too quickly. And he doesn't want to scare the bond market, he wants to keep the bond market happy. And the bond market likes the tightening, because it means down the road inflation will stay at bay. And what could be better for the economy than that?
So it's not -- the Fed is not tightening for the reason of causing recession, because we don't have inflation at 6, 7 percent. And why tightenings are usually so bad for the stock market in the past is that when the Fed tightened it was usually to drive us into recession, and that was the way we could get rid of inflation in the system. This time if he just gives it a few little hikes along the way and slows the economy, then there's no reason down the road to give us a severe recession to get rid of something that's building. So I think this is the right thing for him to do. And as I mentioned, the last three times the Fed tightened -- in '88, '94 and '97 -- the stock market corrected less than 10 percent.
The market seems rudderless.
Garzarelli: Yeah, I do think that. Absolutely I do think that. With the uncertainty of the Fed tightening, I think you'll have, you know, maybe wild rallies, and then big declines the next day -- it'll just be choppy, I think for a while here.
Elaine Garzarelli is a columnist for CBS MarketWatch. You can get more information at her Web site.
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