YOUGHAL, IRELAND – Our screen last Friday was showing the 10-year U.S. Treasury Note with a yield of 3.11% – further evidence that the credit cycle has turned.
Everything else is noise.
We got the idea from the late, great Richard Russell. He was already an old-timer when we met him; he had been almost fanatically studying markets since the 1940s.
For decades, his investment letter, Dow Theory Letters, came to the faithful like the appearance of the Virgin in a remote convent. Richard showed how the markets move in big, long arcs… sweeping up over decades… and then down again over many years.
In between, of course, are booms, busts, crashes, Amazon, technological breakthroughs, bitcoin, panics… and more noise.
You never know from day to day what is going on… or what will happen next. But if you’re on the right side of the major move – what Russell called the “primary trend” – you’ll do just fine.
Of course, you can never be sure you’re on the right side of the primary trend, either. All you can do is watch the numbers and play the long game.
In the late ’40s, for example, stocks were low and bonds were high; it was time to take the other side of the trade.
The war was over. Troops took off their uniforms and went home. They got married. They looked for jobs. Economists feared a resumption of the Great Depression.
Without the orders coming in for tanks and planes, what would factories make? Without the stimulus of wartime spending, how would these men find work?
Interest rates dropped. Savings were plentiful… credit was abundant… and the bull market in bonds, which had begun in 1929, was nearing its end. Rates bottomed out in 1949.
Then, a new primary trend began.
Guns and Butter
It was a boom which lifted interest rates up out of the post-war trough, through the fabulous ’50s… the go-go ’60s… and even the so-so ’70s.
First, yields were pulled higher by demand for loans. Businesses retooled, staffed up, and expanded to meet demand from young families.
They needed houses, automobiles, washing machines, and TVs. And consumer credit took a big leap, too, as layaway plans, household finance, and credit cards became popular.
Alas, the feds were also blundering into finance. “Guns and butter” was what they promised.
Wars overseas… giveaways at home. Both cost money – more than the feds could raise through honest taxation. So they entered the credit market like a shark into a municipal pool.
In the 1960s, most of America’s credit needs were met honestly – with savings. So when the feds borrowed heavily, they were competing with families and businesses for savings. This extra demand forced up interest rates.
Then, when the feds spent the money – on the big boondoggles of the era, the Vietnam War, and the Great Society – they put this money into consumers’ hands, where it was soon bidding for products and services.
Prices rose, too.
Whip Inflation Now
The combination of rising prices and interest rates produced the stagflation of the late ’70s. The economy couldn’t grow because of the high interest rates. Households couldn’t get ahead because of rising prices.
This was the era of foolish “Whip Inflation Now” buttons, implying that the consumer was somehow responsible for the inflation he suffered.
The real culprit was, of course, the government. And it made matters worse and worse… until the election of Ronald Reagan. The Gipper backed Paul Volcker as chairman of the Fed.
Volcker realized that the only way to put the economy back on its feet was to squeeze out inflation expectations. This he did by boosting the Fed’s key rate.
For perspective, recall that the Fed Funds rate is currently 1.75% – after more than a year of modest rate hikes.
Volcker didn’t pussyfoot around. Fed funds had averaged about 11% in 1979. He raised the rate to 18.9% in December 1980.
That pushed the 10-year yield to 12% immediately… and to nearly 16% a year later. And that was the high for the cycle. The next move was down… to 1.4%, recorded in July 2016.
That appears to be the end of that trend after 36 years. Most likely, the primary trend in bonds for the rest of our lives will be rising real rates.
End of the Trend
What does this mean for stocks?
Long patterns apply. They are related, but not coincident.
The low on the Dow came in June 1931 at 42.
The stock market, however, looks ahead. By the late ’40s – when bonds were still headed to a bottom – it already saw a boom coming.
The Dow was edging up to 200 by 1949. The primary trend was up, and it just kept going up until 1966. That was a good run – a 35-year bull market.
But inflation, and then stagflation, hit the stock market in the late ’60s… and ’70s… Nominal prices went nowhere.
You had to adjust for inflation to see the damage. But it was severe – a bear market loss of 70% between 1966 and 1980, in real terms.
Then, Paul Volcker drained inflation from consumer prices while the Fed – with its greasy, post-1971 money – added inflation to asset prices. The Consumer Price Index meekly retreated. But stock prices roared.
Thus began the greatest bull market of all time.
From under 1,000 in 1980, the Dow rose to over 26,000 in January 2018 – a run of more than 25,000 Dow points over 38 years.
That’s what a primary trend can do for you.
Too bad… it looks like it is over.
(Full disclosure to new readers: This isn’t the first time we’ve thought so.)
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Category: Central Banks