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Anatomy 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 inflationary boom.

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 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 more complicated.

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 inflationary-boom meme.

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