If you were an investor in the 1970s, you'd probably rather think about the pop culture of the decade than revisit the financial landscape of the times. There was a lot going on, stylewise. You had Kiss and disco, bell-bottoms, long hair and handlebar mustaches. Then, in the late 1970s, you had something completely different, with the arrival of the Sex Pistols and the Clash with their spiked hair, chains and Doc Martens.
That's all fun stuff. But for most things political and economic, it was a bummer decade — and that's putting it kindly. There was Watergate; a building up of Cold War animosity, culminating with the USSR's invasion of Afghanistan and America's boycott of the 1980 Olympics; and then there was the spectacle of Americans being held hostage in Iran.
The 1970s markets tested the staunchest of buy-and-hold investors after the Nifty 50 flamed out, and inflation destroyed the purchasing power of most fixed-income portfolios. (Remember the acronym WIN? That was President Ford's economic plan: whip inflation now.) Some academics were even pushed to rethink Modern Portfolio Theory. It was a time of oil embargoes, stagflation, immovable indexes, plunging commissions and consolidation on Wall Street.
Fortunately, bell-bottoms are not coming back (well, we hope not), but inflation and rising energy costs sure are. In fact, today's political and economic environment is eerily similar to the 1970s — and 1976 in particular. If we are right — or merely more right than wrong — the next decade will be one of the most challenging for advisors and investors alike. But by learning the lessons of the 1970s, there are plenty of ways to successfully position client portfolios for long-term success.
Oil Was Gold
The 1970s was a volatile time to own stocks: We count four rallies and five bear markets. The most severe bear, of course, was the 1973 through 1974 meltdown, which trimmed the Dow Jones Industrial Average (DJIA) by around 45 percent. It took over 70 months to recover. Interest rates left the decade at 10.5 percent on their way to a 21 percent prime. Gold peaked at $688 per ounce and oil prices rose more than fivefold, to $28 per barrel from $5.60 early in the decade. Foreign equity markets, including Japan's, outpaced U.S. markets; the dollar was anemic.
When the decade limped to its close, the S&P had delivered a 1.6 percent average annual return. But that overstated the health of most stocks because of the index's high weightings in energy holdings (higher than the current S&P). Also, that return lagged far behind average cash returns. The DJIA ended the decade near where it started. But again, America's purchasing power was cut substantially during the decade, with the Consumer Price Index (CPI) up over 100 percent during the period and the dollar down 35 percent against the yen.
1976, the year this magazine was launched, should be particularly interesting to investors in 2006 for a number of reasons. For one, the Dow peaked at 1,014 and quickly thereafter took out its 200-day moving average, bringing the bull market to an end. Driving that decline was an unexpected rise in the CPI, peaking industrial production and the end of the easy money policy.
In 2006, we've had similar events: The DJIA broke through its 50- and 200-day moving averages in May and later fell below 11,000 — both key technical and psychological benchmarks. Plus, Headline and Core CPI began rising, and the economy slowed as the Fed put on the brakes. One difference between now and then is that rates in 1976 had been falling prior to the unexpected spike in CPI that triggered the long run of rate hikes. But the resulting impact on markets may likely be the same today. Valuations, along with the stock market, plummeted over the next two years, from 1976 to 1978, with the Dow dropped nearly 37 percent. Valuation multiples dropped 27 percent, as the impact of higher rates and inflation took its toll on earnings. Once again, investors learned the painful lesson that cheap stocks can keep getting cheaper.
Bonds got hammered, too. From 1976 to 1980, the 10-year Treasury declined in value as interest rates rose to 10.7 percent from about 6.8 percent. Investors saw the principal on a $10,000 bone drop by over 17 percent.
What to Do Now
Today's market — with rising interest rates, significant volatility, few sectors providing positive performance and solid global economic expansion — bears striking resemblance to the 1970s. So, what are an advisors and investors to do? Here are a few ways to weather a possible 1970's environment.
Strategic Allocation Decisions
Equities: Underweight equities until the Fed and the CPI signal that inflation is under control. Three key developments to watch for: the Fed stops tightening or suggests lowering rates; CPI stabilizes and begins to drop; and earnings stay strong, suggesting that companies are profitably passing on higher prices. For our equity allocation, we would tend toward equal weighting of the S&P index, MSCI EAFE (the major non-U.S. global equity index) and value-oriented equities. Going equal weight allows you to capture the benefit of energy, materials, utilities and real estate. With a weak dollar, the foreign allocation provided by EAFE is a help. In addition, value stocks are less susceptible to P/E contractions and the impact of rising inflation.
Fixed Income: The risk of inflation and the possibility of rising rates around the globe (Japan is raising for the first time in six years) pose great risks to fixed-income portfolios. Stay short on the yield curve (one-and-a-half years or less) until the Fed stops tightening for more than a quarter and CPI increases slow or decline or S&P earnings flatten or decline from peak levels. We favor cash, short-term U.S. Treasuries, short-duration municipal bonds, bank loan funds, short-dated mortgage funds and similar fixed-income vehicles that are repriced frequently in the event that rates continue to rise. TIPS, or similar inflation-adjusted securities, may also offer good value but currently are expensive and are less appropriate for taxable accounts.
Absolute-Return, Long/Short Equity and Market-Neutral Strategies: Today, retail clients have access to these hedge-like strategies, which were not widely available to them 30 years ago. Many portfolios are managed on a global basis and seek to offer consistent returns, together with lower volatility and correlation to the traditional equity and fixed-income benchmarks. New offerings are now being introduced in mutual fund formats to provide easier and more effective access for advisors and their non-accredited retail clients.
Commodities/Hard Assets: This asset class should be a core part of portfolio allocations based on its diversification and noncorrelation benefits. If we're indeed in a 1970s environment — one that, like the 1970s, is enjoying a volatile bull market in commodities as inflation rises — then an overweight allocation is in order. The current environment (i.e, the global economy is growing, there is a need for commodities-based alternative energy sources and there is an increase in demand by asset allocators for commodities) adds fuel on top of an inflation thesis for this recommendation.
For those advisors who practice a tactical or satellite approach to strategic asset allocation, like those who actively trade, you might find a good quant to follow. With so much money managed on a macro or quantitative basis, understanding sea changes at the asset class or sector level can help pinpoint good entry points for new sector allocations or help set levels at which to systematically take profits. There are a number of good Web sites or newsletters that can help in this regard. Our favorites include The Leuthold Group's monthly research, Perception for the Professional (also known as the Green Book); Stan Weinstein's The Professional Tape Reader and Global Trend Alert, a weekly newsletter; the Web site, Decision Point (decisionpoint.com); and Stephanie Pomboy's MacroMavens.com (macromavens.com).
What to Do When Things Begin to Turn:
Fixed-Income Allocation: When the Fed stops raising rates, advisors will want to take advantage of extending maturities to three to five years. Do so after the 10-year Treasuries or Lehman Bond trade above their 50-day and 200-day moving averages. While you won't catch the bottom, it should help mitigate risk.
Equities/Sectors: If the global economy starts to slow and energy prices start to fall below $60 and $50 per barrel, consider cutting back on energy and cyclicals and migrating to more defensive sectors. If there is continued economic strength evidenced through continued GDP growth and rising earnings, we would buy technology and financials stocks (globally) and add exposure to emerging markets. Due to continued global demand, large-cap bellwether equities should perform well; companies like Dell, IBM, Microsoft and Citigroup are examples of global market leaders who are currently trading at historically inexpensive prices.
Hard Assets/Commodities: Reduce overweight exposure to hard assets and commodities if: the global economy slows and industrial companies earnings decline; there is evidence of a U.S. recession; housing prices fall more than 10 percent; or the banking system is stressed. If interest rates continue to rise and rise faster than inflation, a reduction of hard assets may also be wise.
Markets, of course, are unpredictable — no matter how well you research the past. But if the next 10 years are anything like the 1970s — a decade that ranks as the second worst in U.S. history after the Great Depression — you may be glad that you put on your figurative bell-bottoms.
The Score Board
Year-by-year performance of major indexes, commodities, inflation and nominal GDP.
| S&P | Dow | EAFE | Japan | CRB | Gold | Oil | JPY Currency | CPI | PPI | Nominal GDP | |
|---|---|---|---|---|---|---|---|---|---|---|---|
| 1970-1980 | 17.25% | 4.80% | 75.72% | 148.95% | 170.93% | 307.09% | 176.74% | (35.42%) | 104.00% | 11.31% | 119.40% |
| Avg. Ann. % Change | 1.60% | 0.47% | 5.80% | 9.55% | 10.48% | 31.43% | 24.82% | (4.36%) | 7.58% | 7.87% | 9.95% |
| Year | S&P | Dow | EAFE | Japan | CRB | Gold | Oil | JPY Currency | CPI | PPI | Nominal GDP |
|---|---|---|---|---|---|---|---|---|---|---|---|
| 1976 | 18.51% | 17.75% | 0.67% | 17.63% | 7.46% | (1.21%) | 0.69% | (3.96%) | 4.93% | 3.77% | 11.45% |
| 1977 | (11.76%) | (18.54%) | 13.93% | (7.05%) | (1.38%) | 22.06% | 7.42% | (19.67%) | 6.00% | 6.24% | 11.23% |
| 1978 | 2.33% | (1.73%) | 26.86% | 19.91% | 13.53% | 37.75% | 0.98% | (19.67%) | 8.55% | 8.14% | 12.95% |
| 1979 | 12.50% | 4.99% | 2.38% | 6.40% | 22.00% | 94.11% | 70.20% | 21.95% | 13.14% | 13.37% | 11.78% |
| 1980 | 24.67% | 15.16% | 19.00% | 8.44% | 10.69% | 18.65% | 21.81% | (15.91%) | 11.74% | 11.12% | 8.83% |
Sources: Geronimo Financial Asset Management with data from Bloomberg L.P. Index returns do not include reinvested dividends
| 1970-1980 | 1976-1980 | ||
|---|---|---|---|
| S&P 500 Index Average Annual Return | 1.6% | 4.59% | |
| Max Drawdown | (46.18%) | (19.00%) | |
| Months to Recover | 70 | 18 | |
| Average Annual Change in Value of US $ | (4.36%) | (5.80%) | |
| Number of Bull Markets | 4 | 2 | |
| Number of Bear Markets | 5 | 2 | |
| 10-Year Treasury Interest Rates | |||
| Range | 5.5% - 10.72% | 6.8% - 10.72% | |
| Average | 7.50% | 8.20% | |
| The Economy | |||
| CRB % Change | 170.93% | 52.30% | |
| CPI % Change | 104.00% | 38.00% | |
| Nominal GDP % Change | 100.58% | 56.23% | |
| Nominal GDP Avg. Annual % Change | 10.10% | 11.90% | |
| Gold % Change | 307.09% | 171.31% | |
| Low Price/Troy Ounce | $34.94 (Jan'70) | $102.80 (Aug'76) | |
| High Price/Troy Ounce | $681.50 (Jan'80) | $681.50 (Aug'76) | |
| Oil % Change | 176.74% | 101.10% | |
| Low Price Per Barrel | $5.60 (Oct'73) | $13.37 (Jan'76) | |
| High Price Per Barrel | $28.71 (Dec'79) | $28.71 (Dec'79) | |
| Sources: Geronimo Financial Asset Management with data from Bloomberg L.P. Index returns are stated as changes in price without reinvested dividends. | |||