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Wednesday, June 16, 1999

FOOL ON THE HILL
An Investment Opinion
by Louis Corrigan

Inflection Point? We'll See

Holy smokes, why did the Nasdaq zoom up 103.2 points (4.3%) to 2,518 today? Why did the Dow cruise ahead 189.9 points (1.8%) to 10,785? In short, the U.S. Labor Department's core Consumer Price Index rang us a lucky number.

The so-called CPI measures inflation at the consumer level, and it showed that prices remained flat for May. That was below (and thus, better than) the consensus 0.2% increase that Wall Street economists had been expecting and light years better than the spooky April jump of 0.7% caused by rising energy prices. The more important core CPI, which excludes volatile food and energy prices, rose by just 0.1% versus expectations for a 0.2% gain. Looking at core items, the price of clothes, computers, automobiles, and transportation declined while the price of housing and prescription drugs increased. Although the first five months of the year show consumers suffering under an overall annualized 2.6% inflation rate, versus just 1.8% for the same period of 1998, the core CPI is running below last year's level.

"So you're telling me that one government stat came in one-tenth of a percent below expectations and that's why the market added multiple billions in value today?"

Yes, more or less.

As Fools, we're interested in investing in businesses for the long-term rather than making short-term bets on which way macroeconomic events will play out and how they'll move the market hither or thither this week, next month, or even next year. If you're investing for the long term (three years plus), as you should be, then you can happily ignore most of the macro stuff that CNBC makes a big deal about. That's why you don't get a lot of economic commentary from us, and you shouldn't expect to. Such economic data is mostly a distraction from the basic task of finding good companies to invest in.

Still, I think you want to understand in a general sense why a day like today happens. It's not in any simple sense silly. The stock market tends to be a leading economic indicator because it reflects the best guesses of millions of participants about where things are heading. The market is always looking down the road six months, projecting how a trend based on points A, B, and C might end up looking at point Q. That is, the market's always performing some connect the dots.

Of course, there's a bit of emotion and uncertainty involved in this process. Imagine that you're hiking blindfolded. You don't have a clear vision of where you're headed, but your other senses give you clues and your mind extrapolates from those clues. After going uphill for many miles, you start heading downhill. Then you notice the sound of a waterfalls, and you know you must be getting near a cliff. With each step downhill, the waterfalls gets louder. You become all panicky as you imagine your body plunging over the edge.

Today, the path changed course. The sound of the waterfall receded a little, the ground evened out so that you're now climbing up again. Today, at least, the idea that you might end up bloodied in that gorge has all but disappeared.

While we all want economic growth, an economy that's too strong can pressure scarce resources like labor, productive capacity, and raw materials. It's pure supply and demand. Too much demand can push up prices for these resources. Onerous inflation destroys the value of a currency while fostering the kind of uncertainties that can lead to more inflation. For example, if clothing and housing prices rise too fast, employees want to get paid more so they can maintain at least the same standard of living. So the Federal Reserve is always interested in keeping inflation in check. It does this partly by pushing up interest rates, when need be, so that market participants like you and me will cool it, reigning in spending on that new shirt, that new car, that new house. When demand outstrips supply and threatens to push up prices, the Fed likes to tell demand to take the day off.

For the last few months, but particularly since the April CPI report, the stock market has worried that the surprising trend of the last few years (strong growth with low inflation) was coming to an end. Lending credence to this worry was the fact that the yield on the 30-year U.S. Treasury bond has steadily increased since hitting a low during the fall financial panic, when Fed Chairman Alan Greenspan pushed through three quarter point cuts in the Fed fund's rate to 4.75%. The bonds have been predicting that the Fed will boost short term rates. And after the May 18 meeting of the Federal Open Market Committee (FOMC), Greenspan & Co. did switch their bias toward raising rates. With more data showing a very strong economy and various Fed officials talking up the likelihood of a rate hike, the yield on the bond has continued to rise, soaring from around 5.50% in late April to last Friday's high of 6.16%. (The yield closed down to 6.07% today.)

Rising interest rates (bond yields) are negative for stocks for a few reasons. For starters, investors choose between the guaranteed return of a bond and the riskier return of stocks. At some point, the risk/reward makes bonds more attractive for many investors. Also, stocks trade based on their discounted future cash flows. Rising interest rates theoretically mean that investors will demand relatively higher returns to invest in stocks. By raising the divisor in this equation, higher interest rates decrease the net present value of a company's future cash flows.

A simpler way of thinking about this is just that earnings are worth less when inflation is high. On the flipside, higher interest rates slow the economy and thus reduce corporate profits. These negatives hit growth stocks (think Internet) the hardest because so much of their net present value is dependent on earnings due to arrive years from now. In other words, high inflation and/or higher interest rates have a dampening effect on exactly the kind of compounding of interest that makes long-term investing so profitable.

The bearish logic has gone like this. Greenspan raised rates only a quarter point in early 1997, but he would have continued raising them to slow the economy and head off inflation except that the Asia financial crisis hit. Indeed, he moved to lower rates last fall just when some figured he would absolutely have to raise them only because Russia defaulted on it loans, other emerging markets fell apart, and Long-Term Capital threatened the global financial system. In other words, Greenspan stepped in with aggressive cuts to curtail panic.

Today, the panic is over, the U.S. economy is incredibly strong, and overseas markets are recovering, so it's back to normal Fed policy of aggressively heading off inflation. According to this view, the Fed funds rate is already 50 basis points below where it was when Greenspan last raised rates. So it wouldn't be shocking to see a string of rate hikes over the next few quarters. The last string of rate increases came in 1994, and that proved a bad year for stocks.

That's the scenario that's had the bond yields rising and growth stock investors grimacing. Until today. It's not just a fear that Greenspan might raise rates the next time the FOMC meets at the end of this month. It's a fear that a quarter point hike at that meeting will be the first of several. And that's bad news for the stocks that investors have loved over the last few years. Today's modest increase in the CPI doesn't alone end those fears, but it certainly alleviates them considerably. It's a potential inflection point because investors who had begun figuring in the likelihood of a series of interest rate increases now think that the inflation picture doesn't look bad enough to justify such a series. Sure, the FOMC may raise rates a quarter point in two weeks. But maybe that will be it for a while. Or at worst, maybe there will be just another quarter point hike later this year.

For an inflation hawk, Greenspan has exhibited remarkable patience and pragmatism when figuring out what to do with interest rates. He's been incredibly vocal about how technology has improved productivity, allowing businesses to pay employees higher real wages while keeping other costs well in check. He's pointed out that information technology has allowed businesses to avoid some of the stockpiling of inventories and other inefficiencies that led to previous boom/bust cycles. He's also watched the ever-tightening labor markets with concern but with a keen eye for how a strong economy actually increases the potential labor force by bringing discouraged workers back into the market.

Indeed, as he said on Monday, "Something special has happened to the American economy in recent years." Yet he also said, "The rate of growth of productivity cannot increase indefinitely. While there appears to be considerable expectation in the business community, and possibly Wall Street, that the productivity acceleration has not yet peaked, experience advises caution."

This afternoon, the Fed released its "Beige book" report on the U.S. economy. It offers the two sides to the story. On the one hand: "Labor markets remain very tight in almost all districts, with increased reports of upward pressure on wages in many parts of the country." Wages rising faster than productivity is inflationary. On the other hand: "Prices, however, with the exception of several construction materials, remain well behaved." Without rising prices, there is no inflation. A conundrum, indeed. Greenspan's comments tomorrow morning before the Joint Economic Committee of Congress will be as closely watched as today's CPI since he should offer some clues about what the Fed will do in two weeks.

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