A Long Boom Cycle Comes to an End

Feb. 23, 2001 -- 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.

This hawkish stance seemed perfectly calibrated at the time. Inflation didn't jump out of control, yet the economy grew 4.2 percent in 1999 and 5 percent in 2000 — undeniably fast rates. Most important for investors, earnings advanced quickly. They grew at 14 percent in 1999 and 11 percent in 2000.

But in 2000, the S&P 500 index actually fell, by 10 percent.

Investors saw a profit slump approaching. Now that contraction is happening. This means we could be in a period comparable with 1989-1991. The Fed hoisted rates dramatically in 1989, but this didn't immediately hurt the economy, which grew 3.5 percent in that year. But in 1990 the economy managed to grow only 1.8 percent, and it actually shrunk 0.5 percent in 1991.

Earnings at companies within the S&P 500 were very poor in this period, falling each year in the 1989-1991 period. But the index soared 26 percent in 1991, despite an 18 percent decline in earnings, as investors began looking forward to a bounceback in earnings growth in 1992.

Always the Flaws

One could make the case, therefore, that 2001 is the year to buy stocks greedily, since the market is likely to soon factor in heady profits growth in 2002. But there are flaws to that argument. In particular, the market was a lot cheaper at the end of 1990, with the S&P 500 trading at 14 times earnings, compared with 23 times at the end of 2000. Using forecast 2001 earnings, its forward price-to-earnings ratio is now 22 times with the index at 1255.

If the S&P 500 were to trade at 14 times its 2001 earnings forecast of $58.29 — and this may still come down some — it would be at 816, which is 35 percent below current levels.

Trying to be as bullish as possible, let's assume the market trades at 1.5 times its 2002 expected earnings growth rate of 17 percent, using the forecast $68.19 in earnings as the "E" in our P/E calculation. That would put the S&P 500 at 1770, some 40 percent above current levels. (However, if the S&P traded at 17 times expected 2002 earnings, it'd be below current levels, at 1159.)

The optimistic stance depends on a swift upturn in company performance. But if investors get any sense that earnings are going to continue to get hit, the S&P and other indices will trend down. The Nasdaq, naturally enough, will hit 1500 in the process.

In addition, the economy is seemingly sicker than the consensus is saying. The Fed, as in 1998, has inundated the system with easy money, which is ensuring that inflationary pressures remain in the economy. However, the economy can't notch up recent high-tempo growth because it appears to be all out of appropriately priced labor, investment capital and plant.

It can't be said enough: The Fed can't print Java programmers, natural gas or routers. Meanwhile, because of the Fed's relaxed monetary stance, businesses have been overestimating how much of certain products consumers really want. As these companies — the Ciscos and Nortels of this world — scale back, broad-market earnings measures will get continue to get crushed.

To be sure, Greenspan's loosening may pay off for a while and give temporary lift to the economy. He has full support for his policy from 99 percent of the media, both main political parties and the White House. And with the Turkish economy about to implode, Greenspan will be getting encouragement from overseas for his expansionary policy.

But make no mistake: The free lunch is about to get very expensive.