The 1998 Market Deja Vu

Does 1999 seem like a replay to anyone else?
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"Wall Street is having a 10%-off sale on over-the-counter stocks." It sounds better that way, doesn't it, than to say the Nasdaq is down by 10% (11% actually, and counting) and the S&P 500 is off by 8.35%? These are measures of the damage done over the past three weeks since the market peaked -- for the time being, at least -- on July 16.

Right now, it looks as if 1999 is a do-over for 1998. Last year's interim peak came on July 17, a culmination of six and a half months of fairly steady progress that resulted in a handsome double-digit gain. This year's progress produced a smaller double-digit and showed quite a bit more nervous volatility in doing so, but the resemblance is more than skin deep so it has no trouble getting attention.

The three-week selloff is the result of market capitulation on the question of the

Fed's

next move. Two weeks ago I wrote that Wall Street opinion seemed tepid in its reaction to

Alan Greenspan's

hawkish

Humphrey-Hawkins

testimony and that I saw this as "wishing it were not so." Last week's employment report, with its solidly on-trend big job creation number and its reinforcing evidence of wage-cost acceleration, leaves our chief central banker now hoist with his own rhetoric.

With stark evidence, first from the second quarter

Employment Cost Index

and productivity reports, and now from July labor market data, the Fed chairman has either to back up his tough talk, or back down.

Neither of those options can be a market positive.

U.S. Treasury

long bonds closed at 1999 new high yields last week despite the announcement that November's auction would be pulled because Uncle Sam just doesn't need the money. The U.S. dollar peaked -- for the time being -- against the euro almost on the same day that our equity markets reached their year-to-date apogee. In three weeks, the buck has given up almost half the gain it had registered since the birthing of Europe's new unit, and it has lost 5% of its value in yen terms.

It is instructive that the dollar has weakened at the same time that market conviction about a Fed tightening has approached certainty. (Fed funds futures can be read as making it only a one-in-eight chance that the Aug. 24

Federal Open Market Committee

meeting will

not

add 25 basis points to its target rate.) An overly simplified teaching model, which some commentators still seem to use in considering real-world currency adjustments, maintains that higher short-term interest rates will be supportive of a currency's exchange value. That may be true, but it's not the whole truth.

The markets have moved beyond the question of whether the next Fed move will come; the issues now are how much and when.

Its conclusions may be more pertinent to an era when capital flows were less important relative to trade flows in determining the overall supply/demand balance between currencies. Today, with so much of our money invested in their markets and, more to the point, so much of theirs invested in ours, the dollar reacts negatively to the near-certainty of a Fed rate hike because our stock and bond markets react negatively. Overseas holders of U.S. stocks and bonds, just as domestic investors, can anticipate getting hurt by tighter monetary policy. Domestic investors will take their proceeds and go to cash while foreigners may take theirs and go home.

Last week's action suggests to me that markets have moved beyond the question of whether the next Fed move will come; the issues now are how much and when.

The fact that 1999's price action rhymes uncomfortably with 1998's is a factor in the judgment call. At this time last year, the Fed had a tightening bias and markets were trying to get used to that idea. Then Russia defaulted, flight capital surged into New York, spreads gapped,

Long Term Capital Management

croaked and financial panic set in. The recollection of those very interesting times remains vivid and is probably a background factor in the way that markets have been trading lately.

It must also be a factor in Fed policy judgments. In this uncomfortably intimate world, monetary authorities cannot be certain of just how or where their brakes may grab. A Fed tightening creates the usual exposures -- falling asset prices, weakening business conditions, deteriorating credit quality, stress on financial institutions -- but now it adds the risk that an emerging-market meltdown or some other far distant balance-sheet eruption will be precipitated. So it seems likely to me that the FOMC will choose to pump the brakes gently but repeatedly, until it has a better sense of just how the globally integrated financial system is going to react. Nobody wants a replay of last year's third quarter.

If this thinking proves accurate, then we face an extended period of concern about how the story will turn out. Will the economy decelerate in a smooth enough manner that only modest monetary restraint will be necessary? Or will recovering economies abroad give ours a push in the back? If that's the case -- as I believe is more likely -- will much more vigor be required of the Fed? If it pumps the brakes hard soon, it risks another crash such as the one that developed last year. If it brakes more cautiously, it may not have much early effect on what now appears to be increasing global momentum.

Any time a difficult conundrum faces the Fed, it faces investors too. It's not a very pleasant outlook at the moment and Wall Street has tried to sweeten it by holding a 10%-off sale. Traditionalists might label it a correction. But with so many new investors in the game, and with uncertainty about just how such greenhorns might act under adverse conditions, I'd prefer to think of it as providing an opportunity to buy great companies at discount prices.

One of the bedrock arguments of the bulls on the way up was the demographic imperative that boomers and other 401(k) retirement savers had to buy and therefore would buy. A 10%-off sale should be an attractive inducement to add to holdings, but it has been the perverse nature of this particular value-unconscious market that people would prefer to pay more.