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Anatomy of the Bull That Will Not Die
Part 2: All That Macro


Ross M. Miller
Miller Risk Advisors
May 3, 2004

Part 1 of this anatomy looked at how the emergence of inflation in the U.S. economy could lead to two vastly different outcomes for equity markets depending on which meme prevailed in the marketplace of ideas. In order for the current bull market to sustain itself, the inflationary-bull meme must ultimately dominate over the it's-all-one-market meme. Last week was the best week in a long time for the it's-all-one-market meme with higher interest rates pummeling asset around the world markets including bonds, stocks, precious metals, and most other commodities. What may have started as merely fear of the unwinding of leveraged positions appears to have blossomed into something real. The Nasdaq and S&P 500 are already within a bad day of their lows for the year.

Reading the wire-service headlines is good for a few laughs during lulls in trading. I noticed that the first quarter GDP numbers were first cast as good for the market when it opened to the up side and then bad for it as the gains evaporated.

Ordinary investors who read or hear my current spiel about memes are usually not impressed—they want to learn more about inflation, interest rates, overspent consumers, elections, Hubbert's oil peak, China, and geopolitics. You know, the real stuff. I pay attention to the real stuff—and, let me tell you, inflation is real stuff—the problem is that no one has a good working model of the real stuff. Not in my opinion, anyway. Yes, the real stuff matters, the problem is that there is a lot of it and frequently what counts is only obvious in retrospect.

When it comes to stocks, the real stuff does matters, just not nearly as much as most people (and the wire services) think. In principal, a stock's price should reflect some measure of the cash flows that it generates with the appropriate discount rate applied to future earnings. This discount rate is determined largely by the prevailing interest rates in market. Reading between the lines of Alan Greenspan's recent testimony before Congress, this is what he believes. It is also what many down-to-earth economists, such as Yale's Robert Shiller, believe. The problem is that stocks spend virtually none of the time priced in line with any objective measure of their cash-flow-based value—let's call it their intrinsic value. They can wander above it for years and then wander below it for years. And that assumes that anyone can actually know what that intrinsic value is.

The late, great economist Fischer Black dealt with this problem and the difficulties that it created for proponents of the efficient market theory by surmising that the market was doing its job competently as long as a stock's price was between 50% and 200% of its intrinsic value. This meant that it was possible for a stock to rise 300% or fall 75% and still be "reasonably priced."

So, this leaves us with two pieces of bad news. First, we can search the web for information until we are Googled out and not be able to determine the real value of any stock. Second, even if we did, its price could deviate from that value indefinitely.

Still, there is a simple way of understanding what is going on in the market. As Alan Greenspan noted, higher interest rates are bad for stock prices because they imply that future cash flows must be discounted at a higher rate, and that leads to a lower intrinsic value for the stock. The complication is that sometimes the same forces that drive interest rates up also drive earnings up with them at an even faster rate. Much of the time this does not happen, which is why many of the studies that are being cited in the press show that higher interest rates on average depress stock prices. But, as the study that I cited in Part I shows, this is only true when interest rates are already high by long-term historical standards. Currently, as in the 1950s and the early 1960s, interest rates are low by historical standards, very low, and so we are in an ideal situation for corporate cash flows to rise considerably faster than earnings, especially, as it seems likely, should the Fed be insufficiently aggressive at raising interest rates. (In my original "The Bull That Will Not Die" commentary, I stated that the "neutral" fed funds rate was north of 5% assuming that the economy was moving along at what would amount to a 3% rate of inflation by historical standards. I am not alone in that opinion, but few economists share it. After considerable study, I have concluded that my time is better spent figuring out how many Fed governors can dance on their boardroom table without breaking it than trying to determine the neutral fed funds rate. Determining the "correct" P/E ratio for the market is a similar exercise in futility.)

Of course, with all the latitude that the late Fischer Black gives stock prices, cash flows can rise faster than interest rate (as they appeared to have done for many stocks during the first quarter of 2004) and we might still witness stock prices fall. For if everyone believes that rising interest rates mean lower stock prices, which is a direct corollary of the it's-all-one-world meme, that is precisely what will happen.

So, you can watch the news and worry that China will abort the global recovery and that consumers use their money to fuel their cars rather than the expansion. You can count the commas in the statement that the Fed issues this week. Or you can watch the memes. The big three numbers to track are the Nasdaq composite, the yield on the 10-year Treasury note, and the price of gold. As long as the rising yield on the benchmark Treasury drives Nasdaq and gold down, the it's-all-one-world meme remains in control and is certainly potent enough to drive all the major averages to new lows for the calendar year. The Nasdaq may once again start swimming upstream this week, but what I'm really looking for is gold to start making its move. Despite a bad week, the matador has yet to fell the bull.

Whatever meme takes over, it is (as the cliché goes) becoming a market of stocks rather than a stock market. Part 3 will look at how inflation the two memes affect individual stocks.

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