Poor Millionaires

The better the economy, the more vulnerable the stock market.
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The bond market wheezed a sigh of relief when last Friday's employment report was less negative than feared. There wasn't much news in the report, to judge by the

Bureau of Labor Statistics'

summary: it described employment as "little changed" and total joblessness as "essentially unchanged." But the long bond accepted this thin gruel as a thrifty banquet, rallying by two points to 5.57% from 5.70%.

Bonds have backed up in yield by fully 60 basis points in the past three months. At their high yield last week, they were within a pitching wedge of the six-handle range they had traded in before last summer's Russia collapse triggered a global flight to quality. As evidence piles up that the world has weathered last year's financial firestorm, the bond market seems to be creeping back toward the "fair value" that had prevailed before the crisis: Credit quality spreads are working in tighter and "junk bonds" have become once again "high yield debt securities."

This is not unalloyed good news to an equity market that trades at historic multiples of trailing, and expected future, earnings. Yes, the


tacked on 460 points in its last two sessions to eke out another all-time new high. But that brings it to a level only 1% higher than two months ago, when long bonds traded 40 basis points richer than they do today and the two year note yield was fully 50 beeps south of here. None of the broader indexes joined the Dow in rarified air, although the

S&P 500

is within a whisker.

These lurching adjustments in market-clearing yields for bonds reflect an improving global economy, or at least the abandonment of the "prepare to meet your doom" mentality that prevailed last fall. The two-year note, at 5.1%, up from the 3.8% it touched in mid-October, reveals a market that has given up all hope of a near term



Alan Greenspan's

latest guidance reinforced my belief that the next Fed move will be to tighten. But that is not a consensus expectation, and in any case the market seems to be convinced that, whatever the answer, nothing negative is likely to take place soon on the monetary policy front.

It is hard to love a stock market that is in record territory when valued against earnings and then begins to look increasingly rich when valued against bonds, its primary competitor for investors' dollars. It is a market that has lost the price momentum it generated when rallying out of the gloom of last year's financial panic. It has been overtaken by its own short and intermediate moving averages and now looks "congested" at current levels. And it is a market whose leadership has begun to vacillate, as technology shares back and fill while long-out-of-favor sectors like energy and basic materials begin to twitch.

Performance remains highly concentrated. Breadth is terrible: the


cumulative daily advance/decline line has deteriorated back to the level of early October, before the S&P 500 put on another 29% in price performance.

According to

Ned Davis Research

, total NYSE equity market capitalization closed out 1998 at 128% of U.S. GDP. To say this is a record is a bit of an understatement of the NDR figures: the norm since 1925 is 50.5%, and the previous all-time high was 87% -- in 1929. A more contemporary peak was the 76% recorded at the end of the bull market of the 1960s.

I don't know whether these NDR historical numbers ought to be taken as normative, or whether something has happened to render them not pertinent to current and future valuation insights, or what the market-cap-to-GDP ratio ought to be. This may be a lot not to know -- on top of it I don't know anyone who does know -- but it is a disturbing statistic and begs for a bit of interpretation.

Market-cap-to-GDP is a stock-to-flow ratio, in this case a wealth-to-income ratio. (You might think of it as the inverse of a bond or dividend yield or, therefore, the inverse of an interest rate: If you have $100,000 principal of 5% coupon bonds, you would have a 20:1 wealth-to-income ratio.) If this is a legitimate way to reason, then high wealth-to-income ratios, i.e. low yields, imply low interest rates. Or perhaps it should be the other way around, that low interest rates imply high wealth-to-income ratios.

In any case, the analysis seems pertinent to today's situation, when it takes a lot more money than it used to take to be "rich." Let's presume you're a millionaire, fully invested in the S&P 500. Congratulations, you ol' plutocrat. But what's your income? At the current 1.25% market yield, that's $12,500 a year, which may not be enough spending money to support a cottage at Newport.

The direction of causation here is fairly clear; today's high market values did not cause today's low interest rates. It was the other way around. Stock market values are hostage to trends in the money and bond markets and, as an inference of the NDR work, much more vulnerable at the current 128% market-cap-to-GDP ratio than at the lower gearings from the past.

Money and bond market trends are going to behave inversely with those of the economy. Therefore, the better the economy does, the more vulnerable the stock market. That may sound like the ranting of a perma-bear, looking for dark clouds in a sunny sky. But it is true to the risk sensitivity consistently expressed in this space for quite some time, that the bull market is more exposed to better economic conditions and higher rates than to worse conditions, with their implied easier monetary policies -- as was the case in last year's crisis.

But caution has not paid in recent years, and did not pay late last week. Another conceivable interpretation for the market-cap-to-GDP ratio is that it is a leading indicator of future boom conditions, that the market is predicting a future of much higher incomes. In the same way that a high price-to-earnings ratio is said to predict a future of higher earnings, so too does the exalted market-cap-to-GDP ratio predict a brilliant future for the U.S. economy. Not every prediction comes true, of course, but it is a relief to be able to interpret the NDR numbers as something other than impending disaster.

So what does this make of the U.S.? It's a large-cap growth country, full of poor millionaires.

Jim Griffin is the chief strategist at Aeltus Investment Management in Hartford, Conn. His commentary on the financial markets is based upon information thought to be reliable and is not meant as investment advice. Aeltus manages institutional investment accounts and acts as adviser to the Aetna Mutual Funds. He welcomes your feedback.