US stock markets staged their most impressive quarterly performance since the late-1990s during the first three months of the year, as the myriad of concerns weighing on investor sentiment at the start of January slipped into the background. The major market indices jumped more than ten per cent in the three-month period to bring the cumulative price gains from the lows last October to 28 per cent, though the upward move lacked conviction with average daily trading volumes dropping to the lowest levels since before the technology bubble began in earnest fifteen years ago.
The stellar price action meant that the optimistic year-end targets divined by the Wall Street sales machine just months ago were either matched or exceeded by the quarter’s end, but rather than temper their enthusiasm, the perennial bulls sharpened their pencils and revised their projections higher with some daring to declare that a multi-year bull market was underway.
As the propaganda machine cranked into high gear, more than one strategist likened the decade ahead to the 1950s when stock markets enjoyed a ‘golden age’ following a prolonged period of hibernation. Back then, as memories of the ‘Great Depression’ faded and fears that a repeat episode lurked in the long grass subsided; investors increasingly shunned the unappealing yields available on default-free Treasury bonds, and embraced the attractive valuations on offer in the stock market.
At first glance, comparisons with the ‘fabulous fifties’ seem quite seductive. Just like today, the stock market enjoyed impressive gains off the lows set in the summer of 1949 and though prices climbed almost 80 per cent in just three years, equities still looked attractively priced relative to current earnings. Meanwhile, just like today, the market-determined price of Treasury bonds was distorted by official policy and looked mispriced given the high level of public debt to GDP.
The potent combination of ‘cheap’ stocks and ‘expensive’ bonds saw the former outpace the latter by more than nineteen percentage points per annum over the ten-year period from 1949 to 1959. Can investors reasonably expect a repeat performance?
As seductive as the comparison might be, there are simply too many differences between the two periods to take the argument seriously. It is true that the public debt-to-GDP ratio was at similar levels to today following the end of WWII, but private sector debt levels were minimal, which allowed for the expansion of private credit at a more rapid clip than economic growth.
Further, demographics were favourable with young families moving to the suburbs and satisfying their demand for discretionary items such as cars and household appliances through the use of instalment credit for the first time. The population explosion that occurred during the ‘fifties’ – with an almost twenty per cent increase in the number of American citizens – opened up vast business opportunities, particularly in suburban housing investment where eleven million new homes were built over the decade.
Fast forward to today and private sector fundamentals are completely different. Demographics are turning less favourable, as the children of the young couples that moved to the suburbs in the 1950s are approaching retirement with insufficient savings to maintain their lifestyles. Their balance sheets remain in need of repair following the excessive credit growth of previous decades, and the wealth destruction that accompanied the collapse in house prices.
Needless to say, continued household deleveraging will exert a drag on growth for some time to come and restrict the investment opportunities available to the corporate sector. In this regard, it is not difficult to appreciate why companies hold relatively more cash today than in the recent past.
Not only is the future level of economic growth likely to more than disappoint relative to the ‘fabulous fifties’, which will make the reduction of private and public debt-to-GDP ratios all the more difficult, but stocks are not obviously cheap as they were then. The stock market may well look undemanding relative to current earnings, but given that corporate profitability is so far above trend, the use of such a metric simply beggars belief.
The ratio of current earnings to their ten-year average is at the highest level since the autumn of 2007 – just before corporate profitability reached its apex. Some might argue that the use of a ten-year average earnings figure distorts the analysis given the steep decline in corporate profits during the ‘Great Recession.’ However, a longer twenty-year average paints a similarly disturbing picture.
This is only the eighth cycle in more than a century that the ratio has managed to reach levels as high as today, and on each of the seven previous occasions a profit recession was not far away with the corporate sector enduring an average earnings decline of more than twenty per cent over the subsequent three-year period. The historical evidence suggests that it is safe to say that corporate earnings cannot be relied upon to push stock prices higher from here.
Some perm-bulls expect a repeat of fifties-style equity performance in the years ahead, but the arguments made are a misrepresentation of the facts at best. Growth prospects are relatively poor today, while equity valuations are far higher. The yields available on default-free Treasury bonds may well be unattractive, but that does not mean that an investor stampede into equities is imminent.
Previously posted on www.charliefell.com
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