Stock market history may not repeat itself, but it tends to rhyme.
So if you’re worried about the economy — and how, exactly, Bernanke will end QE3 — then let me ask you a question…
Do you remember the “jobless” economic recovery of 2002-2003?
Because I see a very similar situation playing out today…
The U.S. economy was a mess after Fed Chief Greenspan’s 50 bps rate hike officially popped the dot-com bubble on May 16, 2000. GDP growth in that second quarter of 2000 was an amazing 8%. But after that 50-point rate hike, growth plummeted to just 0.3% in the third quarter.
By the beginning of 2001, the U.S. economy was shrinking 1.3%. Then came 9/11.
Alan Greenspan was already cutting interest rates when terrorists attacked. He kept cutting rates until the Fed Funds rate was at an all-time low of 1% on June 25, 2003.
Economic growth in 2002 was anemic. Yes, there was a nice 3.5% jump in the first quarter — which fell to 2.1%, then 2%…
At the end of 2002, the economy had stalled again; growth was just 0.1%.
Nonfarm payrolls didn’t stay positive until mid-2003, about the time Greenspan stopped cutting rates. But stocks didn’t care about GDP growth or unemployment.
In fact, in 2002-2003, weak unemployment or GDP data was often greeted as good news by investors because it meant the liquidity would keep pouring in.
The S&P 500 bottomed in July 2002. And Greenspan’s liquidity kept them rallying until that liquidity took physical form in housing prices and mortgage securities.
This may not be a revelation, but we are seeing the exact same cycle play out today. And knowing how it played out during the previous Fed will help you protect and grow your money.
The Investment Lie
Now I’m gonna get existential on you…
Stock prices are based on a lie.
It’s a lie that stockbrokers, fund managers, market strategists, and economists (even Bernanke) all repeat: “Earnings drive stock prices,” they say over and over.
This lie is one of omission.
Sure, maybe earnings drive stock prices. But it’s the cost of money that drives earnings. And the cost of money starts with the Fed and the Treasury.
It’s a simple formula: The Fed lowers the cost of money when it wants to pump liquidity into the economy. It becomes easy for companies to make money, and their stock prices go up.
What’s more, there is a point where the profit/liquidity cycle become self-perpetuating.
Alan Greenspan started raising interest rates on June 30, 2004, and kept up with his quarter-point hikes until December 11, 2007.
Money from the Fed got more expensive in 2004 — but it didn’t matter because there were other ways to get cheap money, like in mortgage lending and securitization. Housing prices more than doubled between 2000 and 2007.
If I had to guess (and really, pinpointing where we are in the liquidity/profit cycle is guesswork), I’d say we’re in roughly the late-2003 stage of recovery. GDP and jobs growth are tepid at best, and the Fed is still providing liquidity.
Now the conversation has started to turn to how the Fed will shut off that liquidity. And that’s put some uncertainty into the market.
But please make no mistake about this: The stock market doesn’t crash when the Fed starts reeling in quantitative easing.
It won’t crash when the Fed starts hiking rates, either.
I know this may sound like heresy, but there will come a time when the U.S. economy can provide both the consumer demand and the cheap money to make it appear healthy. Ironically, that‘s when you’ll want to be on your guard.
The Inevitable Boom/Bust Cycle
In 2004, George Soros said: “Stock market bubbles don’t grow out of thin air. They have a solid basis in reality…”
This may be the best investment/economic quote there has ever been.
The dot-com bubble was based in reality that technology and the Internet would change our lives. That happened.
The gains in home price between 2000 and 2007 were very real… The problem was that money got poorly invested as people’s imaginations ran away with them.
The thing to be aware of is that there’s a limit to how much money can come from the private sector during the boom. And once the losses start — from bankruptcies or loan defaults — the boom part of the cycle quickly becomes a bust.
Right now the Fed is pumping $85 billion into the economy every month (and really it’s more than that, because the Fed is also reinvesting dividends from bonds it holds). This money is essentially unlimited. And the Fed is not operating on a profit/loss basis.
What to Own Now
Unemployment is probably the most obvious area for upside right now.
Companies will start hiring at some point. And that means consumer discretionary stocks have upside. From clothes to cars to vacations, we can expect the American consumer to spend more as unemployment improves.
We are also seeing signs that the European economies are turning around. Still, it seems likely that you wouldn’t have to rush into European stocks immediately. It could take some time before the confidence returns to support a strong rally for European shares.
Many investors are swearing off oil and natural gas stocks these days. And that’s because the shale boom here in the United States has created a supply dynamic that was unthinkable even just two years ago. Even the EIA has pegged U.S. oil demand growth at just 1%.
The problem is the EIA can’t take in any new information when it makes its forecasts, so it can’t allow for any upside to U.S. economic growth. But the oil market is clearly showing that there is upside for oil prices. That’s why oil prices have remained above $90.
Even better, you can own oil assets that pay as much as 15% in completely tax-free income a year. That’s a pretty good deal.
Not only that, but the tax-free payments rise as oil prices rise!
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Owning income investments is the perfect strategy as we await a more robust economy. You can be positioned for the upside when it comes, and you get paid to wait — as much as 15% a year.
Until next time,
Until next time,
Briton Ryle
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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He is also the managing editor of the Wealth Daily e-letter. To learn more about Briton, click here.
