Volatility and Stock Market Prospects 5/14/1997

We live in a world of revolutionary change, upheaval, and mystery. It is a world rich in excitement and opportunity but haunted by anxiety and fear of the unknown. No where is this more apparent than in the equity market. Stock price movements, both individually and in the broad market, have swung wildly this year as opinions shifted from euphoria to gloom, and back. Never has the stock market’s tendency to shoot first and ask questions later been so pronounced. Volatility has become the defining characteristic of the current stock market environment.

What are the causes of this volatility, and will it persist? Despite the ominous warnings of market gurus, is it in fact a bad thing?

The short answer is that the current level of the stock market is such that the daily ups and downs, while eye-catching, represent only small percentage changes. This however addresses only the perception that the stock market is very volatile, not the reality. Factually, volatility is at a very high level historically. After rising sharply in January the stock market declined equally sharply through March. By April 11th the Standard & Poor 500 Stock Average, a popular broad measure of equity prices, had registered a decline of almost 10% while the over-the-counter market declined 17%. The decline in numerous individual stocks, especially some thinly traded over-the-counter stocks, was extraordinary. The recovery has been just as rapid. Already in 1997 there are a record number of days in which the stock market has gained or lost more than 100 points, and the year is not yet five months old. Indeed, over 60% of the trading sessions this year have seen a 1% or more move in the Standard & Poor 500 Average.

There are no easy answers. With the stock market return in excess of 60% over the past two years and the Federal Reserve Board signaling loudly its concern over inflation, a desire to protect gains is clearly a factor influencing stock prices. As virtually every investor remembers, the application of monetary policy in recent years has inclined to a rapid and prolonged series of rate increases. In the twelve months ending February 1995 the Fed increased interest rates a total of 7 times. What is often overlooked in this sequence however is that the Federal Reserve Board overshot its target, nearly bringing the economy to a recession. It was reducing interest rates again by mid 1995. The fear of a repetition of this sequence is influential in the current condition of the market, although attempts at market timing have not been beneficial.

To some degree also the capriciousness of the market is the result of the collapse of the traditional economic patterns of behavior in this cycle. Virtually everyone in business today is well versed in business cycle economics. Traditionalists know that as business conditions expand to stretch available resources, inflation rises and interest rates follow. As the rise in interest rates becomes steep enough to choke off the expansion inflation and economic growth recede, often leading down the slippery slope to a recession. But it is not working out quite this way. In spite of several quarters of strong growth inflation is at the lowest level in many years even as the jobless rate has dropped to 4.9%. While the financial markets are torn by indecisiveness, there is no evidence of inflation pressures in the pipeline. Moreover, the rise in interest rates this year has been quite muted in the face of very strong economic growth. Clearly, anticipating the classical business cycle behavior has not been rewarding so far.

There may be other, more esoteric reasons to explain the high levels of volatility. Many of them, such as the increased use of electronic trading are distractions without permanent substance, in our view. At such times one is best advised to ignore the high-tension electricity of the headlines and focus with fixed attention on the underlying investment fundamentals. These fundamentals are favorable for the financial markets and new elements have actually strengthened the attraction, despite current tremors. A willingness to take a long-term view is essential in view of the extreme swings in market levels.

The healthiest development has been corporate profits at the end of the first quarter. There is no irrational exuberance in the excellent level of corporate profitability. Not only are profits good and increasing, corporate cash flows are very strong and the quality of reported earnings is superior. The employment cost index, a broad measure of wage pressures, was far more favorable than anybody expected in the first quarter. This suggests that contrary to expectations of traditional economists, wage inflation is not in the current picture. And if wage inflation does not increase it is very difficult to see how inflation is going to climb. There is some evidence also that the extremely rapid economic growth rate of the first quarter is receding on its own.

To the extent that the heightened volatility of the stock market this year is a proxy for investor’s fear and uncertainty about inflation and interest rates, we believe it will ebb slowly as time goes on. As we pointed out in the Economic and Market Outlook at the end of the first quarter, inflation has never been this low at such an advanced stage of the business cycle. Economic developments since then have been even more favorable for a continuation of low inflationary growth at high employment levels. The Federal Reserve may raise interest rates again, either at the next or subsequent meeting of the board. We will leave it to wiser minds to judge if such actions are prudent for the country’s overall economic health. We believe that the economy is sound and that the prospects for financial assets remain uniquely positive.

THE INVESTMENT POLICY COMMITTEE
Alfred A. Lagan, CFA, Chief Investment Officer
May 14, 1997