Flashback To The Late 1970s

“Because of structural and attitudinal changes that have taken place in recent years, or are presently occurring, the world economy is being [affected] by powerful deflationary forces.

These forces can only be obviated by a major restructuring of the international payment and credit mechanisms. However, because of political and technical obstacles, such a restructuring may be delayed until an international crisis threatens to erupt, thus forcing governments into immediate action.

Meanwhile, efforts to prevent the world economy from succumbing to these deflationary forces are building up an inflationary time bomb, through a massive increase in total world liquidity. The restructuring of the international credit markets, when it comes, will release this inflationary time bomb. But, because a large slack will have developed in the world economy by then, there could be an interim period of apparent non-inflationary prosperity.”

I wrote these words in… October 1977, in a prologue to a paper entitled “Between Inflation and Deflation: The Dislocating World Economy”.

Why did I recently feel the need to dig up that old report? Because I have felt for some time that we may have entered a period that will, in many ways, feel like the second half of the 1970s.

Periods of transition between more easily characterized and delineated phases of expansion/recession, prosperity/poverty, optimism/anxiety, war/peace, have been the object of relatively little inquiry. The second half of the 1970s was such a period of transition and, I believe, so will be the next several years.

Back then, we had had the great speculation of the late 1960s and early 1970s, accompanied by all kinds of new financial instruments and techniques -- futures, options, hedge funds, money market funds. These had changed the way financial markets worked and, at times, how the economy responded to traditional policy measures. The outcome of the bubble was the devastating 1973-74 bear market, after which the number of hedge fund managers shrank drastically, while the number of market-savvy cab drivers increased proportionally.

From the bottom of that bear market, in December 1974, there was a sharp, eighteen-month rally, which almost brought the Dow Jones Industrial average to its previous highs. Thereafter, the market fluctuated aimlessly (though sometimes widely) until the early 1980s.

During 1973-74 bear market the S&P 500’s price/earnings ratio (P/E) dropped from over 20 to less than 8. The drop in valuation was even more dramatic for many of the “nifty-fifty” pet shares of institutional investors, whose P/E ratios had routinely hovered between 30 and 50 times earnings in 1972.

After rebounding nearly 80 percent (to about 13) in the first leg of recovery, in 1975 and early 1976, P/E ratios resumed a long slide, to reach below 7 in 1980-1982. Not surprisingly, the earlier increase in stock valuations was triggered by an aggressive easing of monetary policy, and it promptly ended when inflationary pressures caused the Federal Reserve to tighten again.

Note that underlying inflation was extremely high in the 1970s, contrary to the present environment where fears of actual price deflation still dominate. Prices had begun to creep up very early in the decade, as a result of the “guns and butter” policies of the Johnson administration and the abandonment of the dollar convertibility into gold by the Nixon administration. In fact, it can be argued that the first oil shock, in 1973, was merely one of the consequences of these policies.

Nevertheless, by 1977, price inflation was decelerating in earnest, and many forecasters were predicting further declines. This was not to be the case, as the money easing of the early decade was about to boost prices again.

Another parallel is that the 1970s disintegration of the Bretton Woods monetary system of fixed exchange rates had ushered a long period of dollar weakness, which was accompanied by major shifts in international trade and capital flows – as well as inflationary trends.

Throughout the 1970s, the behavior of U.S. corporate profits was generally satisfactory, despite the unsettled economic environment. After a fairly good recovery from the deep 1975 recession, growth rates in Gross Domestic Product started to weaken as early as 1978 – even before the second oil shock triggered by the fall of the Shah of Iran in 1979. But profits rose strongly, except for a sharp dip in 1980.

Thus, throughout the second half of the 1970s, there was a tug-of-war between rising earnings and declining P/E ratios, resulting in very little net gain in stock prices.

There are many differences between then and now, in particular the level of interest rates, which was high then (hence the low P/E ratios) and is extremely low now. Thus, in an environment of steadily-rising interest rates (which we expect in coming years as a result of re-accelerating inflation), the P/E hurdle for stock prices will be even tougher to overcome and the onus on corporate profits to boost stock prices even heavier.

After the current, initial rally has run its course (which, if history is a guide, will take a few more months, though with temporary interruptions), I would expect the following several years to be characterized by fairly wide fluctuations of stock prices around a flat trend.

The good news, if my memory serves me correctly, is that such periods of transition are not inhospitable to value investors – especially contrarian ones.

François Sicart

June 30, 2003
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