Laws of Motion and Markets
By Jim Griffin
Special to TheStreet.com
1/30/00 3:45 PM ET
What happens when an irresistible force meets an immovable object? We may be about to find out.
The fourth-quarter GDP numbers released on Friday show that the world's largest economy still has a head of steam. Final sales to domestic purchasers, an indication of the strength of underlying U.S. demand for goods and services, rose 5.2% on the quarter, and 5.4% on the year for the second straight year. What is the meaning, if anything, of these 2.5% or 3.5% "speed limits" that are debated among the economists? Have you seen a cop anywhere lately? The GDP deflator and the Employment Cost Index data show that, posted limits or not, cop or no cop, the economy's rate of speed seems to be showing up on the temperature gauge now as well as on the speedometer.
Or take the equity market. Momentum strategies have worked, value approaches have not. Price momentum models -- buying what's working -- have produced positive performance whereas buying what's cheap has been a drag on return. What would cause you to go against the trend in place, the strategy that's working? And what would then cause the trend in place to change?
Bodies (or trends) in motion will tend to remain in motion unless acted upon by an outside force. Thus, spoke Isaac Newton who, if I'm not mistaken, was the first of the mo-mo hedgies.
What will brake the powerful inertial trends in the economy and the stock market? Two factors have been acting as brakes, although with little noticeable effect. One is the U.S. federal budget and the other is the U.S. current account, or trade deficit. Both of these brakes may be in the process of burning out. The trade deficit, variously defined and measured, is a direct subtraction from GDP: the 5.8% top line GDP number that was printed on Friday would have been 6.5% if the trade sector had been in balance. The trade gap subtracted more than one percent from the U.S. economy's report card in each of the past two full years: we were clocked doing 4.1% in a 3.0% zone -- but the trade brake prevented the U.S. from getting nailed for 5.2%.
This trade gap measures, in effect, the lost sales of U.S. businesses that resulted from weak overseas demand. Top line growth in the U.S. corporate sector would have been faster but for the conditions that gave rise to the current account deficit. One of those conditions, one among a complex nexus, was the strong dollar. It contributed to translation losses for U.S. corporate profits; they were reported to be weaker than they otherwise would have been but for the dollar and puny overseas demand.
Then there is the federal budget situation. The shrinking deficit has now given way to a rising surplus. Both shrinking deficits and rising surpluses exert "fiscal drag" upon a growing economy. With CBO now projecting massive surpluses far into the future, the budget is on track to act as an "automatic stabilizer," dragging against the momentum of a speeding economy. That is, if the budget is permitted to remain on the present track. What odds would you give on that score?
President Clinton's last (or is that long last?) State of the Union speech demonstrated that there is no end of ideas for how to spend the windfalls of revenue delivered by a booming economy. Republicans may be disinclined to go along with most of these notions but they are more than eager to take credit for returning those windfalls to the voters in the form of tax cuts. If you think of spending plans as ransom notes for tax cuts -- it works in reverse, too: tax cut ideas are ransom notes for spending plans -- you can see that they've got the drop on each other. What is the easiest thing to do when faced with a difficult choice? Choose both. Goodbye surplus. Goodbye braking effect.
So if we slip the two brakes that have been in place, should we then expect an acceleration in inertial momentum? The market, sensibly, doesn't seem to think so. Fear of the Fed knocked it down last week. The Fed right now shapes up as the lone cop on the beat, charged with enforcing the posted speed limits. It is making noises like it is up to the job. We'll see. The decision to be posted this Wednesday afternoon will be an important signal. A 25-basis-point tightening is baked in the cake, but 50 would signal a tougher enforcement stance.
The current situation facing the Fed is reminiscent, in pertinent respects, of the one that confronted Paul Volcker when he took the reins with inflation raging and "inflationary psychology" under a full head of steam. Momentum then was a fact of life, as it is now, even if the sectors that were moving were somewhat different than those today. Then it was houses, commodities, and collectibles that could only become dearer with time and therefore should be bought on any dip. Now it is dot-coms and e-anything, software, bandwidth, and cyber turf that will rise inexorably but for the accidental bump that creates opportunity.
The mentality in the late 1970s and early 1980s was that there was no force, nothing really likely, to get in the way of the irresistible force then in place. The Volcker Fed, as it turned out, proved to be an immovable object and the immovable object prevailed. That single sentence history, however, hardly does justice to the tale.
Prior to the Volcker years, yield curve inversions had been painful but mercifully brief market responses to effective Fed restraint. Their effectiveness as economic brakes, and their brevity, made them excellent buy signals. But when Volcker jammed on the brakes against the rolling momentum of inflationary psychology in the 1970s, the collision of irresistible force with immovable object produced a titanic stand-off that lasted for three years before inertia was deflected and the trend was broken. Three full years of the incredible financial pain implicit in an inverted curve!
There is nothing like that sort of pain foreseen by today's markets or today's market seers, anymore than there was back then. What it took for Volcker to prevail, to be effective against the inflationary psychology of that time, was a much greater effort than anyone, presumably even Volcker himself, could have imagined.
"Dip buyers" and momentum strategies are the contemporary expression of inflationary psychology -- they will rush in whenever the Greenspan Fed knocks this market down, as fear about its next move has done lately. Dip buying and momentum-following plays have been and probably will continue to be an irresistible inertial force. They will, says Isaac Newton, remain in place unless acted upon by an outside force. We'll see.
It's shaping up to be a wild ride this year. Check your seat belt.
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