Why the Gulf War Example Doesn't Apply

In times like these, history is no guide to the future. Especially when it comes to the stock market.

Stocks rose sharply in the months following the 1990-91 Gulf War and the near-collapse in 1998 of Long Term Capital Management, both of which were initially seen as deeply bearish for markets. Now, optimists are pointing to those rallies and arguing that stocks could jump after last week's terrorist destruction.

Oh, would that it were so. While there are similarities between current market conditions and those existing in 1991 and 1998 -- like the sort of aggressive interest-rate cuts that the Fed and the European Central Bank announced Monday -- much is different. The economy, stock valuations, corporate earnings and bond yields all are working against a rally from here.

The Rebound Mirage

Recent history looks reassuring. Iraq invaded Kuwait in August 1990, when the S&P 500 was at 323. A year later it was 22% higher. A year after the Fed-orchestrated bailout of LTCM, the index was up 26%. In both cases, the Fed cut rates and flooded the financial system with cheap money. Alan Greenspan was hailed.

Good Times and Bad S&P 500 operating earnings*

Source: Standard & Poor's. * 2001 number is a consensus estimate from before last week's terrorist attacks.

So what drove the markets up then that might not exist today? Let's go through the checklist.

A simplistic, fundamental approach that looks solely at earnings says little. The lesson on profits is contradictory. Looking at the aftermath of 1998, profits would appear to be the deciding factor. S&P 500 profits jumped 17% in 1999 and rose 9% in 2000, appearing to justify the soaring stock prices of the period.

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However, earnings growth stunk for three whole years after a U.S.-led coalition drove Saddam Hussein's troops out of Kuwait in February 1991. In fact, it wasn't until 1994 that S&P 500 earnings exceeded the level they'd reached in 1989. The markets rallied despite the sluggishness in earnings, leading some to assume that a sustainable rally is possible now in the midst of a grinding profits recession.

Easy Money

If it's not profits, what is it? One factor 1991, 1998 and 2001 all have in common is an extremely accommodating central bank. Greenspan slashed the key fed funds target rate to 3.25% by August 1992, from 8% two years earlier. Some market mavens say that sort of liquidity-based rally could happen now, as the Fed has brought the fed funds rate down to 3% from 6% at the start of this year, and is now expected to lower it to 2% by year-end. The market could, of course, pop to the upside. But the interest-rate theory overlooks valuation.

In August 1990, the S&P 500 was trading at 14 times trailing-12-month earnings, compared with 23 times now (using analyst estimates for the third quarter). You don't need fantastic earnings growth to buy stocks when they're trading in the mid-teens. You do when their P/Es are in the low 20s.

But wait a minute: Wasn't the market even more expensive after the LTCM crisis -- trading at nearly 30 times earnings in 1999 -- and stocks rallied anyway? Sure, but the economy was humming, profits were prodigious, government surpluses were predicted and New Economy hype was at its most pervasive. Wrongly, people believed the good times could last forever.

So what does drive stock prices? Ultimately, a combination of corporate bond yields and stock valuations. After 1990, the interest rate on corporate bonds rated Baa by Moody's fell consistently, providing cheaper funds to corporations after a recession that weeded out the most inefficient companies. As stock indices moved higher, valuations also rose. But, by 1993, dynamic earnings growth returned, making the low-20s P/E on the S&P 500 bearable for investors.

However, people forget that, after the 1998 LTCM bailout, interest rates soon snapped back. The Fed, fearing inflation, refused to underwrite mounting capital demands with lower rates. This forced up borrowing costs and, by early 2000, put downward pressure on stock prices. The bear market we're now in has its roots in that period.

The Inflation Question

The outlook for stocks is not good. Valuations are still too rich to attract long-term buyers. Meanwhile, bond yields are refusing to come down by much. Just before the attacks on the World Trade Center and Pentagon, the average corporate bond yield for a Baa corporate was 7.78%, marginally below the 7.84% that existed in March. Reflecting lenders' fears about overleverage and the diminishing profits outlook for corporate America, corporate bonds sold off Monday, pushing yields higher.

A Look Back Bonds and stocks over the past 12 years

Source: Yahoo! Finance, Detox

So where do stocks go from here? Much depends on inflation. Prices may rise if central banks continue with this massive monetary stimulus and taxpayers tolerate big government deficits to finance the fight against terrorism. Money supply growth had been extremely strong before the attacks.

If higher inflation forces corporate bond yields even higher, stocks are bound to plunge. The S&P 500, if it traded at 15 times expected 2001 earnings, would be around 700, or 33% below where it closed Monday. However, if inflation stays licked and bond yields shrink, the S&P probably will trade in the 900-to-1000 range until an earnings recovery comes.

The lesson? Avoid equities for now. America needs the money elsewhere.