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This chapter is from the book

This chapter is from the book

Inflation/Interest-Rate Bear Markets

The inflation/interest-rate bear market can be the most damaging to investors and the economy in general. The 1973–1974 bear market was especially devastating. (See the table in Chapter 1, "Bear Markets.") Economists believe that inflation is the most dangerous threat to our economy. The Fed's Chairman Alan Greenspan agrees. His best tool to fight inflation is interest rate adjustments. During the recent bull market, he raised interest rates six times in an attempt to cool off the white-hot economy. These interest rates, along with other factors, finally took hold in 2000 and the economy began to slow. Unfortunately, it looked like it was slowing too fast and headed for a recession. In an effort to prevent the recession or at least soften its blow, the Fed lowered interest rates in early 2000.

The falling stock market reacted predictably to the interest-rate hikes and slammed on the brakes. Higher interest rates mean money for expansion and growth is more expensive. Increased borrowing costs cut into future earnings. Investors began to worry about the double whammy of a bear market and a recession. The super hot Internet and technology stocks began to crumble in the spring of 2000. With a bear market and recession looming in the near future, investors dumped the former darlings of Wall Street for more secure issues.

As I noted earlier, one of the reasons the economy and the stock market don't always move in concert is they are influenced by the same factors, but from different perspectives.

CAUTION

Investors once assumed that there would always be "secure" issues to buy in times of turmoil. Don't assume past safe havens will remain so in the future.

Looking Backward

The Fed must adjust interest rates based on information from the recent past, knowing that its actions may take some time to be effective. The stock market looks at information from the present and attempts to guess what impact it will have on future earnings and stock prices.

The stock market is so concerned about the future that it won't wait for official information. Investors anticipate the information before its release and act on it. The Fed normally meets on a quarterly basis and decides what to do about interest rates. The stock market makes an educated guess and moves before the meeting.

TIP

Analysts pore over every clue they can find to guess what the Fed will do to interest rates. Fed officials must be extremely cautious in public statements to not send unintended messages.

Normally, the market guesses right; but the Fed can surprise the market. When this happens, the market may react strongly. The Fed doesn't have to wait until its meeting to act. It can act whenever it feels the need. The stock market always greets these surprises with fevered activity.

What Does This Mean To You?

Investors are always looking to the future. You invest today in hopes of a gain in the future. You view the economy through this lens. Rising interest rates will almost certainly affect future earnings. Likewise, inflation will affect future earnings for most investments. Either rising interest rates or inflation can cause a bear market. The cure for inflation is raising interest rates. Either way, investors are stuck. In Chapter 4 we will look at indicators that you can watch for signs of rising interest rates and inflation along with other important indicators.

What you're looking for is a balance between a reasonable rate of inflation, economic growth, and interest rates. One could argue that such a balance facilitated the bull market and economic expansion of the 1990s. During this time, inflation averaged around 3 percent and interest rates, especially toward the end, were relatively low. The economy was growing at a rate that suggested inflation was a real possibility.

CAUTION

A booming economy may not be great for the stock market. Rapid growth is a known cause of inflation, and the Fed watches growth numbers very carefully.

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