Workshop Portfolio How a Bear Market Could Happen
Bear markets, Part IV

By Moe Chernick
February 29, 2000

Last week, we discussed how today's booming economy, with U.S. corporations leading the way, make the stock market look like a very good investment to long-term investors. Yet, short-term investors look at these same conditions and see them as cause to worry. Since more people tend to invest with a short-term perspective, these investors could drive the market down in the short term. Let's explore what they fear and how it could affect your investments this year.

Why would a booming economy and strong growth of U.S. corporations scare the short-term investor? The answer is inflation. A booming economy can lead to inflation in a number of different ways. Some of the major ways inflation affects an economy are listed below:

1. The demand for employees exceeds the supply so employees are in a better position to demand and get higher wages.
   
   
2. Companies try to expand their businesses to meet higher demand from customers so they borrow money. More demand for borrowed money drives up interest rates.
   
   
3. In a booming economy, people spend like crazy. Instead of saving for a "rainy day," consumers feel secure in their jobs and start buying more, racking up more credit card debt, car loans, etc., than they do in bad times when they fear loss of income.
   
   
4. To supply those voracious consumers, industry demands more natural resources such as fuels, which causes the price of those resources to increase dramatically.
   

In summary, a booming economy and stock market causes an increased demand for credit and natural resources. With everyone in consumption mode, both interest rates and the cost of raw materials start moving sharply upward -- and there you have it: the spectre of inflation.

Inflation has two major negative effects on stock prices. First, when interest rates increase, the rate of return from bonds goes up, which increases the demand for bonds. Money going into bonds is not available for investing in stocks. Weakening demand for stocks causes prices to drop.

Normally this plays out more or less in balance. When stock prices drop, they start looking more attractive to investors and money flows back out of bonds and into stocks. But a big jump in interest rates can keep money in bonds because of reason number two.

The second effect of inflation on the stock market works through corporate profits. Profits are affected negatively in two ways. First, costs such as salaries and transportation rise faster than companies can pass them on to customers. Second, the cost of money goes up, resulting in higher interest expenses, which come right out of corporate profits. Third, loans become more expensive, and new ventures that would normally be financed by borrowing tend to be delayed, slowing the creation of new jobs and cooling off the economy.

Is there anything that can be done to prevent inflation in a fast-growing economy? The answer is yes, and that's where the government steps in.

The first place most people focus on is the Federal Reserve. The Federal Reserve tries to keep the economy growing, but not so quickly that inflation will increase. The Fed manipulates the economic growth rate by controlling the money supply and interest rates. By pushing interest rates up, the Federal Reserve attempts to get companies and consumers to stop spending before things get out of control. Higher rates discourage borrowing, lower rates encourage it. This is why the Federal Reserve Board has moved recently to raise interest rates.

Congress also plays a role. It has the power to make laws that will encourage saving. Both corporate and personal loans are funded from savings. The more people save, the greater the supply of money for loans and thus the lower interest rates will be. A recent example of how laws can encourage savings is the Roth IRA. Many people put money into the Roth that they might otherwise have spent because the Roth's tax-free retirement benefits are designed to be very attractive.

Both the president and Congress control the federal budget. The U.S. government is by far the biggest borrower of money in the country, and thus how much they borrow has a big effect on interest rates. One of the most positive developments for the economy lately has been the budget surplus. The surplus has allowed the government to stop borrowing, and it may actually start retiring some debt. This is a huge boon for the economy. While consumers are creating inflationary pressure, the government is causing deflationary pressure by paying back the debt.

Of course, the only reason the politicians haven't messed up this advantage yet is political gridlock. If the politicians were smart, in my opinion, they would be happy with the surpluses and leave the status quo alone. However, politicians are politicians so they give investors a lot to worry about, especially in an election year. The words "Tax Cut" just seem to leap involuntarily from their lips. Sure, I would love a big tax cut, but the bigger the tax cut, the less money the government has to pay back its huge debt and help keep inflation down. Also, giving consumers more money to spend during inflationary time only adds fuel to the inflationary fire.

Then there are the politicians who want to spend the money on additional government programs. The effect of spending the money on programs isn't much different from giving it back as a tax cut. If the money is spent, it can't go toward paying off the debt and lowering interest rates. Also, the spent money goes to people, creates jobs, and does other things that stimulate an already overly stimulated economy.

If the deflationary pressure created by the budget surplus weakens, growing inflation becomes a real possibility. Will the government have enough strength of character to keep its grubby hands off the surplus? Yeah, right.

So as you can see, there are good reasons to be concerned about a possible bear market. What can or should a long-term investor do? Next time, I will conclude this series by exploring that issue.

Until next time, Fool on!