Monday, December 10, 2018


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Traders work on the floor of the New York Stock Exchange (NYSE) in New York.

Brendan McDermid | Reuters
Traders work on the floor of the New York Stock Exchange (NYSE) in New York.

It’s been a hard-fought and often-frustrating year for stocks.

The year 1994, the bulls hopefully insist, resembles 2018 in several important ways:

  • After a few years of sluggish growth and low interest rates, the U.S. economy was heating up and the Federal Reserve raised rates aggressively to head off inflation. At the time, breaking below 6 percent unemployment (somewhat like 4 percent now) was viewed as risking a wage-inflation “overshoot,” and the rate sliced below 6 percent in 1994.
  • The major indexes were flattish for the year but sustained a “rolling correction,” with financial stocks and small caps crunched and the “average stock” dropping.
  • The S&P 500‘s price-earnings multiple was compressed dramatically through a combination of earnings growth and flat indexes.
  • Credit markets weakened significantly, raising worries about corporate balance sheets.
  • It was a midterm election year when the opposition party to a first-term president logged huge gains to take control of the House amid widespread worry over deficits.

Tony Dwyer, strategist at Canaccord Genuity, has been citing the echoes of 1994 in the recent cadence of the economy and markets, which inform his upbeat forecast for the S&P 500 to surge by 15 percent over the next several months. He notes that in ’94 and this year, Fed hikes flattened the yield curve dramatically, with the gap between the two- and 10-year Treasurys sinking below 0.2 percentage point, but never quite flattening entirely.

Near the end of 1994, the Fed signaled that it would ease up on rate hikes as the economy slowed, and stocks rushed higher through all of 1995, as bond yields fell sharply across the curve.

Jurrien Timmer, director of global macro at Fidelity Investments, has been detailing the parallels too, and ties it to Fed Chairman Jerome Powell’s perceived effort last week to soften the outlook for the pace of further rate increases after this month.

“With growth slowing, credit spreads now widening, and both real rates and TIPS [inflation-protected bonds] breaks coming down, the Fed certainly has the cover to guide the market that it plans to space out its remaining four hikes over several years instead of several quarters,” he said.

“The exact same thing happened in 1994, when the market bottomed as soon as the [bond market] started pricing in fewer rate hikes. This was in November 1994 when the S&P 500 suffered its second 10% drawdown in less than a year. The Fed kept raising rates … but that was the point when expectations peaked. It was all that the market needed to hear.”

A look at the S&P in 1994 and 1995 offers a clear hint why bullish investors might wish for a replay.

Chairman Powell himself has invoked the lessons of this period as well. In his speech at the Fed’s Jackson Hole, Wyoming, conference in August, he devoted several paragraphs to extolling the wisdom of his predecessor Alan Greenspan for throttling back on tightening as he saw a productivity revolution taking hold that would allow the economy to run hotter without generating as much inflation. Powell was putting this out there to suggest a comparable moment might be ahead now, with the link between growth and inflation very much in question.

Barry Knapp, former Barclays strategist and founder of Ironsides Macro Research, says he sees current heavy capital investment in software and other technologies raising the prospect for another productivity bump that would allow the economic cycle to last a while longer with benign inflation and high corporate profit margins.

This is where it becomes necessary to complicate this happy picture with important differences between 1994 and now, and the relative rarity of that late-’90s corporate and investor nirvana.

This expansion might not be winding down very soon, but however it’s sliced the current economic and credit cycles are certainly more mature than in the early ’90s recovery was back then. Corporate profit margins in ’94 were half of current levels and rising fairly fast, offering an extra boost to earnings. The forward price/earnings ratio in ’94 went from 15 down nearly to 12, compared to the trip from 18 to a bit over 15 now.

And, as Gluskin Sheff economist has been noting, Wall Street loves the 1994 analogy because it was virtually the only time a Fed “pause” engineered the perfect “soft landing” rather than a more serious growth scare or recession.

This bull-market cycle arguably already had its rerun of 1995-style low-drama levitation in 2013, when the Fed calmed fears of the end of its stimulus and a modestly valued stock market marched higher by 30 percent. In fact, the market’s inability this year to hold two separate all-time highs despite surging profits has many strategists on alert for confirmation of something far nastier.

So it probably doesn’t make sense to pencil in for next year a low-volatility melt-up in the S&P 500 just because this year was a high-stress trench war of valuation compression fought against a tough-love Fed.

But it helps to know what history has to say about how such periods can sometimes — when everything breaks just right — redeem the dearest wishes of the bulls.

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