of the Bull That Will Not Die
Part 1: Meme Wars
Ross M. Miller
Miller Risk Advisors
April 26, 2004
Two week ago, I posted a commentary entitled "The Bull
That Will Not Die" with my thoughts on why the current bull market in many
stocks should continue through the November elections and into 2005 along with
an incipient inflationary boom. Judging by the surge in hits on my web site and
the links on Google, word has gotten around cyberspace.
This is the first of three pieces that will explain the
analysis and the thinking behind that commentary. Part 2, which will come out on
May 3, will look at the macro side of things and Part 3, which will come out on
May 10, will examine how to select stocks that will do well during an
Immediately after the March employment numbers were announced
in early April, I thought back to some statistical work that I had done while
working on an article with Evan Schulman. (See http://home.earthlink.net/~millerrisk/Papers/MI.htm
for an electronic version.) What Evan and I discovered is that when T-bill rates
are high, stocks and bonds tend to move in lock step—an increase in interest
rates is almost guaranteed to be bad news for the stock market. This is not
surprising. However, when T-bill rates are low, as they are now, the story gets
On average, stock prices no longer take their cues from
interest rates when rates (and inflation) are low; indeed, they can rise in
tandem with interest rates for months at a time. I wrote "The Bull That
Will Not Die" because there were early signs that the market was entering
such a period. It appeared that the upward pressure of an unexpected
acceleration in earnings driven by an inflationary boom would more than offset
even the most aggressive moves by the Fed.
I also began to wonder about the widespread belief among
investors that the current bull market could not last past November 2. There are
two reasons, however, (beyond common sense) that one cannot be certain that the
stock market—excluding the stocks of financial companies and industrial
companies with large financial subsidiaries)—will rise as the inflationary
boom brings on higher interest rates.
The first reason is that once stocks start moving in sync with
bonds, it can take months, even years, for them to begin to move in the opposite
direction. Given that stocks have been rising while interest rates have been
falling for quite some time, it would take something extraordinary to have them
continue to rise once rates begin to climb in earnest.
The meme—a fancy word for idea that leaps from person to
person—that an increasing interest rates must be bad from stocks is strongly
ingrained in the financial marketplace. This meme gets constant airplay on CNBC.
The April 26 issue of Barron's can be viewed as one large advertisement placed
by this meme.
The second reason stocks may falter in the face of rising
rates is that the returns of stocks and bonds are more highly correlated now
than they used to be. Part of this long-term trend is clearly due to the growth
of financial companies in the S&P 500 and other major indices, but there is
something bigger going on, something that is causing correlations among other
asset classes to increase as well. Therefore, the meme that high interest rates
are bad for stocks is just one consequence of an even greater meme: the
it's-all-one-market meme. Under this meme, when interest rates go up, it is not
only bad for stocks and bonds; it is bad for every asset.
This meme appears most clearly in the actions of market
participants who engage in "carry trades." The simplest form of a
carry trade involves borrowing at short-term interest rates (which are currently
at exceedingly low levels by historical standards) and using the proceeds to
purchase commodities that are appreciating at a faster rate. When short-term
interest rates go up, the more leveraged players are forced to unwind some of
their positions, putting pressure on the prices of the commodities that must be
sold. One need only look to the recent plunge in gold prices to see this and the
tendency of such selling to snowball because once commodity prices stop rising,
carry trades are unprofitable no matter how low interest rates are.
Carry trades are not limited to commodities, however. The same
idea works for both stock indexes and individual stocks; indeed, buying stocks
on margin or with credit-card debt is a simple form of carry trade, though at a
higher interest rate than the professionals pay. Although many stock prices have
risen along with interest rates during the past month, in the days following
with the CPI surprise, stocks have had to cope with two sudden downdrafts that
show the strength of the it's-all-one-market meme. No doubt, the stock market
would already be down for the count were it not for the reason that interest
rates are going up: strong economic growth that translates into even stronger
earnings growth. If the market can continue to fend off the it's-all-one-market
meme in the face of continuing bad news about inflation and interest rates, a
new meme will emerge from the shadows to displace that meme. Let's call it the
One might ask, "Why should it matter which meme wins? The
economists at the Fed and the big brokerage houses have their fancy stock
valuations models and they don't care about memes?" That may be, but those
models assume that stock prices are determined by a process that has a single
equilibrium and they implicitly assume that the reigning meme will not be
deposed. As a result, when these models are wrong, they can be embarrassingly
wrong. (How do you explain to clients when your forecast for the growth in
durable goods is off by a factor of five?) In reality, the economy does not have
one equilibrium, it has several, and they can be miles apart. The balance of
power among memes determines which equilibrium the economy gravitates toward.
Both the it's-all-one-market meme and the inflationary-boom
meme are especially powerful memes because they are self-fulfilling prophecies.
If everyone thinks that high interest rates are bad for everything because they
suck liquidity out of the system, then, sure enough, when rates go up,
everything comes down. Similarly, if everyone believes that certain investments,
such as many non-financial stocks, are the salmon that can swim up the financial
stream of Fed tightenings and higher interest rates, then the resulting rise in
stock prices is self-perpetuating. Whether or not this belief is rational in the
sense of being supported by sufficient growth in earnings does not matter to the
bull market, though it does influence how it ends.
The price action of the past two weeks shows that the
it's-all-one-market meme, though alive and well, is loosing some of its grip on
the market. Friday's reaction to the durable goods number was more encouraging
than the reaction to the March inflation number and to Greenspan's opening
remarks last Tuesday. Bonds were hammered again on expectations of the Fed
acting sooner rather than later; however, the S&P 500, Dow, and Nasdaq all
climbed (powered by Microsoft, Intel, and their ilk) while the broader Russell
3000 registered only a token loss. Stock prices still have the
it's-all-one-market meme priced into them, so any further shift in favor of the
inflationary-boom meme as a long way to go.
Of course, market perception is market reality only up to a
point. Next week's installment will look at how interest rates and all the
numbers that Alan Greenspan stays up nights studying contribute to where the
market is heading.
Copyright 2004 by Miller Risk Advisors. Permission granted to
forward by electronic means and to excerpt or broadcast 250 words or less
provided a citation is made to www.millerrisk.com.