In October 1968, with the United States fighting wars against poverty at home and perceived communist threats abroad, the S&P 500 Index climbed on the back of an overheated economy to record highs in both real and nominal terms. The boom times were not to last. Adjusted for inflation, stocks would not return to their late 1968 levels until mid-1992 (chart data). In nominal terms, full recovery took about seven years from a January 1973 peak.

I offer this cautionary tale by way of explaining why recent decades have differed so dramatically for equity market investors from those generally unprofitable years a generation or two ago. Unlike current conditions, what characterized the period beginning in the late 1960’s were cost of living increases that compelled President Richard Nixon to impose wage and price controls and the Federal Reserve to raise interest rates to levels that today would seem unfathomable.

At the vanguard of the Fed’s anti-inflation effort was the late Paul Volcker, the central bank’s chairman from 1979-1987. Volcker allowed benchmark rates to reach nearly 20%, but his tough love approach to price stability is widely credited with subduing inflationary expectations and thus sowing the seeds for the long economic expansions and bull markets to follow.

So, while recessions are the most obvious and direct causes of severe market declines, it’s rising inflation that triggers economic downturns by motivating the Fed to take away the monetary punchbowl. Of course, recessions cause corporate profits to fall as well, but earnings are only half the story. The other half concerns the impact of rates on valuations.

Historically, the equity market’s price-earnings ratio has moved inversely to bond yields as money flowed out of stocks and into higher-yielding assets. Viewed another way, the equity market’s earnings yield – its P/E ratio expressed as a percent – closely tracked the yield on Treasury bonds. (A P/E ratio of 20 equals an earning yield of 5%, or 1.00/20=0.05)

Which brings our story to the outlook for stocks in the months ahead.

Among the enduring mysteries of what’s become the longest expansion on record is the breakdown in the relationship between unemployment and inflation, also known as the Phillips Curve. In the past, tight labor markets have fueled fast-rising wages and benefits, which in turn fed through to consumer prices and finally to higher interest rates. This time, not so much. Despite the lowest jobless rate since the boom days of the late 1960’s, inflation has consistently undershot the Fed’s 2% target, as measured by the central bank’s preferred metric, the Core Personal Consumption Expenditures Price Index. That’s allowed rates to stay low by historical standards, thus extending the bull market in stocks.

Some economists believe the recent failure of the Phillips Curve to explain inflation can be attributed to a changed definition of full employment while others think a myriad of complex global factors are at work.


What matters most for investors, however, is that inflation expectations remain anchored and that core inflation stays at or below the Fed’s 2% target. Until that changes, we aren’t likely to find the Fed’s fingerprints on whatever weapon eventually brings about the demise of the longest bull market in U.S. history.

Bonus websites of interest…