Tabell’s Market Letter – May 22, 1981

1——- TABELL'S MARKET LETTER 909 STATE ROAD, PRINCETON, NEW JERSEY 08540 DIVISION OF MEMBER NEW YOAI STOCK EXCHANGE, INC MEMBER AMERICAN STOCK EXCHANGE May 22, 1981 We seized-,the oPP!'rtunitY'in'this'space-last'week to'commnt on the recent .linkage which exists, at- – andleast in the mind of many analysts, between the stock market 'shortterm interest -rates in- those' remarks, we tried to suggest that this relationship was, first of all, a rather recent one, and secondly, a good deal less simple than the conventional wisdom would have us believe. When one stands back and looks at the long-term relationship between interest-rate levels and the stock market, the whole ques- tion becomes fraught with paradox. The current conventional wisdom is, for example, that rising interest rates are bearish for the stock market and falling interest rates are bullish. This has been an accepted bit of folk wisdom over the entire 27 years of our own career as a stock market observer. What is interesting is that the accepted rationale as to why this should be so has varied widely over the past three decades. Basically what has happened is that analysts over the years seem to have accepted the gospel of rising interest rates bearish — falling interest rates bullish as a matter of faith, and then drawn whatever documentation from the most recently available economic history that seemed necessary to justify that belief. For the benefit of youn-ger readers and those without an historical bent, let us recapitulate the situation of about 30 years ago. At that point, the approximate interest rate for long-term, high-grade corporate bonds was about 3 percent, and yields on such instruments as T-bills were often as low as H percent. By contrast, quality stocks provided yields in the 7-9 percent range. The accepted doctrine of the time viewed this relationship as entirely appropriate, citing the variability of common-stock dividends and the certainty of return provided by high-grade senior securities. The late Dr. Benjamin Graham, the accepted savant of the period, developed something called the central value theory, a theory which suggested that average earnings on the Dow over the prior ten years should be capitalized at twice the available rate On high-grade bonds, thus arriving at a normal or central value for stocks. Indeed, when one stood at the vantage point of the mid-50's and lOOked back as far as the mid-20's, ' tYiis particUl,, theory nandily -expl8ineoagaoCl-deaI'of-Ule-variationof–StocpriceS7'The-only-prob- , ,.- lem, of course, is that it hasn't explained them since. Following the middle fifties, as the stock market consistently rose and stocks became more and more over-valued under the theory, Dr. Graham, in successive editions of his book, revised the formula a couple of times. Unfortunately, however, there arrived the point when even revision made it totally useless, and it quietly died a natural death. Were the theory to be applied today, the normal value of the Dow would be calculated at approximately 600, and, while there remain those in the fever swamps who believe such an outcome will eventually transpire, their opinion is not widely heeded. Today we hear very little about the variability of common stock dividends. It is presumed, indeed, that they will follow a gradually rising course, most probably because, over recent years, that is precisely what they have been doing. We are instead informed that rising bond prices are necessary for a rising stock market because current high interest rates provide a sufficiently high totru return to compete with common stocks for investment funds. In order for such competition to cease, we are told, interest rates must come down. Now one would have thought that bonds, having yielded more than stocks for over a decade, had been doing a pretty good job of competing with equities as far as return is concerned. However, we are assured, in an inflationary era such as the present, the real rate of return on bonds is quite different from the nominal one. This is an argument that we ourselves have repeatedly put forth for at least a half-dozen years, and it remains irrefutably true. Its truth, however, has led to the currently vogueish construct of a real interest rate. Money rates, we are told, consist of two components', a real rate and an inflation premium, the real rate being around 3 percent, and the rest compriSing a built-in recompense for expected inflation. This theory explains the past 25 years just about as well as the central value theory explained the 25 years prior to 1955. As Steven Leuthold, in his excellent book, The Myths of Inflation and Investing, has pointed out, it explains almost no other period in economic history . What all this tends to suggest, of course, is that the basic credo of the market technician remains a sound one. That credo states, quite simply, that the prices of financial instruments, both bonds and stocks, are determined by supply and demand. Supply and demand are, in turn, created by the actions of individuals in the market place. Individuals, in turn, have, throughout history, accepted the conventional wisdom of their day, including the real interest rate, the central value theory or –if one goes back far enough — the efficacy of leeches in the cure of disease. This is' not meant to argue that interest rates Or that the valuation of stocks relative to those interest rates should not be considered in their proper context by the investor. It is simply to suggest that investors' ,attitude,S (and technical analysis remains the only tool we possess for diagnosing those attitudes) remain an equally valid consideration. Dow-Jones Industrials (12 00 PM) S & P Composite (12 00 PM) Cumulative Index (5/21/81) AWTsla 974.24 131. 40 1141. 79 ANTHONY W. 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