A Long Boom Cycle Comes to an End

Feb. 23 -- In times of confusion, return to the basics. Even if the basics have seemingly been abolished.

Common assumptions about the economy and the stock market are being sorely tested. The Fed has been lowering interest rates. Yet stocks, instead of consistently rallying, have failed to hold on to their Greenspan-inspired gains.

Look at recent charts for the Nasdaq or the S&P 500. The economy has most definitely slowed in the last six to nine months, but key inflation indicators like the Producer Price Index and Consumer Price Index are showing unexpected strength.

Yet these seemingly confusing trends would appear entirely normal to anyone who has a clear memory of, or understanding of, the business cycle, something the New Economy was supposed to have abolished.

What we are seeing at the moment are the consequences of a particularly elongated cycle coming to an end. Knowing that this is happening won't magically produce the right investments. And simply assuming that the economy and the market are on the verge of quick recovery could be downright dangerous.

Past and Prologue

Now, it's easy to see why the speedy recovery theory has so many adherents; it happened in the glorious '90s. In 1994, the Fed, fearing inflation, strenuously tightened monetary policy, after a period of low rates in 1992 and 1993.

OK, the S&P 500 slipped 2 percent in 1994, but patient investors would've been rewarded with a 34 percent return in the following year. In addition, S&P 500 earnings increased 18 percent in 1994 and 21 percent in 1995.

The meager 1994 S&P 500 performance was mostly a response to the Fed's higher interest rates; investors thought the tightening could damage profits. It didn't, so the index rallied.

So what's happening this time? In 1998, the Fed again reduced rates hurriedly, like in 1992 and 1993. This time the cuts were designed to help financial institutions that were getting hit by the Russian ruble devaluation and the meltdown at the gargantuan hedge fund Long Term Capital Management. It spent 1999 and 2000 hiking rates again to offset the effects of the 1998 loosening.