Stock markets don't always wait for the economy
12 October 2001
In these times of turmoil, with the world economy weakening by the day and the United States and her allies engaged in a struggle against Afghanistan in particular and terrorism in general, many commentators have suggested that there is very little chance of a recovery in the stock market until the economy shows signs of recovery as well.
For example, on 1 October 2001, The Business Times ran not one but two articles suggesting that the poor economic outlook implies a slow recovery for the stock market. In the article "Singapore market cap down $40b last month", with the Straits Times Index at 1319.53, the writer remarked that "the current wave of selling may not have ended yet A US recession will weaken global economies further, making recovery a much more difficult process. Thus we will likely see equity prices clawing their way back up slowly, economists said, giving investors ample time to accumulate stocks of their choice."
The second article, "Paradigm shift", commented that there was a new paradigm among investors that short-term war concerns would give way to long-term recovery as central banks flood markets with liquidity, thus justifying recent stock market rises. However, the writer questioned this focus on the presumed long-term recovery. He believes that the recent positive market sentiment may have been distorted by end-of-quarter window-dressing, an "odd reluctance by the US consumer to demand his money back from mutual funds", and unsustainable pump-priming.
The problem with articles such as these is that while the economic analyses are sound, they may not be very relevant since stock market rallies don't necessarily depend on immediate positive economic developments. Market valuation and liquidity are also important -- and often overriding -- factors.
In his book, It Was a Very Good Year, Martin S. Fridson looks at the U.S. stock market's ten best years in the twentieth century. Out of these ten years, the following years were remarkable in that at the beginning of these years, there was little evidence that the economy or the stock market would do as well as it did.
1908
1908 saw the stock market, as measured by the Cowles Commission index, rise 45.78 percent. This was a complete turnaround from the previous year, when, in the face of financial turmoil brought about by a worldwide credit shortage, the Dow Jones Industrial Average had dropped 38 percent, while the railroads had dropped 32 percent. The Dow hit a low point in November, then began a remarkable rally that extended well into 1908.
Fridson noted: "On May 21, The Nation cautioned that the second leg of the 1908 stock rally was signaling a business recovery that wasn't actually materializing. In fact, certain business statistics suggested that the economy was worsening. U.S. Steel's March 31 orders for future delivery were below the December 31, 1907 level. Iron ore production in the United States declined in April, while the number of idle railroad cars increased after a promised drop in March.
"'Here was apparently a picture of uninterrupted depression,' The Nation proclaimed. 'Yet on the Stock Exchange, a second upward movement began at the close of April, and has continued, with increasing rapidity and violence, ever since.'"
Fridson added that although "credit conditions began to improve early in the year, the stock market ran well ahead of the economic recovery. Earnings on the Dow industrials declined by half from the 1907 level. Numerous dividend cuts and omissions likewise gave investors little to cheer about, yet New York Stock Exchange volume rose slightly in 1908."
1915
In the midst of World War I -- just as we are now in the midst of an anti-terrorism struggle -- the Cowles Commission index rose 50.54 percent in 1915. For that year, Fridson noted: "At the low point following the outbreak of war in 1914, investors worried that the stock market would be crushed by European liquidations. A cutoff of trade was also foreseen, culminating in a U.S. depression. All of these fears proved to be greatly overstated. By the end of 1915, brokers were complaining that the belligerents weren't selling stocks fast enough to keep activity at an acceptable level. Foreign trade boomed to such an extent that Wall Street thought the volume of gold flowing into New York was unhealthy. The U.S. trade balance rose from $324 million in 1914 to $1.7 billion in 1915, producing a bonanza for American industry. Steel capacity utilization climbed from 50 percent in January to 100 percent at year-end."
1933
In the midst of the Depression, the S&P 500 rose 53.97 percent in 1933. By the beginning of 1933, the stock market had started its recovery from the crash that started in 1929. But with "immense uncertainty prevailing about the direction of government policy, a long-simmering bank panic began to heat up". On February 26, as bank holidays and withdrawal restrictions were being announced across the U.S., the Dow slid to its 1933 low of 50.16, leaving it 37 percent below the peak of September 1932.
Then, on 12 March, President Franklin D. Roosevelt, in a nationwide radio broadcast, appealed for cooperation in restoring public confidence. The next day, banks in the Federal Reserve cities reopened. From February to July, the Dow climbed by more than 100 percent -- from 50.16 to 108.67 -- "the only time that feat has ever been accomplished within the space of a single year". As Fridson remarked: "The Depression, as it turned out, was many years from conclusion. But for a brief, shining moment in 1933, investors believed that they were in the money."
The Dow Jones Industrial Average, which had bottomed out at 41.22 on July 8, 1932, finished the year 1933 at 99.90. Fridson remarked: "The decade of the 1930s proved to be the most volatile ever for the Dow Jones Industrial Average Two of the market's Very Good Years occurred during the Thirties." He concluded: "Clearly, economic properity is not a necessary precondition for extraordinary returns in common stocks."
1954
1954 was another great year for stocks. The S&P 500 rose 52.62 percent that year. In assessing the year's prospects earlier in the year, Fridson noted: "In contrast to the stock market's surge during late 1953, the U.S. economy was looking tired. Rated capacity utilization in the steel industry, which measured well above 100 percent earlier that year, had fallen below 90 percent. A major factor underlying that drop was a slowdown in auto production from a 7.5-million annual rate in July to under 6 million. Additionally, consumers were balking at new purchases of major appliances and businesses were turning conservative in their capital spending plans. Housing starts were down, to boot."
Fridson reported that B. C. Forbes adopted a "cautious, but not calamitous" stance on the economy. Moody's Investors Service, early in 1954, advised investors to keep a quarter to a third of their portfolios in cash. Short-run speculators should be even less fully invested in stocks, Moody's reckoned, because the market did not look very bullish in the near term. The rival analysts at Standard & Poor's considered "a sustained general movement in either direction unlikely over the medium term." Fridson noted that there "was no indication from these quarters that 1954 would go down as one of the greatest years in stock market history".
A. T. Miller of the Magazine of Wall Street noted that the consensus economic forecast called for a moderate recession, defined as a 5 percent to 8 percent decline in industrial production. "With the experts accordingly predicting a 10 percent to 15 percent drop in corporate earnings," wrote Fridson, "Miller thought it likely that the stock averages would remain close to their 1953 range. Over the near to intermediate term, though, he saw more downside than upside in prices."
"Somewhat reassuring, in Miller's view, were the reasonable valuations of stocks, notwithstanding the late-1953 run-up in prices," Fridson added. "Industrials were trading, on average, at less than 10 times 1953 earnings. Dividend yields in excess of 6 percent made stocks appealing in light of prevailing yields of just over 3 percent on high-grade corporate bonds."
Fridson's own comments on the year's spectacular performance were as follows: "Instrumental in the remarkable rally of 1954 were investors' low expectations at the outset. As the year began, the most ballyhooed recession in U.S. history, in Business Week's estimation, was already underway. Industrial production was falling. Some economists warned that conditions would deteriorate into a full-fledged depression. The Great Depression of the Thirties was a recent enough memory to render consumers and investors exceedingly cautious."
"In the end, the worst did not come to pass. No mass unemployment developed. By June the Treasury and Federal Reserve Board retreated from their hard money policy," wrote Fridson. "At year-end, industrial production was on the rise." Thus, the stock market foretold the economy, not the other way around.
1958
The S&P 500 rose 43.37 percent in 1958. Rail stocks, in particular, rose by 61 percent in that year. However, as Fridson noted, "[a]t the moment a great rally was beginning, corporate profits were dismal. Earnings for the Dow Jones industrials were down by 38 percent, year over year, in 1958's first quarter. For rails, the decline measured a staggering 85 percent."
February was the low point of the stock market in 1958. After that, stock prices began to climb despite an absence of clear indications of earnings recovery, to the extent that Lucien Hooper of Forbes deemed the continued rally "illogical". Forbes' Heinz Biel said "the second quarter's rise had been too much too soon". A. T. Miller of the Magazine of Wall Street warned that "the market was getting ahead of improvement in business activity". H. J. Nelson, writing in Barron's, noted that unfilled orders for all manufacturing concerns had been declining steadily since the end of 1956.
In Fridson's view, the stock market rally of 1958 could not be justified by earnings recovery. "All in all, it's difficult to ascribe the extraordinary stock market performance of 1958 to investors' anticipation of extraordinary corporate profits," he wrote. Various factors were suggested for the bull run, including the increased role of institutional investors, loose monetary conditions and inflation expectations. Ultimately, he concluded: "The rally that actually occurred represents a sobering experience for would-be forecasters."
1975
The S&P 500 rose 37.21 percent in 1975, a year which saw "the most severe U.S economic contraction since the 1930s". In conjunction with an attack on Israel by Arab states, the Organization of Petroleum Exporting Countries (OPEC) imposed an embargo on the United States in 1973. Oil prices and inflation rose sharply while the economy contracted through 1974. Industrial production declined 15 percent during the 1973-1975 recession as a whole, while unemployment nearly doubled to 9 percent. Although the economy hit bottom in April 1975, full-year earnings per share for the Dow industrials that year declined by 24 percent from 1974.
In spite of high inflation, high unemployment and trouble in the banking system forced the Federal Reserve to ease up on its effort to restrain money supply growth. From a cyclical peak of 8 percent in November 1974, the Fed cut the discount rate in stages to 6 percent in June 1975.
Fridson, however, noted one positive point for the stock market in 1975: the depressed price levels. From its peak of 1051.70 on 11 January 1973, the Dow Jones Industrial Average fell to a trough of 577.60 on 6 December 1974, a drop of 45 percent. By that time, the Dow's dividend yield was 6.12 percent while its price-earnings ratio was 6.2. "As it turned out extreme financial conditions in 1974 paved the way for a sensational rally," he wrote.
Conclusion
In his epilogue, Fridson analyses the ten outstanding years he covers in his earlier chapters to determine the causes of the performances. Contrary to popular wisdom, he concluded that earnings rebound is not a reliable predictor of outstanding stock market performance. Rather, he suggests that the key factors are depressed stock prices combined with sudden credit easing. "When a huge volume of credit suddenly enters the U.S. financial system, whether through Fed action or as a result of some other nation's central bank policy, it must find an outlet," he explains. "On several occasions during the twentieth century, capital markets have provided that outlet. In these situations, inflation has occurred in financial assets, rather than in goods and services."
And does the present situation satisfy Fridson's two criteria of depressed stock prices and sudden credit easing? Most definitely. Looked at from this light, the market's recent rebound is not surprising at all.
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