"That Deflationary Feeling"
MARKET WATCH
By GRETCHEN MORGENSON -- September 6, 1998
NEW YORK -- "Bear markets never happen when
interest rates fall." This argument has been
trotted out in
the last few months by all manner of Wall Street
strategists, perhaps to calm nervous investors as they
watched their portfolios drift lower.
Trouble is, it's not exactly accurate.
Although it is unusual for stocks to decline in tandem
with interest rates, it is by no means impossible, as
recent weeks have shown. From the peak of the Standard
& Poor's 500-stock index on July 17 to Friday's close,
the market has lost 17.9 percent of its value. At the
same time, interest rates have made a huge move down,
with yields on the 30-year Treasury bond falling to
5.28 percent, from 5.74 percent.
A similar fate befell stock and bond
investors in another great bull market,
said Louise Yamada, director and
senior technical analyst at Salomon
Smith Barney -- the run in stocks that
began in 1860 and lasted into the
1890s.
The biggest bull market of that
century is depicted in the
accompanying chart, courtesy of the
Security Research Co. in Wellesley Hills, Mass.
After moving up smartly during the 1860s, the stock
market reached a peak in 1872. At the time, bond yields
were falling. There was no federal debt yet -- imagine!
-- but yields on railroad bonds and other benchmark
issues fell to 4 percent, from about 5 percent.
Yet despite the decline in interest rates, stocks lost
34 percent of their value in a bear phase that lasted
until 1877. Then stocks began to climb again.
This history lesson helps explain why, contrary to
popular wisdom, stocks can, indeed, fall alongside bond
yields. The reason, in a word, is disinflation.
The 1870s through the 1890s were one of the nation's
longest periods of steady, even falling, prices, not
too different from the situation today. As the
Industrial Revolution unfolded, the United States
General Price Level, that day's version of the Consumer
Price Index, fell 1.3 percent a year, on average.
Today, while consumer prices are up about 1.5 percent,
producer prices have fallen about 0.5 percent in the
last year.
The earlier period also parallels ours in that lower
prices were accompanied by real gross domestic product
growth and higher wages. Today it's a technology
revolution that is producing those results.
In the last 50 years, investors have grown unfamiliar
with the effects of deflation on stocks and bonds. In
most people's memories, the American economy has been
driven by scarcity; demand for goods has led supply.
Manufacturers followed scarcity, producing goods that
fetched the highest prices.
Now, excess capacity around the world is driving
demand, argues James Paulsen, chief investment officer
of Norwest Investment Management in Minneapolis.
"Wherever prices are falling fastest, like technology,
it brings more demand," he said.
Great for consumers, but not for corporations. Those
unable to cut costs fast enough show profit declines.
"As long as prices are falling slowly, corporations can
adjust," Paulsen said. "If prices fall sharply, they
can't." Which is where we may be now.
As the stock price recovery in 1877 proves, companies
can adjust to disinflation. As demand catches up with
supply, stocks stabilize.
Where does that leave investors today? "There are
certainly signs that this is a bear market," Ms. Yamada
said. "But we don't have enough evidence to suggest
that it's the end of the secular bull market that began
in 1982." It may simply be a painful but temporary
period in which companies adjust to falling prices.
When they do, stocks can move up again.
If history repeats, stocks have further to fall. Then,
get ready for the rebound.
Copyright 1998 The New York Times Company |
