"The Market" by Sheldon M.
Bell
Volume 2 - Issue 2 - June 30, 1998
The second quarter in 1998 was quite a phenomenon for the financial markets. The doomsdayers didn’t get fulfilled , and the bulls were not stampeding, as the market was range bound, ending up where it started. When looking back to this quarter in the future it will be seen as a resting-place for the market, and as such, it may have increased the short-term safety of the market.
The fear and uncertainty in reference to the U.S. government bond market that I had written about in my newsletter in the first quarter of 1998 never materialized. I mentioned that the Japanese might sell off some of their U.S. government bond investments in order to raise cash for their floundering economy, increasing U.S. interest rates. However, they have held on to our treasury bonds , helping to bolster the U.S. bond market, reducing interest rates. The benchmark 30 year treasury bond finished the first quarter of 1998 yielding 5.93%, it finished the second quarter yielding 5.624% , a historically low yield for the long bond since it was first issued in the mid 1970s.
Keep in mind that there has never been a major bear market in the stock market against a backdrop of declining interest rates . That doesn’t mean to say that the bull will continue to advance either.
The economy is roaring along with GDP up 5.4% for the first quarter of 1998. This exceeded the GDP growth of the fourth quarter of 1997 which booked in at a 3.7% growth rate.
In my last newsletter I expressed some concern in reference to the growth of corporate profits, which can be an engine or an anchor for the equity markets. Corporate profit growth has slowed down significantly in the past two quarters to single digit growth . This might not be so ominous if it weren’t for the run-up in stock prices, especially in 1995, 1996 and 1997, anticipating double digit growth for corporate profits.
On the other hand, with the inflation rate nearing an historic low, the U.S. dollar maintaining it’s strength and with the unemployment rate at 4.3%, (nearing an historic low), the U.S. economy is quite sound and should continue to grow. This should lend support to the aging bull market.
The Federal Reserve hasn’t raised interest rates since it’s meeting on March 25, 1997. At that meeting they raised the federal funds rate one quarter of a percent to 5.5%. The discount rate remained at 5%, and the prime rate charged by banks to their most credit worthy corporate customers also went up one quarter of a percent to 8.5%. At the end of the second quarter in 1998 these three benchmark interest rates remained the same.
With such a robust economy the fact that the Federal Reserve has been on hold since March 25, 1997 is unusual. The Federal Reserve is always on the lookout for inflationary pressures building up in the economy. They often raise interest rates at the first signs of any inflationary pressure. Their goal is to preempt the forces of inflation.
Conventional wisdom dictates that if the unemployment rate drops below 5% then inflation will begin to escalate. The reasoning is that if the unemployment rate gets too low then there may be wage pressures building up in the economy. Corporations may have to pay more in wages to their employees to lure them in a decreasing labor pool, and therefore increase their prices.
There has not been any significant wage pressures in the economy even with the low unemployment rate. The Federal Reserve has also been focusing on the productivity gains by corporations in the past ten years. These gains can offset the need to raise prices by corporations if wage pressures escalate.
The Federal Reserve may be accepting a new "paradigm" for the economy. Accepting that the increasing productivity of corporations can keep prices in check even with escalating wages.
The other factors dictating the Federal Reserve neutral policy is the foreign markets.
The developing Asian economies have been suffering ever since last summer, with no end in sight. At that time Thailand devalued it’s Baht (dollar) sending it’s currency into a free-fall, along with currencies from South Korea, Indonesia, The Philippines and all the other developing " Asian Tigers".
The collapse of these currencies, which has subsequently fueled a deflationary spiral, is due to the mismanagement of their respective economies, and the overbuilding of their infrastructure and industrial base.
Since these economies export to the U.S. they will try to export their way out of their financial turmoil. They can do this by reducing the prices of their exports to the U.S.
The deflation imported from these nations can help offset any inflationary pressures building up in the U.S.
The slowdown in demand for our exports to these economies will soften the growth in our economy and help offset any inflationary pressures building in the U.S. due to robust growth.
In addition, the fact that the Japanese Yen is trading at a seven year low against the U.S. dollar should give additional support for the Federal Reserve to stay on hold. An increase of interest rates in the U.S. will strengthen the dollar and would cause problems in Japan and other Asian countries.
Investors should be wary of the foreign markets as Asia is still in trouble and Europe is too frothy.
The magnitude of corporate profit growth will play a major role in determining how the stock market performs for the rest of 1998, barring any international calamities.
However, it is unlikely for the U.S. stock market to correct significantly as long as interest rates remain low.