The investment world is indeed an interesting one. It is a magnificent study of collective human behavior and conditioned responses to long business cycles.
I remember the early 1960’s as being a very stable time, with inflation being steady at 1% per year and interest rates hovering between 5-5½%. The typical American was enjoying prosperity, good real estate markets, good stock markets and a strong currency. Except for the cold war, the world was at peace. There was no person acknowledging a possibility of double digit inflation and 14% treasury interest rates over the ensuing 10-20 years. Lyndon Johnson was President, and as we inched our way into the Vietnam War, we continued a massive highway beautification plan and adopted new social programs that were deemed to be insignificant because of government’s well-publicized “safety-net”.
Bond investors were a complacent lot, buying into the bond markets as interest rates and inflation began their upward spiral.
Similarly, real estate lenders and investors were willing to commit long-term funds for low mortgage rates and “cap” rates.
Stock market investors were willing to pay high price/earnings multiples for stock as a reflection of low and steady interest rates.
Investors had become conditioned to the environment over many years, and only the rarest of investment minds were able to perceive problems that could be caused by the accumulation of debt and liquidity building in the markets.
Arthur Burns, then Chairman of the Federal Reserve Board, began a series of tightening moves designed to stabilize the monetary environment. Each of these moves precipitated bad markets and the spectre of dire economic consequences. Ultimately the Fed. would panic and loosen the monetary reins only to precipitate another “boom cycle” created by the new monetary accommodation. The cycle would be repeated several times and finally exacerbated by Fed. Chairman William Miller who promised “all the money we wanted and needed”. The end of the story was quite ugly, with mortgage rates at 16%, treasury rates at 14%, inflation at 12% and extremely low price/earnings ratios for the best of companies. The understanding of these excesses took 15+ years. It took investors that long to realize the magnitude of the inflation problem and the vicious cycle they had been through. The survivors of the investment struggle had become “boom & bust” investors, timing the minicycles within the long cycle. “Fed. watching” became a daily exercise for many on Wall Street.
By 1980, investors had become conditioned to high interest rates and the relative values derived through such an environment. The Dow Jones Industrial Average was well under 1,000 and interest rates were 14%. Inflation hovered near 12% and virtually no one was able to conceive of the possibility of Dow 12,000 along with 4% interest rates and 1-2% inflation. This ensuing cycle has lasted for 25 years, and once again investors seem to be conditioned to low inflation, low rates and good real estate and stock values. There seems to be complacency in the bond market and a high degree of confidence that the stock market will continue upward as a sea of liquidity chases a diminishing number of shares outstanding.
The most successful investors of this long cycle have stayed the course and leveraged their winnings; a very different strategy from those who endured the previous cycle. -over- Today, virtually no one is calling for high inflation and high interest rates. In fact, very few Fed. watchers are expecting the Federal Reserve to continue raising rates.
Granted, price/earnings ratios are not as high as they were at the peak 40 years ago. Granted, Dr. Ben Bernanke is no Arthur Burns or William Miller, and while we feel these good conditions will last awhile, I think it’s time to begin dusting off that old “boom & bust” playbook. Today’s complacency is all too familiar.