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Boom-Bust Mentality: Lessons From the Past

October 07, 1994|TOM PETRUNO

Maybe you can't be too rich or too thin, but the economy can be--too rich, at least, for the stock and bond markets' tastes.

With each piece of economic data over the past month, it has become apparent that U.S. business activity isn't slowing appreciably. In fact, it isn't slowing at all in many sectors of industry, even though the Federal Reserve Board has raised interest rates five times this year.

On Thursday, in another bit of good news for working people--and mostly bad news for stock and bond owners--the latest four-week data on the number of Americans applying for unemployment benefits fell to a five-year low.

That sets the stage for today's report on September employment, which, if also bullish for the economy, will be just the opposite for Wall Street. Interest rates could jump again and stocks could resume their latest selloff.

Ironically, for anyone hunting for work or thinking of starting a business this year, the financial markets have become a great reverse-indicator: The worse they look, the better the economy, in general, must be.

Consider for example that while the bank prime lending rate has jumped from 6% to 7.75% since February, major loans outstanding at commercial banks have risen by nearly $100 billion, to $2.03 trillion--hardly a sign that business borrowers find the higher rates a deterrent.

For the auto industry, sales of cars and trucks are robust and growing more so, if September trends are an indication. "It's just wall-to-wall strong," a senior General Motors executive boasted this week.

Except for GM investors, that is. Their stock price fell to a new 1994 low of $44 on Thursday and is now down 33% from its record high of $65.375 last winter.

GM's business is up but its stock is down. Why? The simple answer is that many investors have become increasingly unable to enjoy the economy's good times, because they are already looking ahead to the bad times they expect will follow. And as the good times get better, investors assume that the bad times will be that much worse. In other words, that boom will lead to bust.

The danger for markets now is that the boom-bust mind-set will become the dominant mind-set. Greg Smith, investment strategist at Prudential Securities in New York and one of the stock market's premier "big thinkers," is warning clients to prepare for what he dubs "the new world economic order." The underlying assumption of the new order, he says, is that "the world economy is building up quite a head of steam" as capitalism's spread begets consumerist societies on every continent.

Thus, says Smith, even if the Fed continues to slowly raise interest rates to hold down U.S. economic growth, rising demand for American goods and services in the rest of the world provides an offset. The U.S. economy, therefore, may continue to expand at a higher rate than the Fed thinks is prudent. So interest rates keep rising, while business nonetheless keeps getting better.

Obviously, such an environment would be bad for bonds. Stock prices, meanwhile, could continue to be tugged between the positive force of higher earnings and the negative force of rising interest rates, as they have been all year, with little net progress.

The big risk for stocks today is that as the economy rolls on and interest rates keep pushing higher, more investors will begin to treat most stocks the way they have come to treat the auto stocks: totally looking past the current boom to the inevitable bust somewhere in the future.

Wall Street analysts who are bullish on the downtrodden auto stocks contend that any bust is far off; they say the auto companies' earnings will be higher in 1995 and higher still in 1996 and that the stocks therefore deserve better.

That argument was also heard in 1984, when, like today, the Fed was raising interest rates and investors began to focus on prospects for an economic bust rather than bet on sustained growth.

The optimists turned out to be right in 1984. Higher rates did not precipitate recession. The economy grew in 1985, 1986 and 1987, and the auto stocks soared as their sales and earnings rose.

But before investors got over their fears in 1984, they did some severe damage in the stock market. Fretting about interest rates and an imagined economic bust, the market slashed Ford Motor's stock price by 30% between 1983 and '84, and at its '84 low it sold for a mere 2.1 times that year's earnings per share.

So far this year, Ford is off 22% from its peak price and sells for 6.4 times estimated 1994 earnings. Maybe it's already cheap enough. But the 1984 lesson was that, once a boom-bust mentality takes control of investors, things can get very bad for stocks before they get better again.

The Big 3, Then and Now

As in 1984, the Big Three auto stocks have tumbled this year even though sales have been booming. But while some analysts argue that the stocks are dirt-cheap, their price-to-earnings ratios remain far above the trough levels of 1984.

GM Ford Chrysler Stock price decline, '83-84 -24% -30% -41% Stock price decline, '94 -33% -22% -30% P-E at stock bottom, '84 4.3 2.1 1.8 P-E today on '94 est. EPS 6.8 6.4 4.8

Source: Value Line Investment Survey data

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