Wealth Manager

Chapter one of such a review could be a new study from the
Federal Reserve Bank of St. Louis, which reminds us that above-average
economic growth and below-average inflation have accompanied
market booms in the 20th century. But the booms have
often ended when the favorable conditions reversed.

“Most booms were procyclical—arising during business cycle
recoveries and expansions, and ending when rising inflation and
tighter monetary policy were followed by declining economic activity,”
asserts the working paper co-authored by Michael Bordo, an
economics professor at Rutgers University, and David Wheelock, an
economist at the St. Louis Fed. (A copy is available
at research.stlouisfed.org/wp/more/2006-051.)

According to their study—“When Do Stock Market
Booms Occur? The Macroeconomic and Policy Environments
of 20th Century Booms”—the numbers
tell the story. Embedded in the chronicling of the
ebb and flow of equity prices and economic cycles
is a potent reminder that timing can be crucial. For
example, the authors find that booms tended to develop when inflation
was below its long-run average and falling. As the graph on page
78—courtesy of the paper—shows, the median inflation rate for the
countries studied was roughly one percentage point below its long-run
average during the four-to-seven-year period ahead of market
peaks. As market tops drew closer, inflation dropped further. In the
two years before the peaks, inflation dipped to a median of about
two percentage points below its long-term average.

Booms have an annoying habit of eventually turning to busts. Once
again, the accompanying variables share a recurring aura—notably,
higher inflation. That tends to bring out the hawkish side of central
bankers, the paper observes, a bias that’s no small factor in the death of
bull markets. “Rising inflation tended to bring tighter monetary conditions,
reflected in higher real interest rates, declining term spreads, and
reduced money stock growth,” the authors write. It’s no accident, that
equity markets don’t usually flourish under such conditions.

That lineup of threatening factors doesn’t exactly reflect recent
history, but it’s close, and perhaps too close for comfort. Indeed,
inflation has been an on-again, off-again threat in recent years,
and the Fed has only recently stopped raising interest rates, which
has flattened the yield curve and raised the specter of recession in the minds of analysts. Meanwhile, not everyone is convinced that pricing pressures have been quashed.

The past does not repeat itself, Twain counseled, but it rhymes.
With that in mind, we recently talked with David Wheelock about
booms, busts, history and the outlook for seeing a fresh round of
rhymes in the future.

Q: What can you tell us about the nature of bull markets over the
past century?

A: We tried to document the experience of the United States and
several other countries in the 20th century regarding the environment
in which stock market booms have occurred. Booms in the
paper are loosely defined as extended periods of very rapid increases
in inflation-adjusted stock prices.

Maybe our findings aren’t terribly surprising, but we find a pretty
close relationship between rapid economic growth and stock
market performance. But that relationship seemed to be looser, or
less robust, than the relationship we found between inflation and
growth in real [inflation-adjusted] stock prices. That is, we learned
that most stock market booms of the 20th century in the U.S. and
other countries occurred when inflation was low or stable, and perhaps
declining; booms tended to end when inflation picked up.
There are several possible explanations for that. We focus on monetary
policy—that’s kind of our bag, although there are other explanations.
For our paper, it comes down to the old saying, “Don’t fight
the Fed,” which seems to hold a lot of water. We see evidence that
when monetary authorities tightened credit, it really did have an
effect on stock markets. The tighter central banks squeeze, the more
likely a boom’s going to end up as some kind of a crash.

Q: Did any of the paper’s findings surprise you?

A: I expected to see a stronger relationship between stock prices
and real economic activity, especially productivity growth. That
was the big argument during the 1990s stock market boom—the
so-called New Economy story. And it does hold up for the U.S. During
the 90s, we did have an acceleration of productivity growth, which we might associate with higher long-run growth of profits
and dividends and so forth. But you don’t see that relationship
hold up in a lot of other countries.

In general, the stock market booms of the last couple of decades
in other countries weren’t clearly associated with pickups in productivity
growth. Maybe that’s because the U.S. dominates [the world
economy]. We have globalization of finance and so forth, and so
maybe domestic economic conditions in some smaller countries are
less important than what’s going on in the global economy.

Q: Could part of the answer also be that U.S. financial markets are
more efficient compared with other countries, and so the connection
between economic trends and equity prices is tighter?

A: Maybe so, but I’m not as knowledgeable about the inner workings
of the stock markets outside the U.S. There have been, of
course, moves all around the world toward electronic trading and
derivative securities and so forth, which does tend to push markets
in a more modern direction. And the U.S. is a deeper market
and has always led the way in terms of efficiency and so forth.

Q: What does history say about the causes of inflation?

A: We think that inflation is primarily caused by monetary policy,
which creates excessive growth of liquidity or the money supply. We
think [inflation] is largely in the hands of the Fed. We do have shocks,
such as the oil shocks of the 70s, which can have a temporarily destabilizing
effect on the price level. But monetary policy is what causes
inflation to get going and to stay going, and so monetary policy’s really
the only thing that can reverse inflation once it gets out of hand.

Q: Then you believe that slower economic growth doesn’t lessen
inflation—a line of reasoning that has received some lip service
in recent months?

A: In the 1970s, there was a period of stagflation: We had poor economic
performance in inflation-adjusted terms and high inflation. Particularly
in the late 1970s, the Fed tried to goose up the economy with higher
money growth, but didn’t respond sufficiently to inflation. The consequence
was a pretty high rate of inflation by the late 1970s.

Q: How would you describe the economic background that accompanied
the market booms of the 1980s and 1990s?

A: The 1990s boom in the U.S., at least, and in a lot of other countries,
arose in an environment when we achieved price stability in macroeconomic
terms. There was very low inflation, an environment
that was conducive to good economic growth, and good returns
in the market. But a feature of the 1990s’ experience that perhaps
we haven’t seen since before World War II was the globalization of
finance, meaning a period of high international market integration
and globalization of financial markets. But the earlier international
market integration was muted as a result of the Great Depression
and the Second World War. We’ve seen international markets open
up in the last 20, 30 years, which has probably changed the character
of stock market booms all around the world.

Q: How so?

A: [Globalization] probably reduced the association of stock market
performance with economic conditions within the domestic country. In the past, domestic conditions in smaller countries
would more directly reflect circumstances at home, but now those
countries are also influenced by conditions around the world.

Q: Has the influence of inflation and monetary policy in stock
market booms and busts remained steady over time?

A: It seems so. Their influence appears to have held pretty tight across
different monetary regimes in the interwar period. We were on the
gold standard in the 1920s, and then later on there was Bretton Woods
[the dollar-based monetary system from 1946 to 1971] and capital controls
and so forth. But you see a general correlation between inflation
and monetary policy and the stock market over time. The relationship
does seem to have held up robustly across different eras.

Q: Is there any reason to think that the relationship might change?

A: I wouldn’t think so. A lesson here is that an environment in which
central banks are able to maintain low inflation and keep it under wraps
is one that’s conducive for good economic growth and for the market.

I will say, however, that the historical data on real economic
activity isn’t as good as it is with inflation. Perhaps that’s because
the estimates on economic activity historically aren’t as easy [to
calculate compared with inflation and monetary data].

Another complication is that the market is forward looking. It’s
not necessarily the case that booms will be associated with the current
level of economic activity, but rather with expectations. There
was a major stock market boom in 1928 and 1929, even though
the 20s had good but not exceptionally strong growth. Still, there
were arguments [at the time] that the U.S. could expect strong real
activity, good growth of corporate profits, etc. [Bull markets are an]
expectations-driven phenomenon. Unfortunately, we don’t have
very good measures of expectations [for the distant past], so we
have to rely on the current economic activity.

Q: Thanks to the rise of derivatives, globalization and other factors,
central banks don’t seem to have as much control over the economy
as they used to. Does that mean that the future relationship
between monetary policy and the stock market might change?

A: It’s hard to speculate. History does seem to repeat itself on and on again, however. We think of finance as very high tech, and of course it
is. But there have always been developments in creative ways of producing
information and getting it to the markets. I’m not one to really
believe that relationships fundamentally change with new eras.

Globalization is drawing markets closer, and so they’re less solely
dependent on their domestic monetary policy and economic
activity and the world economy. So that’s one area going forward
where the relationships won’t be as strong.

Q: Correlations among stock markets rose in the 1990s, which parallels
the rise of globalization. It’s also true that the former age of globalization
faded, and so the same might happen again. If so, would
that imply that correlations among stock markets would fall?

A: Yes, that’s quite possible. Eras of financial integration seem to
end with a major shock. In the 1930s, it was the Great Depression
and the disintegration of the international gold standard and the
imposition of capital and exchange controls by individual countries
in an attempt to wall off their financial and monetary systems
from what was going on in the world. That was followed by the
Bretton Woods system, and then the oil shocks in the 1970s, which
ended another period of integration and created more chaos. So
there are periods of increasing integration, and then something
that happens to cause a disintegration.

Q: What does history tell us about previous periods when correlations
among stock markets declined?

A: It’s very impressionistic, but we found that in the 1950s and
1960s, when markets were less integrated, the timing of stock market
booms across countries was more varied. That is, the booms
were less coincident with one another. By contrast, in periods of
high market integration, booms are occurring all over the place.
Periods of low integration were more about what was going on in
your domestic economy.

Q: What basic lesson does your paper impart?

A: We’re looking at it from the perspective of monetary policy makers
rather than stock market participants. So, from a policy maker’s
perspective, the key lesson is to keep inflation under control and
not let it rear up; it’s better to nip it in the bud before it gets going.
There’s also going to be a relationship between macroeconomic
policy and financial regimes or regulatory policy, in terms of capital
controls and so forth. You can’t really look at regulatory policy
in isolation of macroeconomic policy.