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We are all constantly reminded by Fed Chairman Ben Bernanke and politicians that we are reliving the depression of the 1930s. How the sage at the wheel at the Fed has studied the era and has the remedy to overcome the ailment through large rounds of Quantitative Easing and repressive zero interest rate policies.

Well, I wasn't alive in the 1930s, and my guess is that most investors reading this article weren't either. But, I do remember the 1970s vividly. And when I look at the 1970s versus what investors have been going through since 2004, I cannot help but notice immense correlations. The '30s were more a battle of deflation, the '70s more inflationary; currently our economy seems to be somewhere in between. But when you take the 1970s data and look at it on a relative basis, I believe there is substantial information that investors should be aware of as they choose investments in the coming year and beyond.

Macro Comparison - Broad Brush of Then Versus Now

Remember the 1970s. In the early 1970s we began trying to extricate our country from a war gone awry - Vietnam. The debt accumulated from fighting this war put severe pressure on the U.S. government to raise money to pay for the war. So the U.S. government ditched the gold standard and began quantitative easing while holding Treasury rates below inflation. Snap - oil prices realigned and the first oil shock happened in early 1974 as the price per barrel went from $4 to $10 overnight. By September of 1974, the S&P dropped to 64 from a high of 118 in December of 1972. Then the market began a slow slog back toward its previous high, reaching 102 in January of 1977.

Flash forward to 2004-2008. The U.S. government was struggling with the Iraq war. To pay for the war it was running a perpetually loose interest rate policy below inflation in 2004. In the same time interval, the price of oil jumped from $40 a barrel to a high of $140 in the month of June 2008. Snap, the S&P 500 fell from a high of 1531 in May 2007 to 735 at the end of February 2009. Over the next 4 years, we now have experienced a similar retrenchment as 1974-1977. The S&P is back to its old highs of 1500 as we begin 2013. Additionally the Fed policy, and fiscal government spending policies in the U.S. remain aligned with 1977 - quantitative easing by the Federal Reserve with interest rates repressed below inflation.

Empirical data - What is Fair Relative Value of Assets in the Current Market

The very strong anecdotal evidence correlating market and Federal Reserve actions in the 70s versus today led me to examine the actual empirical data from these two time periods much more closely. And, voila, the performance of the major market indexes relative to the oil and the interest rate policies became very clear - and also worrisome, which I will explain later in this article.

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The table above shows data from the two 9 year time periods December 1968 to January 1977, and May 2004 to January 2013. During these time periods, the correlations of each of the above markets are very high. The S&P 500 for instance drove up to a peak of 118 in December 1972, and then crashed to 64 in September 1974. In May 2007 the market was at 1531, and then crashed to 735 at month end February 2009. Crude oil market prices went from $3.07 a barrel in 1968 to $10.11 in September 1974, and likewise CPI went up dramatically. The years 2004 to 2008 also showed a dramatic increase in energy prices from $40.28 a barrel to a peak of $140 in June 2008. The peak in oil prices in 1972 and 2008 also were points in history when the stock market "crashed". In other words, oil price shocks matter to stock markets, particularly if the Fed has a tight policy going into the oil price shock.

Another relevant data point from these time periods is the Federal Reserve interest rate policy as noted in the Fed Funds Rate - CPI column. This data point reflects whether the Federal Reserve was using a policy to hold interest rates on the short end of the yield curve above or below the 12 month moving average inflation rate. The trend in Federal Reserve policy over the two time periods is nearly identical on a relative basis. It is particularly interesting that the immediate response of the Fed to the spike up in oil prices was to do a major decrease in rates well below inflation almost immediately and hold this policy until the stock market returned to its general trading range pre-price shock.

Market Scenario for 2013-2016 via Extrapolation

Given that the market action in the 9 years leading up to January 1977 was very similar to the 9 year period before January 2013, trend analysis using the time period 1977 through 1982 to extrapolate future year performance can provide good investment information. In the table below, I have done an extrapolation using the 4 years from 1977 to 1980 to produce a potential likely investment climate for the years 2013-2016.

(click to enlarge)

The extrapolation analysis provides the following scenario information for portfolio planning:

  1. The stock market over the next 4 years will likely trend steadily upward, but not dramatically so. Although off to a fast start in 2013, the S&P 500 is more likely to finish flat to down rather than up. Expect a 4.75% return plus dividends annually for the 4 year period, which relative to the expected decrease in bond returns is a better investment.
  2. Inflation will rise over the time period, primarily in response to likely energy price increases in response to continual Federal Reserve accommodation policies debasing the U.S. currency. Slowly rising inflation expectations over the next two years will keep steady pressure upward on the 30 year Treasury rate.
  3. Energy and commodities in general on a relative basis will be undervalued investments compared to the S&P and fixed income interest bonds in the early years of this time period. Prices can be expected to rise during the time period, with the real wild card being whether there is a potential major price shock upward in the 2016 time period of 2-3 times today's price level. The likelihood of some type of price shock is relatively high. This scenario has also been noted as one of the fears of certain Federal Reserve members.
  4. Fixed income rates will rise steadily over the time period as the Fed slowly withdraws accommodation as it did in 1977 to 1980. But just as in the late 1970s, the Fed will remain accommodative. Expect the 30 year Treasury in today's rate structure to trend from 3.18% to the 5% level going into 2016. Overall returns for many longer dated fixed income investments in this time frame will be marginal or negative.
  5. The wild card in this scenario is "will there be a showdown between the Federal Reserve's interest rate policy and energy prices?" If energy prices spike, the 1977-1980 time period history predicts that the Fed, because it is overly accommodative rather than tight as in 1974 and 2008, will not be able to come to the rescue by lowering rates. On the contrary, the extrapolation predicts that the next oil shock will require the Fed to actually raise interest rates, like Paul Volcker in the past, in order to stabilize the impact of the inflation seeds laid by the excessively loose policies leading up to the next shock.

Investor Options

Accumulate Energy Assets: In the extrapolation scenario in the upcoming 4 years the most undervalued assets at present are hard assets, with energy standing out as the potential best hedge against likely market events. For investors who want to position to benefit (or protect) their portfolios in the event this scenario happens, investments in energy MLPs are one of the best alternatives for taxable portfolios. The integrated oil companies that pay high, stable dividends are probably best for IRA accounts and more conservative stock portfolios. Other alternatives are energy trusts. Focus on trusts which have remaining life reserves of at least 20 years.

Buy Equity Index and ETFs at 1977 Relative Prices: Taking equity investment positions in S&P 500 index funds or ETFs is also likely to be a better risk reward investment than fixed income during this time period. On a relative basis, the S&P at 1500 is selling at the same price as January 1977. This value level turned out to be a relatively safe floor for the market for the next decade.

Manage and Shorten Duration of Fixed Income Portfolios: The projected worst performing market over the next 4 years will likely be fixed income. This does not mean drastic measures should be taken, particularly if you own high coupon investments. The best advice is to try to shorten the duration of investments where it makes sense economically to do so, and target the 2016-2018 time period as a time period in which you might potentially have a higher percentage of funds available for reinvestment.

Disclosure: Dan manages a diversified portfolio of stocks and bonds. The portfolio is heavily weighted in fixed income investments. Recent new investments have been into equity and shorter duration bonds. The portfolio is not invested in indexed funds or ETFs at this time. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Investing In 2013: Remember 1977