From the December 2006 issue of Wealth Manager Web • Subscribe!

History Lessons

Low inflation and strong economic growth fuel equity bull markets. But the process also works in reverse, and so the seeds are sown for bear markets when conditions turn hostile on the economic and inflation fronts. That's hardly the best-kept secret in finance, but it's a history lesson worth revisiting with equities recently climbing a wall of inflation and recession worries.

Chapter one of such a review could be a new study from the Federal Reserve Bank of St. Louis, which reminds us that above-average economic growth and below-average inflation have accompanied market booms in the 20th century. But the booms have often ended when the favorable conditions reversed.

"Most booms were procyclical--arising during business cycle recoveries and expansions, and ending when rising inflation and tighter monetary policy were followed by declining economic activity," asserts the working paper co-authored by Michael Bordo, an economics professor at Rutgers University, and David Wheelock, an economist at the St. Louis Fed. (A copy is available at

According to their study--"When Do Stock Market Booms Occur? The Macroeconomic and Policy Environments of 20th Century Booms"--the numbers tell the story. Embedded in the chronicling of the ebb and flow of equity prices and economic cycles is a potent reminder that timing can be crucial. For example, the authors find that booms tended to develop when inflation was below its long-run average and falling. As the graph on page 78--courtesy of the paper--shows, the median inflation rate for the countries studied was roughly one percentage point below its long-run average during the four-to-seven-year period ahead of market peaks. As market tops drew closer, inflation dropped further. In the two years before the peaks, inflation dipped to a median of about two percentage points below its long-term average.

Booms have an annoying habit of eventually turning to busts. Once again, the accompanying variables share a recurring aura--notably, higher inflation. That tends to bring out the hawkish side of central bankers, the paper observes, a bias that's no small factor in the death of bull markets. "Rising inflation tended to bring tighter monetary conditions, reflected in higher real interest rates, declining term spreads, and reduced money stock growth," the authors write. It's no accident, that equity markets don't usually flourish under such conditions.

That lineup of threatening factors doesn't exactly reflect recent history, but it's close, and perhaps too close for comfort. Indeed, inflation has been an on-again, off-again threat in recent years, and the Fed has only recently stopped raising interest rates, which has flattened the yield curve and raised the specter of recession in the minds of analysts. Meanwhile, not everyone is convinced that pricing pressures have been quashed.

The past does not repeat itself, Twain counseled, but it rhymes. With that in mind, we recently talked with David Wheelock about booms, busts, history and the outlook for seeing a fresh round of rhymes in the future.

What can you tell us about the nature of bull markets over the past century?

We tried to document the experience of the United States and several other countries in the 20th century regarding the environment in which stock market booms have occurred. Booms in the paper are loosely defined as extended periods of very rapid increases in inflation-adjusted stock prices.

Maybe our findings aren't terribly surprising, but we find a pretty close relationship between rapid economic growth and stock market performance. But that relationship seemed to be looser, or less robust, than the relationship we found between inflation and growth in real [inflation-adjusted] stock prices. That is, we learned that most stock market booms of the 20th century in the U.S. and other countries occurred when inflation was low or stable, and perhaps declining; booms tended to end when inflation picked up.

There are several possible explanations for that. We focus on monetary policy--that's kind of our bag, although there are other explanations. For our paper, it comes down to the old saying, "Don't fight the Fed," which seems to hold a lot of water. We see evidence that when monetary authorities tightened credit, it really did have an effect on stock markets. The tighter central banks squeeze, the more likely a boom's going to end up as some kind of a crash.

Did any of the paper's findings surprise you?

I expected to see a stronger relationship between stock prices and real economic activity, especially productivity growth. That was the big argument during the 1990s stock market boom--the so-called New Economy story. And it does hold up for the U.S. During the 90s, we did have an acceleration of productivity growth, which we might associate with higher long-run growth of profits and dividends and so forth. But you don't see that relationship hold up in a lot of other countries.

In general, the stock market booms of the last couple of decades in other countries weren't clearly associated with pickups in productivity growth. Maybe that's because the U.S. dominates [the world economy]. We have globalization of finance and so forth, and so maybe domestic economic conditions in some smaller countries are less important than what's going on in the global economy.

Could part of the answer also be that U.S. financial markets are more efficient compared with other countries, and so the connection between economic trends and equity prices is tighter?

Maybe so, but I'm not as knowledgeable about the inner workings of the stock markets outside the U.S. There have been, of course, moves all around the world toward electronic trading and derivative securities and so forth, which does tend to push markets in a more modern direction. And the U.S. is a deeper market and has always led the way in terms of efficiency and so forth.

What does history say about the causes of inflation?

We think that inflation is primarily caused by monetary policy, which creates excessive growth of liquidity or the money supply. We think [inflation] is largely in the hands of the Fed. We do have shocks, such as the oil shocks of the 70s, which can have a temporarily destabilizing effect on the price level. But monetary policy is what causes inflation to get going and to stay going, and so monetary policy's really the only thing that can reverse inflation once it gets out of hand.

Then you believe that slower economic growth doesn't lessen inflation--a line of reasoning that has received some lip service in recent months?

In the 1970s, there was a period of stagflation: We had poor economic performance in inflation-adjusted terms and high inflation. Particularly in the late 1970s, the Fed tried to goose up the economy with higher money growth, but didn't respond sufficiently to inflation. The consequence was a pretty high rate of inflation by the late 1970s.

How would you describe the economic background that accompanied the market booms of the 1980s and 1990s?

The 1990s boom in the U.S., at least, and in a lot of other countries, arose in an environment when we achieved price stability in macroeconomic terms. There was very low inflation, an environment that was conducive to good economic growth, and good returns in the market. But a feature of the 1990s' experience that perhaps we haven't seen since before World War II was the globalization of finance, meaning a period of high international market integration and globalization of financial markets. But the earlier international market integration was muted as a result of the Great Depression and the Second World War. We've seen international markets open up in the last 20, 30 years, which has probably changed the character of stock market booms all around the world.

How so?

[Globalization] probably reduced the association of stock market performance with economic conditions within the domestic country. In the past, domestic conditions in smaller countries would more directly reflect circumstances at home, but now those countries are also influenced by conditions around the world.

Has the influence of inflation and monetary policy in stock market booms and busts remained steady over time?

It seems so. Their influence appears to have held pretty tight across different monetary regimes in the interwar period. We were on the gold standard in the 1920s, and then later on there was Bretton Woods [the dollar-based monetary system from 1946 to 1971] and capital controls and so forth. But you see a general correlation between inflation and monetary policy and the stock market over time. The relationship does seem to have held up robustly across different eras.

Is there any reason to think that the relationship might change?

I wouldn't think so. A lesson here is that an environment in which central banks are able to maintain low inflation and keep it under wraps is one that's conducive for good economic growth and for the market.

I will say, however, that the historical data on real economic activity isn't as good as it is with inflation. Perhaps that's because the estimates on economic activity historically aren't as easy [to calculate compared with inflation and monetary data].

Another complication is that the market is forward looking. It's not necessarily the case that booms will be associated with the current level of economic activity, but rather with expectations. There was a major stock market boom in 1928 and 1929, even though the 20s had good but not exceptionally strong growth. Still, there were arguments [at the time] that the U.S. could expect strong real activity, good growth of corporate profits, etc. [Bull markets are an] expectations-driven phenomenon. Unfortunately, we don't have very good measures of expectations [for the distant past], so we have to rely on the current economic activity.

Thanks to the rise of derivatives, globalization and other factors, central banks don't seem to have as much control over the economy as they used to. Does that mean that the future relationship between monetary policy and the stock market might change?

It's hard to speculate. History does seem to repeat itself on and on again, however. We think of finance as very high tech, and of course it is. But there have always been developments in creative ways of producing information and getting it to the markets. I'm not one to really believe that relationships fundamentally change with new eras.

Globalization is drawing markets closer, and so they're less solely dependent on their domestic monetary policy and economic activity and the world economy. So that's one area going forward where the relationships won't be as strong.

Correlations among stock markets rose in the 1990s, which parallels the rise of globalization. It's also true that the former age of globalization faded, and so the same might happen again. If so, would that imply that correlations among stock markets would fall?

Yes, that's quite possible. Eras of financial integration seem to end with a major shock. In the 1930s, it was the Great Depression and the disintegration of the international gold standard and the imposition of capital and exchange controls by individual countries in an attempt to wall off their financial and monetary systems from what was going on in the world. That was followed by the Bretton Woods system, and then the oil shocks in the 1970s, which ended another period of integration and created more chaos. So there are periods of increasing integration, and then something that happens to cause a disintegration.

What does history tell us about previous periods when correlations among stock markets declined?

It's very impressionistic, but we found that in the 1950s and 1960s, when markets were less integrated, the timing of stock market booms across countries was more varied. That is, the booms were less coincident with one another. By contrast, in periods of high market integration, booms are occurring all over the place. Periods of low integration were more about what was going on in your domestic economy.

What basic lesson does your paper impart?

We're looking at it from the perspective of monetary policy makers rather than stock market participants. So, from a policy maker's perspective, the key lesson is to keep inflation under control and not let it rear up; it's better to nip it in the bud before it gets going. There's also going to be a relationship between macroeconomic policy and financial regimes or regulatory policy, in terms of capital controls and so forth. You can't really look at regulatory policy in isolation of macroeconomic policy.

James Picerno ( is senior writer at Wealth Manager.

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