Your Economy (No Politics)

[Bullwinkle]

Lessons Ignored
Comstock Partners, Inc.
Thursday, April 6, 2006


While the payroll employment report, due tomorrow morning, is still the most closely watched economic indicator, the current Wall Street interpretation is completely different than it was until fairly recently. Investors previously cheered a strong number and expressed extreme disappointment over a weak one. Now, however, the bulls are strongly hoping for a weak report that would presumably encourage the Fed to stop raising rates. Conversely, an employment number that looks too strong would indicate more Fed tightening ahead and send the stock market into a dive.

Against all historical probabilities, the Street has convinced itself that an end to Fed rate hikes mean a soft landing for the economy and a strongly rising market when, in fact, the opposite is the case. As we have pointed out in past comments, in the vast majority of cases the market declines substantially after the final rate hike, and almost all periods of Fed tightening are followed by recessions rather than soft landings. In every series of rate hikes we have been through investors have never seen a recession coming, and have always predict a soft landing. They have seldom been right. We remember going through the same discussion in 2000. The following comment appeared on our website on June 29, 2000, and, with few exceptions, it sounds as if it were written today.



The Exception That Proves The Rule
Comstock Partners, Inc.
June 29, 2000

Why 1994 Was An Anomaly

Now that the Fed meeting is finished, many are assuming either that the tightening period is over or that an August increase will be the last one. They are also assuming that the end of the tightening period is highly bullish for the stock market, and that the economy will glide effortlessly into a soft landing. In large part they are basing their reasoning on the 1994 monetary tightening experience, when the stock market marked time during most of that year and then took off in early 1995, just prior to the last interest rate hike in February. The 1994 experience is also cited as an example of a soft landing, since the economy slowed down, but did not deteriorate into an outright recession. On the contrary, we believe that the 1994 episode was an exception to the rule, and that the odds are now stacked against a favorable market outcome.

There are two main reasons for our beliefs. First, soft landings are a rarity in U.S. economic history; and, second, market conditions today are much different than they were at the end of 1994. In the eight tightening periods prior to 1994, seven resulted in recesssions. Monetary policy is a blunt instrument with lengthy and varying time lags. If the Fed stops tightening too soon, the economy stays overly strong, and the tightening has to be started again. If they go too far, a recesssion occurs. It is extremely difficult, even for the most capable economists, to get it just right.

As for market conditions, in comparison with year-end 1994, we now have far higher market valuations, lower cash holdings, more optimism, far higher public participation, higher relative interest rates and a lower unemployment rate. For example, the price-earnings ratio of the S&P 500 was 15 then as opposed to 28 now; mutual fund cash as a percent of assets, 8.8% then and 4.7% now; and 36% of market letter publishers bullish then, 50% now. In addition the ratio of the T-Bill yield to earnings yield was only 0.94 in 1994 compared to 1.62 at present, and the public's ownership of stocks as a percent of household assets was only 27% as opposed to 43% now. The economy itself was far earlier in its upcycle than it is today with much more potential to expand. The unemployment rate at the end of 1994 was still at 5.7%, compared to 4.1% at present, and there was a much larger pool of labor supply. All in all, the valuation, monetary, sentiment and economic conditions that are present today do not at all resemble the conditions that prevailed at prior market bottoms, but are more typical of market peaks.” (End of comment).


As the article shows, investors at that time were saying virtually the same thing they are saying now — that the end of Fed tightening would jumpstart the market and that the economy would enter a soft landing. In fact, on the previous day, the Fed had left the fed funds rate unchanged at 6.5%, and did not raise rates again on that cycle. So it turned out that the last rate hike had already taken place on May 16, 2000. Furthermore the next move to lower rates was instituted at an unscheduled telephone meeting in early January 2001, just a little over six months after our comment appeared. Nevertheless the S&P 500 dropped 47% over the next 28 months, and a recession started in March 2001, 10 months after the final Fed rate hike.

http://www.comstockfunds.com/index.cfm/act/newsletter.cfm/CFID/3100225/CFTOKEN/15616716/category/Mar....