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Got a yellow power tie? Why Wall Street is fondly recalling 1986

·Michael Santoli
Got a yellow power tie? Why Wall Street is fondly recalling 1986

Maybe it’s fitting that Hollywood is prepping a “Top Gun” sequel, because Wall Street is busy replaying plot points from the year that movie appeared.

Even if not too many people now on Wall Street saw the Tom Cruise flyboy flick in its first run through theaters, plenty of investment pros are speaking fondly of the 1986 market and its rough, mostly reassuring, resemblance to today.

By 1986, the U.S. was a half-decade into a bull market that had followed a devastating recession. The Standard & Poor’s 500 was up 160% from its 1982 low – not too far short of the 200% rise it has enjoyed in the current one, since 2009.

As the stock market barreled ahead and a corporate debt boom underwrote a buyout binge, several significant economic shifts took place that will seem familiar to investors today:

- From late 1985 into the first half of 1986, crude-oil prices plunged by more than half, from the high-$20s to $12 per barrel, as Saudi Arabia and close allies flooded the market with supply in a gambit to gain market share against upstart producers.

Since the middle of 2014, of course, crude crashed by more than half from above $100 to the mid-$40s, as the Saudis gunned supply in a bid to preserve market share versus North American and Russian producers.

- Aggregate corporate earnings in the U.S. are on track to decline this year, yet there is little leading evidence of a recession on the horizon.

Morgan Stanley strategist Adam Parker this week noted that there have been only three periods in the past 40 years when total corporate net income fell outside of a recession – one of them was in 1986.

- Short-term interest rates were at a nine-year low in August 1986 when the Federal Reserve began raising them to help brake the economy and restrain financial-market speculation. While growth did slow, consumer spending continued to rise briskly.

Today, the market’s best guess is that the Fed will end its seven-year stay at zero short-term rates by boosting the federal funds rate for the first time in nine years, in recognition of a sturdier economy and healthier consumer activity.

The appeal of the 1986 experience for Wall Street handicappers seems to be its example as a year when several possibly scary or ominous patterns emerged -- oil crash, profit drop, Fed tightening -- but the economic expansion and stock bull market ultimately powered through them.

The S&P 500 gained nearly 15% in 1986, and then sped skyward by another 38% through August of ’87 despite further Fed tightening as the financial markets entered full overheating mode before topping in August 1987 ahead of the October crash.

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Scott Minerd, chief investment officer of Guggenheim Partners, raised the 1986 example last week in suggesting that oil could drop further and would mainly be a help to the economy and markets. Back then, “Low oil prices were beneficial even in the face of the Fed raising interest rates,” he says. Now, as then, Minerd says, “The consumer is the dominant story.”

While he suggests the bulk of the oil decline is done, the technical condition of the market and still-rising oil inventories suggest lows might not come until the mid-$30s – possibly in the $20s if a “painful capitulation” is needed.

The impact of oil prices

The U.S. economy today is less reliant on the energy industry than it was in 1986. The industry accounted last year for 6% of private fixed capital investment, compared to 9% in ’86.

The veteran financial advisor who's become known in this column as the Mystery Broker has been telling clients since January that an oil crash “is a negative for 10% of the economy but positive for the remaining 90%.” Each time oil has dropped at least 50%, stocks have recorded double-digit percentage gains in the ensuing 12 months, though not without some nasty volatility as the crude market attempted to stabilize.

Some economists are suggesting that the Fed’s own economic models are telling Chair Janet Yellen and her colleagues exactly this – that after a lag cheaper energy should drive a quickening of the economy. Which is, perhaps, a big reason Yellen has steadfastly kept the markets alert to the idea that she is looking for an opportunity to begin “normalizing” interest rates.

Needless to say, there are innumerable differences between today and 1986, too. Back then, the Fed was in the habit of modulating interest rates up and down with some frequency, and short rates were above 5% the entire period. Today, rates have been zero since 2008 and there is tremendous suspense surrounding a policy change.

And if, as Parker of Morgan Stanley indicates, stocks can do fine even as earnings ebb, it will have to happen with stocks already rather more expensive than they were in the ‘80s.

The natural question for anyone considering the 1986 metaphor is whether that means we're in for a radical market break similar to the ’87 crash, when stocks tumbled 22% in one day. There’s no way to predict such rare and extreme events, so that’s not really a factor in the popular comparison.

Yet Minerd thinks the broader subject of overconfident, unstable markets is prominent in the mind of Janet Yellen.

He says that if the Great Depression scholar Ben Bernanke, Yellen’s predecessor, was obsessed with avoiding the mistakes of the 1930s, central bankers in general are fixated on not stoking financial bubbles such as the Tech Mania of the ‘90s and speculative housing boom of the early 2000s.

This may be why Yellen and colleagues “want to do something” to get away from zero interest rates, if only to forestall the unchecked inflation of asset bubbles, which are “their worst nightmare,” Minerd suggests.

Perhaps on some level this is reassuring that Yellen is flying patrols as the economy and markets skirt the danger zone.