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The Fed May Not Be Done

The Fed finally let the cat out of the bag--no rate hike combined with a “doveish” statement adding up to the ever so elusive, widely anticipated “pause.” Of course, you too noted the shouts of glee on Wall Street as stocks rallied for about 15 minutes today only to reverse course and end the day down 49.23 points, with the S&P down 4.29 and the NASDAQ down 11.61. Pretty disappointing action to be sure in the wake of what should have been one of the bigger positives for the bulls -- the perceived end of Fed tightening. Of course, with inflation still building as a by-product of several years worth of high energy prices, it really may not be the end of the tightening cycle at all. Instead, what the stock market truly fears could be a scenario of more entrenched inflation forcing a continuation within a few months of still more rate hikes.

Humbly submitted for your consideration, the idea of the day may be the old Marty Zweig cliché of “Don’t Fight the Fed” and the Fed may not be done for this cycle. Back in the day, circa 1970’s when inflation was prone to fits and starts, rising inflationary trends meant Fed tightening and bear market conditions for equities. It was never pretty, and in fact, in 1970, 1974 and 1982 people got more excited about a game of solitaire than they did about investing in the stock market. Bear markets back then were relentless -- down day after down day -- 1/4 point by 1/4 of a point -- like watching paint dry -- you ended up just watching share values melt away. While they were not always exciting, and were not always volatile, bear markets are normally relentless and can destroy wealth at an amazing clip leaving many to give up in disgust and just exit the market for good – that happened in the 1970’s and right now, we could be setting up a relay of that difficult decade.

Source: Don R. Hays, Haysmarketfocus.com, 1/11/02

Years ago, I came across this chart showing the “Cycle of Market Emotions” which I always keep on my office wall. It is my reminder to pay attention, especially when things are quiet, as very often those are the times when truly big moves are setting up. For the bear market, fear can lead to desperation, to panic and capitulation, and ultimately despondency and depression. Coulda, woulda, shoulda sold ? and why didn’t I sell ?? are the questions investors always end up asking when they’ve ridden on the downside escalator too long.

To be sure, there is always a point to sell any stock or any sector. The answer is always in the charts, in broken trendlines, broken moving averages and broken support levels. However, too often we tell ourselves, 'Well, this stock is special, or this group is special because of this X- factor (fill in your own reason).' Example, Oil Stocks can’t possibly go down with the stock market because Oil is at $80 per barrel and they are making loads of money. Or Food Stocks and Utility stocks can go down with the stock market because they are defensive. I mean, as bad as a recession can get, we still have to pay our utility bills and eat, don’t we? So are there special exemptions to the grip of the bear; are there places you can hide and make money? Or is there no hiding from the old $800 pound grizzly when he lumbers into town? To answer these questions, let's take a walk down memory lane and review what has happened in the past to “defensive stocks.”

The 1970’s Bear Markets Including the Great Bear Market of 1973-1974

As we look back at prior bear market environments, a good place to begin would be some of the bear markets seen in the 1970’s when inflation became a problem and stagflation was born. In looking at the next group of charts, we see that in the first bear market of the 1970’s, the bear market of 1969 to 1970, certain big name defensive groups like Energy and Gold did not hold up all that well during the market's major slide.

Above: S&P 500 top clip, with Basket of Energy Stocks lower clip.

Below: Gold Stocks (Homestake Mining) and the S&P 500

One major reason that both of these defensive sectors declined sharply was the Federal Reserve, which between mid-1969 and mid-1970 pressed the 3 Month T-Bill Rate up from 6% all the way to 8%. The very aggressive period of Fed tightening shown in the box below directly correlated to the Bear Market in stocks and dragged down virtually all stock sectors. In defense of the Gold Stocks, at the time the London Gold pool had not been broken and Gold was still being artificially suppressed, so that global problems which should have benefited the gold market were not allowed to flow thru into a higher gold price. As we all know, that situation proved temporary with gold prices exploding beyond anyone’s control in the early 1970’s and into the early 1980’s.

Next came the Grand-daddy Bear Market of 1973-1974 where political and financial upheaval resulted in the wake of the First Arab Oil Embargo. Again, short term interest rates exploded to the upside from an early 1972 low of 3.06% to an August 1974 peak of  9.90%. Again, the market plunged with the S&P 500 losing almost 50%, a devastating decline embodying the bulk of a 20 month period.

However, with Gold trading freely and the end of the London Gold pool, a cartel that artificially tried to suppress the gold price, Gold Stocks performed in admirable fashion with the Mining Index exploding throughout the balance of the 1973-1974 time frame. As we see in the chart of Homestake Mining, from a January 2nd, 1973 low of $1.91, HM advanced to a high on August 19th, 1974 of $11.60, a gain of 507.32% in less than two years!! Only when the stock market began to find its footing and President Nixon resigned did the air of despair lift with the stock market recovering and the gold stocks selling off. Even then, the give-back on behalf of the gold stocks was quite limited and within the context of a normal correction (see ellipse).

Above: The Gold Stocks in 1973-1974 with Homestake Mining up over 500%.

Other groups were not so lucky and really varied in their results. Aside from Gold and Precious Metals, it is worth noting that Energy Stocks did manage to hold up well about half way into the entire bear market.

Without any doubt, Energy was a champ thru all of 1973 and the first quarter of 1974, but as the market broke down out of long consolidation into its death spiral, Energy was dragged down with prices ultimately tumbling to multi-decade lows despite what were still record high prices at the pump. For Energy stocks, there appears to be a point where they begin to anticipate recessions -- a slowing economy -- and the damage it will do to final demand. Nevertheless, as you will see along with Gold Stocks, Energy Stocks have had a definite defensive quality holding up pretty well into most bear markets. That is not true of other sectors often thought of as “defensive.” Back in the mid-1970s, a money manager might have argued that Household Product companies like AH Robins, Richardson Vicks, Procter and Gamble, Clorox, Gillette, Colgate Palmolive, Alberto Culver, Bausch and Lomb were “defensive.” As can be seen in the chart below, some of these names were Nifty 50  favorites and actually ended up crashing worse than the overall market.

Overall, it was not a pretty picture for Consumer Staples as even the Food Stocks ultimately collapsed during the second half of 1974. The difference in performance between Household Products and Food Stocks appears to have been the fact that Household Products went into the bear market in an over-extended position (where they had been darlings) while food stocks never enjoyed much of a bull run. As a result, the foods held up during the first half of the bear market and then gave up the ghost in the purge of 1974.

What about Utility stocks, you say? Well, Utilities were a bona fide disaster in the 1970’s as higher interest rates adversely affected their huge bond portfolios causing the stocks to collapse, led lower by New York's Con Ed which filed bankruptcy in 1974. Today, Utilities are not cheap, and have been a favorite “hiding place” in recent years leaving many issues extremely extended. Despite these negatives, it could be argued, in fairness, that it is also true these companies are far less rate sensitive now than they were in the 1970’s. In addition, courtesy of de-regulation, today’s utilities are in a far more flexible position to pass along higher raw material input costs. With these changes, it is possible that the performance on Utility shares could be improved in an inflation driven bear market today, relative to what was seen in the 1970’s, but to be sure, it is not at all clear just how well this group will fare.

The 1980-1982 Bear Market

This Bear Market was not as deep as the 1973-1974 bear, or even the 1977 bear, but is worth noting because the Fed induced this bear market with a bout of ultra tight monetary policy. Chairman Paul Volcker essentially jammed short term interest rates thru the roof in early 1980, creating ultra high “real” inflation adjusted rates. After years of lagging behind the Inflation curve, the Fed finally moved out in front with a death grip on inflation. The price was a plunge into the deepest recession seen since the 1930’s and a bear market that dragged down virtually every stock market sector. When the Fed takes policy to ultra high levels in terms of Real Rates, nothing does well. At present, we are a long way from this type of condition with Real Rates still relatively low by any historical standard. Nevertheless, note that back in 1980-1982, Energy Stocks, Gold Stocks, Food Stocks and Staples, all performed poorly in a declining market.

 
Above: S&P 500 (top clip) and 
Below: Homestake Mining versus the S&P. These results were very negative as the Fed got tough on rates.

The 1987 Stock Market Crash

Crashes are also highly problematic. Most often in a crash everything will collapse in sync and there is little escape. Yet, in the last great crash -- 1987 -- we did notice that the Utility stocks “hands down” performed the best, in most cases quickly recovering their losses within just a few days. This was particularly true of quality utility names like Southern Company, Duke Power and Con Ed. Other sectors that tried to resist the decline were the Household Product companies like Procter and Gamble or Colgate, but the resilience was passing and when confidence was restored, money flowed out of these names so quickly that they ended up retesting their panic lows.

For the Gold Stocks, both the 1929 and 1987 Crashes produced staggering losses. In the case of 1929, the losses proved to be very temporary as the depression commenced and moved the purchasing power of gold to new all time highs. As a result, during the Great Depression and in its immediate wake period of 1934-1937, the Gold Stocks were the most defensive group, racking up huge gains and paying huge dividends to shareholders. In the 1987 instance, physical Gold managed to hold up very well on the day of the crash, gaining $18 dollars an ounce, and continued to make upward progress for two to three months after the crash. The result was a sharp recovery rally in the Gold stocks immediately after the crash, but as gold weakened amid growing fears of a recession, the gold stocks rolled over and resumed the decline.

In 1987 the United States, while indebted on a fiscal basis, was still the world's largest creditor with a positive surplus of trade. In today’s environment, the potential for a recession to lead to a debtor revolt in the currency markets is at unprecedented levels, implying that the fundamentals for Gold and Gold Stocks could assure that things turn out differently if a panic were seen today. Of course, one can never be too sure as Gold Stocks are by nature, a high beta asset class. But the key in assessing their performance probably resides in the underlying nature of the problem inducing the crash. If the problem is a currency market decline centered about the Dollar, odds are very high that gold will find traction and with it, increasing chances that gold stocks will be defiant in a panic.

The Gulf War – 1990 Bear Market

Back in the summer of 1990, the First Gulf War with Iraq and Saddam Hussein drove Oil prices to the then unprecedented levels of $44 per barrel. Gold also surged past $400, which combined with high Oil prices breathed life into the Gold and Energy Stocks. Were they a defensive safe-haven for the broader equity market decline which ensued? The answer was a most definite YES as Energy stocks held up well until almost the entire stock market decline was complete. Falling only once the crisis was over and energy prices began to recede. In this instance, Gold followed Oil and also rolled-over post the American military victory in Iraq, causing the Gold Stocks to decline. But again, throughout the actual crisis both of these groups did provide a high measure of both protection and appreciation potential. In addition to Gold and Energy, the food stocks and some of the consumer staples companies held up reasonably well in the 1990 outcome, although in these instances, we were looking at groups that did not go down as much as the broader market, but nevertheless still trended lower. Utility stocks did not prove to be a great safe haven in 1990 and generally were a lagging performer even well into the recovery of 1991.

 
Above: Oil Stocks versus the S&P in 1990 (holding up very well during the First Gulf War), and then
Below: Gold Stocks followed Oil & also held up very well until the war was over when both gold & oil rolled over.

The 2000-2002 Bear Market

During the course of the 2000 to 2002 bear market, once again there were few safe havens. For their part, the Utility stocks performed miserably with the DJ Utility Index tumbling from a high of 420 in 2000 to a low of 161 in 2002, a whopping decline of 61.66% almost, but not quite as bad as the NASDAQ. Among other sectors, the Household Product-Consumer Staples group actually did fairly well, appreciating throughout the bear market until its very final stages when a bout of heavy liquidation forced these stocks down in July 2002, giving back all of the gains. That said, they still managed to hold their own and did not generate huge losses. There is one additional point worth noting, namely, that going into the 2000 bear market, the group had already been in its own private bear market and thus, was starting the negative trend in a very depressed state.

In addition to the Household Product – Staples companies, the Energy Stocks also proved to be quite defensive thru most of the 2000-2002 bear market with the Energy Indices only giving up the ghost at the very end of the stock market bear – similar to what was seen in the Household product stocks.

Above: Energy Stocks versus the S&P 500 in 2000 thru 2002.
Below: Gold Stocks versus the S&P 500 over the same period of time.

Finally, the Gold Stocks did rise to the occasion in 2000-2002 – by far turning in the best performance of all stock market sectors with the HUI gaining nearly 238% during the balance of the stock market bear.

Conclusions

History strongly suggests that while Energy stocks, Utility stocks and Consumer Household Product “Staple” Stocks can be defensive at various times there are a few concepts that stand out. They are:

1. During the course of most bear markets, the end stages of a bear where there is panic, liquidation can take these groups down very harshly causing them to give back a good deal of the defensive gains they may have accrued during the broader equity bear market. In essence, if a bear market continues for too long a period of time, as in the 1973 to 1974 and 2000-2002 bear markets, these stocks have a tendency to give up the ghost and succumb to the selling pressures in the final stages of the bear.

2. If one of these groups is deeply depressed going into a bear market and has for several months or years been out of sync with the broad market (underperforming) there is a good chance it will shine in a down market and live up to its defensive potential.

3. Ultra-tight Fed policy and very high real rates makes it almost impossible for any of these groups to perform well, so at some point, the switch from defensive names to cash is necessary if the Fed appears intent on strangling the economy.

4. None of these groups really holds up well in a crash, with the possible exception of Utility stocks, which in years prior had big dividends. Today, the new equivalent might be the Energy Trusts which frequently sport ultra-high dividend yields as many utilities now only pay mediocre returns.

5. Gold Stocks tend to have the strongest non-correlation to the market but will only hold up and perform well if the price of gold itself is gaining momentum and showing tenacity in the face of whatever economic event is driving the bear market. If Gold rolls over, the Gold Stocks can very quickly turn into a high risk proposition and can very quickly give back accumulated gains.

Finally, it is worth nothing that IF a group does manage to hold up well during a bear market, chances are that if the bear market ends, money will rotate away from that group making it important again to exit in timely fashion and not give back prior gains. A good example of this can be found in the Gold stocks post the 1973-1974 bear market. When the S&P finally hit bottom and began to rally in early 1975, the gold stocks began to retrace their prior bull market gains and gave back a reasonable portion of the preceding advance.

The reminder here is that there are no “up only” escalators, and one must always be alert and nimble to spot trend changes as early as possible. For now, today’s muted response to “good news” from the Fed should have investors wondering where this market is headed next and asking, “how well positioned is your portfolio to handle the potential risks?” Chances are a good weighting in Energy and Gold would be a great place to start.

Frank Barbera

Copyright © 2006 All rights reserved. Frank Barbera, C.M.T. Investment Analyst, Manager Commentary Archive

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