by Gary North
A familiar rule of stock market investing is this: "When the Federal Reserve System raises rates, the stock market falls." Everyone believes this in retrospect. But at the end of a stock market boom, when the FED starts raising rates, almost nobody believes it. "This time, it's different."
Why should the rule be true? It has to do with the discount we apply to future income. It also has to do with the way in which the FED raises rates.
There is a kind of wide-eyed belief among otherwise sophisticated investors that the FED can raise rates merely by announcing that it intends to raise rates. While it can raise the overnight rate at which banks lend to other banks — the federal funds rate — it can do this only because bankers believe that a policy announcement by the FED will soon be accompanied by a change in FED policy. What change?
To raise short-term rates, the FED must restrict its rate of monetary expansion. That is, it must purchase fewer government debt certificates. By purchasing fewer debt certificates, the FED creates fewer fiat dollars with which to make the purchases. This reduces the rate of newly created fiat money. This reduces the flow of new loanable funds into the banking system.
Demand for new loans does not normally fall as rapidly as the FED reduces the flow of new money into the economy. Banks that have lent more than their reserves allow must by law cover the shortfall. This means paying more for overnight money. So, the price of overnight money rises, i.e., the federal funds interest rate.
Borrowers still want to borrow money. Banks still want to lend. The demand for loans tends to be "sticky." It stays up there. People think the good times will continue. They want to buy now, pay later.
The FED's reduction of money creation is what the longest-serving Federal Reserve Board Chairman, William McChesney Martin, once described as taking away the punchbowl when the party is really getting rolling. But it takes time for the effect of the reduced flow of fiat money to make itself felt in the economy. Short-term rates rise. Then borrowers begin to re-think the cost of borrowing.
Then they cut back.
In anticipation of the likely effects of any cut-back in borrowing by employers, stock market investors begin to sell shares. The profitability of owning shares in a time of economic slowdown looks less promising.
All of this has to do with the way in which the FED raises rates. The FED does not permanently raise rates by handing out a press release that says, "We will decree higher rates." It does so by having Greenspan tell Congress something about protecting the dollar against inflation. Then the Federal Open Market Committee (FOMC) backs up Greenspan's words by reducing the rate of purchase of government debt.
The statistics of the adjusted monetary base confirm the change in policy of the FED. Beginning in late September, the FED really put on the brakes. Then, for one month — January — the FED increased its purchases sharply. After that, stability. From mid-February until April 13, the adjusted monetary base remained flat: 0.1% annual rate of increase.
This has had a dramatic effect on the monetary statistic known as MZM — money of zero maturity. Since late November, it is down by 0.3%. Since early February, it is down by 2.5% annually. Since late June, it is up by 0.8% annually.
The result of this policy change has been obvious in the federal funds market. The St. Louis FED has a handy chart that compares the expected rate of interest as registered in the financial futures market with the announced targeted rate. You can see the rise. The futures rate exceeds the targeted rate when announced. The interest rate experts believed that Greenspan was telling the truth about rising rates.
THE STOCK MARKET
It was still rising through early March. The fund managers, who cannot easily liquidate, were still optimistic. That optimism has disappeared.
The investor in the financial futures market operates with a tiny margin. He must liquidate when the market moves against him. If he doesn't, his position will be sold out from under him by his brokerage house.
In contrast, the stock market fund manager can grit his teeth and hope that he will not be hit with a flood of "sell" orders from his fund's investors. His problem is that if he does get hit with sell orders, and his peers are also being hit, there will not be ready buyers for the corporate shares he must sell in order to redeem with cash the fund's shares. The stock market can drop rapidly.
We are now seeing headlines regarding fear about the stock market. The Dow has dipped below its 200-day moving average, which for some investors is an indication of further weakness. I am not a chartist, and so I regard this indicator as important mainly as an early warning indicator of a shift from optimism to caution. We have not yet seen real pessimism. We have not yet seen fear.
Take a look at the S&P 500 chart for the last decade. It is now at the same level where it was in mid-1998.
For almost seven years, the S&P 500 has returned zero capital gains. It has paid minuscule dividends — under 2%. Most dividends are consumed by fund management fees.
There are millions of investors out there who honestly believed in 1998 that the stock market would pay 20% per annum indefinitely. Many surveys taken in the late 1990s revealed this opinion. People believed that the abnormal returns from 1992 to 1998 were part of a new era. This is what Federal Reserve-funded booms do to investors. They lose their sense of history. "This time, it's different."
It was not just common investors who believed this. In October, 1999, Harry Dent's book appeared: The Roaring 2000s: Building the Wealth and Lifestyle You Desire in the Greatest Boom in History. The following March, three months after the Dow Jones Industrial Average peaked at 11,750 and two weeks after the Nasdaq's peak at 5040, Business Week published an interview with Dent.
Demographics tells author Dent that the Dow will hit 40,000
The Dow Jones industrial average's bad behavior may give you cause to doubt the durability of the great bull market. Don't worry, says Harry S. Dent Jr., the author, lecturer, and money manager. The bull market is as vast and powerful as the baby boomer generation, and the two are inextricable. The 80 million or so boomers — those born between 1946 and 1964 — are hitting their peak earning, spending, and investing years, and that's what's driving the economy's incredible performance and the stock market's spectacular returns. His target for the Dow is 40,000 — which he believes it will hit somewhere around 2008.
After that, watch out. As an economic force, the boomers will have peaked, and there just aren't enough Generation Xers to sustain the economic and stock market boom. Even the revolutionary changes wrought by the rapid growth of the Internet don't change that. In Dent's view, the economy goes into a deflationary funk for another 10 or so years, until the boomers' children — the 83 million "echo baby boom" generation — reach their economic prime. Dent's warning: Make your money now, and secure it before the inevitable bust that can take the Dow down to 10,000 again (chart, page 212).
That's a bummer if I ever heard one. Here we are, with the Dow at 10,000, and it's 2005. The clock is ticking. The Dow seems headed toward 7,000 rather than 40,000. But not in March, 2000.
Demographics as destiny? It's a simple idea, really, and with it, Dent, a 46-year-old boomer himself, has built quite an empire. His latest book, The Roaring 2000s Investor, is fifth on the Business Week Best-Seller List. His previous work, The Roaring 2000s, is ninth on the BW paperback list. On the lecture circuit, Dent is a favorite of brokerage firms and mutual-fund companies, which use him to fire up their sales forces and investor groups. He recently upped his lecture fee to $50,000. "I'm trying to cut down on the speaking engagements," says Dent. "I was doing over 200 a year, and that's too much." He recently launched the Dent Advisory Network, which licenses Dent materials and the right to give investment seminars based on his work in particular territories.
It sounded so easy. It sounded so good. It sounded like something worth paying $50,000 to bring before clients in a one-hour lecture.
It was a crock.
THREE YEARS TO GO. . .
Dent based it on demographics. The boomers are scheduled to begin retiring in 2011, when the first contingent, born in 1946, turns 65. Then why 2008? Because early retirement at age 62 is legal under Social Security.
Anyone who took him seriously in 2000 has five years of evidence that he did not know what he was talking about. Demographics was not destiny after all.
Except that it really is. In fact, in economic life, there is hardly anything more certain than demographics. It's the "death" half of "nothing is sure except death and taxes." The boomers are going to see to it politically that as they approach death, the workers are going to pay more taxes.
The boom is off the rose. The Dow has gone down since the date of Dent's interview. Five years have passed by, and there is no boom in sight.
People did not invest because of Dent. They invested because the FED expanded the money supply, created a boom, and lured in the suckers who are always ready to believe in a new era. But brokerage houses paid Dent big money to come on stage and provide charts and stats to reinforce the march of the lemmings. His message was clear: demographics is destiny, and in 2008, destiny says the market will go back to 10,000 from 40,000.
Question: Where will it go to if, in 2008, it begins its descent from 10,000?
I feel sure that Harry Dent's arguments are not bringing him $50,000 per speech today. The closer we get to 2008, the less market value his thesis has for brokerage houses.
To those of you who have not yet received your offer from Social Security to retire early, let me tell you what that letter means. It means that the clock is definitely ticking. It means that the likelihood of your being able to retire in three years is nil unless you can afford to retire today.
That letter has not yet arrived in the mail boxes of the boomers. It arrived in mine late last year. Not planning to retire, I found it amusing. With my income level, the tax man would collect so much of my promised early retirement windfall that anything left over would barely pay my medical insurance and my life insurance premiums. So, I ignored the offer. Besides, I like my work.
I began planning my non-retirement over three decades ago, when I started my newsletter, Remnant Review. I plan to open a day care center this fall. I'm ready to branch out into a new career. I figure I can earn 25% on the day care's real estate alone, not counting appreciation . . . in the middle of a boom area. (Note: it will be located within jogging distance of mid-America's shrine: Graceland.)
Tens of millions of Americans my age or close to it have lived an illusion, an illusion fostered by men like Harry Dent. They really did believe that there was an escape hatch from both poverty and work. There isn't — not for at least 80% of Americans.
April 20, 2005
Copyright © 2005 LewRockwell.com