Now that we've described both the major players and the most significant issues on Wall Street, let's consider the main event: the glorious bull market in the United States, during which stocks and bonds soared, fortunes were made, and people still managed to suffer.
Two conclusions can be drawn from this review. First, the similar trading patterns of stocks and bonds highlight the interrelationship between the two markets. Second, the ability of the stock market to confound the general consensus during these seventeen years argues against trading the market. Through the years, the best values were created by pessimism and the worst by optimism. If you were a participant in this bull market, this (long) walk down memory lane might also remind you of how easy it was to follow the crowd, however wrong that path now seems...
Beginning in mid-1982, shareholders have enjoyed a market climb of almost 11,000 points on the Dow Jones Industrial Average. And yet, many probably have mixed emotions about the ride. Unless you bought in August 1982 and took a seventeen-year vacation, you were continually under pressure to make the wrong decisions. Even when rising, the market tended to do whatever it took to make the maximum number of people miserable.
By August 1982, stockholders were beaten, battered, and bruised. The double-digit inflation of 1979-1980 had been met by tight monetary policy from Paul Volcker's Federal Reserve beginning in late 1979, the Fed had targeted money supply growth rather than interest rates. As a consequence, three-month T-bills soared to an unprecedented peak of 16.3 percent in 1981. At the same time, inflation paranoia drove the long-term Treasury Bond rate to an all-time high of 15.4 percent.
This rise in interest rates to double-digit levels was the catalyst for the worst recession since WWII, with its consequent impact on corporate profits. Meanwhile, Mexico put itself at the brink of defaulting on its foreign debt, threatening an unraveling of the debt structure worldwide. Pessimism was at its highest level since 1974. The Dow Jones Industrial Average slid to 777, within 50 points of the level it had first reached in 1961, more than twenty years earlier.
The result of this seemingly hopeless mess was the bull market of which we are all now so envious. The Fed, in response to the recession and the debt crisis, eased aggressively. Short-term rates fell an extraordinary three percentage points in as many months, while long-term rates continued to decline from their 1981 peak. The stock market bottomed on August 12, 1982 and rose 35 percent by the end of the year.
By mid-1983, the Dow was over 1200, and the economy was eight months into recovery. Enthusiasm for stocks was particularly strong in the smaller names, which had been outperformers since 1974. IPO's were prevalent, trying to satisfy what seemed an insatiable demand for these small capitalization stocks.
The aftermath for investors, especially individual investors, was grim. Interest rates had begun to rise as the economy strengthened; in the first five months of 1984, T-bond yields rose over two percentage points. The Dow slipped 20 percent from its mid-1983 level, while the previous year's new issues were decimated. The boom of hot deals had gone bust, as the results of these newly public companies disappointed their owners and the illiquidity of their shares left no easy way out.
By mid-1984, the gloom that pervaded Wall Street was reminiscent of a Russian film festival. The concerns of too weak an economy two years earlier had been replaced by those of excessive growth. Real economic growth in the first half of 1984 was an incredible 7.4 percent, which, in combination with a tightening monetary policy, had pushed long government rates near 14 percent.
The economy began to slow under the weight of unprecedented real interest rates: T-bond yields were ten percentage points above the inflation rate. As a result, rates began to fall in June, beginning another leg in the bond bull market. Stocks had an explosive one-week rally at the end of July and traded erratically higher with the bond market.
In the third quarter of 1985, the bond and stock markets had a brief correction. Two favorite names of the time, Hospital Corp. and Burroughs, were hit hard after announcing disappointing earnings. Surprisingly, pessimism among investment newsletters reached the highest level since 1982, even though the Dow was 500 points higher by then.
Both markets resumed their rallies in September. Bonds turned sharply downward in early January 1986, but recovered to new highs due to the collapse in oil prices. The Saudis, angered by the lack of production discipline from its OPEC partners, engineered a price war. Spot prices fell from over $25 a barrel to under $10 by mid-1986. In April, stocks turned down sharply, even while bonds continued their blow-off on the upside. This move by the stock market, in advance of the bond market, was uncharacteristic. The bond market spiked on the upside soon afterward and then began to decline.
The market stepped onto a roller coaster for the next six months, rising through June, plummeting in July, climbing again in August, and then collapsing in September. Although the market had simply returned to its level of March, its participants were unsettled, and worse. Particularly hurt were a legion of trend followers, who wait for the market to assert its "direction" before buying or selling. Each time a trend had seemed established, and they had climbed aboard, the market had turned sharply, whipsawing their positions. By late September 1986, pessimism had replaced the optimism of spring. The loss of the Senate by the Republican Party and the Boesky scandal in November didn't help the mood.
The wall of worry had been rebuilt, and stocks climbed it far into January 1987, rising 400 points in two months. A violent one-hour, one-hundred point sell-off on January 23 raised another fear, that of volatility. The market kept climbing through the spring and summer but, for the first time in many years, without the bond market's lead. The existent and expected strength of the economy drove stocks on the hope for vastly improved corporate profits. Meanwhile, interest rates continued to rise. The significant overvaluation of stocks relative to bonds did not prevent the market from moving higher.
The success of the stock market in the face of the bond market's decline became almost a self-reinforcing mechanism stocks rose because people wanted to buy them because they had been rising. Optimism peaked in February, but momentum continued until March, and prices continued upward until August. Even the tightening of monetary policy engineered by the new Fed chairman, Alan Greenspan, did not create an attitude of fear. At least, not immediately.
Investors had now become conditioned to view sell-offs as buying opportunities, given the precedents of 1982, 1984, 1985, 1986, and early 1987. But when stocks declined in early October 1987, it was not a buying opportunity. The magnitude of the sell-off that followed, fueled by portfolio insurance and program trading, was unlike anything investors had ever seen or, hopefully, will ever see again. The stock market lost $1 trillion in value in a matter of weeks, including a 23% decline on October 19.
After the Crash, investors dazed by the collapse in prices and aware of the eerie similarities with 1929 waited for the next shoe to drop. In fact, the next disaster almost occurred the next day; as James Stewart profiled in The Wall Street Journal, the financial markets came dangerously close to shutting down on the morning of October 20, staging a remarkable comeback that afternoon. Instead of disaster, the bull market in stocks resumed. Meanwhile, bonds resumed their rise, as well, triggered by the greatest overnight advance in history on the evening of October 19.
As the memory of the Crash faded a bit, brokerage firms increasingly sought to encourage the return of retail investors, which had become the investment equivalent of black holes: we know they're out there; we just can't find any. The Wall Street Journal highlighted one interesting approach to lure back the individual investor: the euphemizing of the Crash. The word itself, with its ugly connotations of panic and poverty, has frequently been replaced in brokerage reports by less threatening terms, such as "correction" or "sell-off." Laszlo Birinyi had the final word on this out-of-sight, out-of-mind strategy, describing it as "Wall Street's version of 'I'm sorry, Mrs. Lincoln, but how did you like the play?"'
In the three years following the correction/sell-off of October 1987, the Dow Jones Industrial Average rose over 70%. By mid-1990, the Dow was at 3000, as fears lessened about the economy in general and the stock market in particular. The latter half of 1990, however, produced two events guaranteed to impact the market: recession and war.
In the face of a declining domestic economy and concerns about the increasing likelihood of war with Iraq, the Dow fell twenty percent in three months. The stock market bottomed out in November 1990 as the troop build-up reached its peak, amid fears of another protracted conflict in another foreign land (Iran and Iraq had fought each other for years over the same territory).
From the first night of Desert Storm, however, the world realized that fighting a war of technology in the desert was very different from a war of attrition in the jungle. The extraordinary success of the allied forces was the catalyst for the next leg up in the bull market, which has continued in fits and starts to the present day.
Within the general rise of the market, various groups at various times have fallen into and out of favor. The steady-growth brand-name companies were the darlings of the market in 1991 many of them spent the next several years with flat stock prices, however, even as their earnings continued to rise. The healthcare group suffered a significant sell-off from late 1991 until early 1994 as a national healthcare agenda was promoted by the Administration; since them, the group has risen sharply. The collapse of the Russian economy in 1997, and the deep recessions which followed in Asia and Latin America precipitated a financial crisis in the U.S. in 1998 as hedge funds, most notably Long-Term Capital Management, quickly lost tens of billions in the currency markets. Their strategy of betting on normal relationships in the financial markets was ill prepared for an abnormal but very real world. This strategy was reminiscent however of the earthquake-insurance scheme suggested in Doc Hollywood: collect the premiums and, if an earthquake does occur, declare bankruptcy. More to the point, Long-Term Capital's short-term bets exacerbated the problem as it was forced to sell its positions into an unwelcoming market, not unlike the difficulties created in the 1987 crash by portfolio insurance and program trading.
The combination of international economic downturns, domestic financial crisis and rich valuations sent the stock market into a funk (a securities-industry term) in the summer and fall of 1998. Technology stocks in particular were hit hard, even more severely than in the first half of 1996,
then rebounded to new all-time highs by the first quarter of this year. The new-found optimism for tech stocks, led by Internet plays, was rewarded however by a severe sell-off into late 2000.
In looking back over this eighteen-year bull market, the best opportunities were created when the pessimism when the pressure to sell was the greatest; the worst situations, in turn, were marked by optimism at the intersection of Wall Street and Main Street. For those investors who lived
through the ups and downs (and ups) of this extraordinary period in the stock market, a good memory is a great recommendation for the WealthEffect Strategy.