Recently I heard a CNBC contributor point out that 92% of the time when the stock market starts a year with a positive January and first quarter, it ends the year positive.
So what about the 8%, and is there a potential lesson hidden in history? I quickly would point investors to 1946. In that year, the market was riding the euphoria of the end of WWII, troops were returning to home base and the country was making a structural adjustment from a war based economy to a peacetime industrial complex. During his 1946 State of the Union Address, Truman outlined the country's plan to address the large U.S. debt that had grown to $230B, 120% of GDP. Essentially it involved trading "guns for butter" as my political science professor pointed out long ago - and the budget curbed government spending growth and returned the country to a balanced budget. Flash forward to 2013, and there are major similarities, at least in terms of the task required and our government's focus.
In this article, I focus specifically on the equity market performance and trading pattern through the 1940s in order to glean information about the effects of a U.S. Debt level of greater than 100% of GDP, a Federal Reserve policy of pegging interest rates at near 0%, and as in 1946 - a decision to reverse the rapid escalation of government debt and reducing the debt level relative to GDP over time.
The times do have stark differences, particularly in the willingness of the government to address the debt problem, the influence of overseas trading partners on the USD currency for export pricing advantages (see article - Will Japan Create Inflation of Export Deflation?), and far less abundance of jobs in the U.S. labor force. Therefore, using this time period as a model for today needs to be adjusted for a much lower real growth and inflation outlook. However, as a foundation the data from the 1940's is rich in information about equity market performance in a repressive interest rate environment - so you can definitely learn from the information.
The Debt to GDP Issue
The U.S. has faced the problem of having too much debt in its past. However, the last experience was almost 70 years ago. So it is not a recent memory that many investors can easily relate to. Personally I am on the tail end of the baby boomers. My parents were both too young to be directly involved in the War. But my wife's mother and father were directly in the middle of it. Her father flew missions as a radio operator in the Jolly Rogers 400th Squadron from 1942 - 1945. Her mother was a new college graduate from Syracuse University in 1945, and went to work in Manhattan at Remington Rand. I asked her to give me a personal, non-financial view of the times as I prepared this article. And her account is very useful in understanding the numbers, so I incorporate it throughout.
The time was the beginning of 1946. The U.S. had won the war, and the stock market was rising in a euphoric expectation of better times ahead. Troops were returning to the U.S. in masses and the war-time industrial complex was faced with a large transitional task. As my mother-in-law pointed out:
"In 1945, I was 21 years old in the spring and graduating from college. Unlike today, I had no trouble finding work. During the war itself, factories were operating day and night trying to manufacture all the supplies needed for the troops -- not just guns and things like that, but anything that would be needed where the troops were based. Once the war began to slow down, some servicemen began coming back home in the first part of 1945 -- many of them took advantage of the GI bill and went to school. As far as I know, the servicemen who didn't go on to college didn't seem to have any trouble finding work -- some would go in training with a plumbing company, or something like that, and ended up doing very well for themselves. We always needed plumbers and electricians, etc."
At the beginning of 1946 Truman made his State of the Union address, which in addition to praising the country for the great achievement in winning the Great War, also re-directed the country to focus on its next big challenge - paying off its debt created in the war:
"Since our programs for this period, which combines war liquidation with reconversion to a peacetime economy are inevitably large and numerous, it is imperative that they be planned and executed with the utmost efficiency and the utmost economy. We have cut the war program to the maximum extent consistent with national security. We have held our peacetime programs to the level necessary to our national well-being and the attainment of our postwar objectives. Where increased programs have been recommended, the increases have been held as low as is consistent with these goals."
The Truman plan was not put forward without diligence in putting forward a plan to address the employment transition faced by the country:
"The Government needs to assure business, labor, and agriculture that Government policies will take due account of the requirements of a full employment economy. The lack of that assurance would, I believe, aggravate the economic instability. With the passage of a full employment bill which I confidently anticipate for the very near future, the executive and legislative branches of government will be empowered to devote their best talents and resources in subsequent years to preparing and acting on such a program."
And the debt issue faced by the country was very large. U.S. Government debt had grown 4.71 times from 1941-1945, from $50B to $230B, and as shown in the graph below was at 120% of the country's GDP.
The Truman budget slowed the growth in government debt dramatically, but it did not reverse its increase.
From 1946-50, federal debt increased 14% to $263B. The big change in the transition was the private economy taking over and generating GDP growth sufficient to lower the total debt to GDP ratio below 80% in what in retrospect on today's standards is almost as Herculean a task as winning the war itself. This transition period put the country into position for many years of solid economic performance. It is noted that over the recent history, the U.S. economy has performed best during periods in which U.S. government leverage is in the 50% - 80% window. (article: The Sequestration Why No Wall Street Panic)
How the U.S. Paid off Its Debt
One of the interesting aspects of the 1946 to 1950 transition for the U.S. government financial situation was how the country actually managed to pull off the feat. The chart below breaks down the composite GDP over the period between real GDP and inflation. GDP over the period averaged 8%, far greater than has been experienced in our recent history. It was reflective of a time in which going to work was expected, and necessary for most people. There were safety valves in the economy that government had created in the depression era, and history gives credit that they were useful in smoothing out the bumps in the time. But the dependency on government was not ingrained, so people worked.
But there was a bump created in the transition, and real growth suffered in 1947 to early 1949. As my mother-in-law pointed out:
"By 1947, I remember one factory closing that had been around for years in Syracuse. Whether its product was becoming obsolete or another problem, I don't know. Eventually, a city that had been such a successful industrial area for so long began losing many of its companies -- some because they were moving to the South."
The country's GDP in the early days after WWII was ridden with high inflation, much of which was pent up due to wartime wage and price controls. The country responded with a tax cut in The Revenue Act of 1948, and real growth became the economic driver in a much lower inflationary period from that point forward for many years.
Can the U.S. Accomplish a Similar Feat with A Grand Bargain Now?
The U.S. entered 2013 with a task equal in magnitude to the one faced by Truman and the country in 1946. The country's debt relative to economy's current capacity to pay-off the debt has grown to over 100%, and the target of returning it to a more manageable 50%-70% range is discussed as the correct direction for the U.S. In fact, in discussions among G-7 nations, it is generally agreed that it is the proper target for all developed countries.
The question one needs to ask is - "On what timetable is it reasonable to expect such a correction of course? What is actually required for an economy to dig its way out from under the mountain of debt?" I have already noted the main differences in today versus the 1940s - inflation, or lack of inflation in the case of today, and the availability of jobs in the U.S. In the case of job growth, the table below shows the magnitude of the task to create jobs at a pace relative to the 1946-1950 timeframe in the U.S. today:
Current trailing twelve month job growth is 169K, and that seems to be the high end of what growth will be as we progress through the next several years. To reduce the debt to the 70% level over 4-5 years, a not likely almost 400K per month job growth is presently required. The Digital Age, Internet creation driven economy of the 1980s and 1990s were able to generate only 200K-300K per month in high growth recent periods in history. In my opinion, we do not have a similar catalyst at the present time. In this environment, the likely time frame for curing the financial government ills with growth is a slow roll 10-20 year proposition.
Inflating the economies' price level to cure the problem is the second way that the debt level was reduced quickly in the late 1940's. Today, on the other hand, we are facing deflation, not inflation in the general economy. The U.S. Federal Reserve is managing the money supply in a fashion which is producing a 2% inflation rate, and in many cases is doing a lot of heavy lifting with very large asset purchases (QE1, 2, 3…) to keep asset prices from totally collapsing. This is inter-twined with the high debt levels and currency war with many of the U.S. trading partners, particularly Japan and China, and I do not expect this situation to change quickly either.
In view of the current environment, the tackling of the debt issue in the U.S. is not expected to be accomplished as quickly as our forefathers and mothers addressed their problem. The children and grand children of the WWII generation would be served well to coalesce around a more dramatic plan, but at this time, the willingness of the current generation is not there. So, my current expectation is a much more prolonged low growth (1 to 2%), low inflation or even deflationary environment (0 to 2%). Inflation will be concentrated in food and energy through time. Growth will await a clear market catalyst.
The DOW and May 1946
The framework laid out in this article is only useful to an investor if it can be put into context of how to fairly value assets in the context of what is happening and expected to happen. This brings me to the DOW Industrial Average and how it performs at different times in recorded history relative to the country's GDP. The graph below shows the timeframe from 1941 thru the present day on this measure.
(Author note: Typically I use the S&P500 (SPY) as the market proxy, but the historical data set for the S&P500 starts in 1950, so I have used the DOW. The two markets are highly correlated, and the analysis can be extrapolated on a relative basis to apply to the S&P aggregate index.)
The bookends of the graph are very similar in two important ways: 1) The country's debt to GDP was / is over 100%, and 2) The Federal Reserve in both time periods was / is pegging the term structure of interest rates with the shortest term rates being at or close to 0% and below the rate of inflation.
So, as a model for estimating what the fair value of the aggregate market should be at the present time, and how different events and changes should affect valuation, this time period can provide an investor very useful information.
DOW Performance in the 1940s
In the chart below, I have mapped the DOW performance in aggregate and shown its relationship to the change in GDP through the time period. This brings me to the interesting point where I began this article. In 1946, the first quarter of the year was marked by a continued upward movement in the DOW as the country euphoria over the exit from WWII caused a definitive bid in the market. By May 1946 the DOW was trading at a level which was roughly 1 time GDP, well above the trading range of .65 to .80 times from 1941 until mid 1945. Additionally, the DOW had broken through a multi-year high of 187 set in 1937. The crash of 1937 was a brutal one, set off by what historically is considered a Federal Reserve "mistake" of over-tightening in an economy that needed continued stimulus. The drop in 1937 from 187 to 100 on the DOW was roughly equal to the DOW decline of 48% in 2008 to early 2009.
Then we reached May of 1946, and there was a major sell-off of 22% peak to trough from May to September as the fiscal budget re-alignment was digested by the market. The stock market did not break through its 1946 highs until Jan 1950. GDP did grow steadily and at a fast pace throughout the period, but the DOW was not capable of trading at a premium to GDP until after 1952. By that point, debt to GDP was at 72%. In addition, it was also the year the Fed got back its independence from the Treasury in the 1952 Treasury - Federal Reserve Act, and interest rates began to float more freely with market forces.
Equity Market Extrapolation Analysis - 2013 and 2014
When you review the trading pattern of the stock market, using the DOW (DIA) as a proxy, over the 2008 to present time period, the similarities from a relational standpoint are compelling, and the events which are being dealt with by investors are very similar. In particular, I point to the federal budget constraints and the repressive interest rate structure being implemented by the Federal Reserve. In addition, we are coming off a 4 year package of high Keynesian fiscal stimulus spending, which was what happened during 1941-45. (I will point out that the FDR spending was an order of magnitude bigger relative to the 2009 Obama plan, and definitely produced more GDP growth for the buck; but after the War ended, even many staunch Keynesians agreed it was not sustainable at such high debt levels).
The euphoria trade post WWII may not have an equal today, and certainly the country as a whole is not mobilized to take on the challenge faced from a leadership standpoint. But I liken what the Fed is doing with QE3 as forcing a simulated euphoric trade in the market. The resulting run-up in valuations without firm economic underpinnings is producing a very similar trading pattern.
If you overlay the 1946-1950 relative GDP trading range on the current DOW and project forward to come up with expected outcomes, the chart below reflects the likely trading pattern as well as the likely bounds on the DOW using a 4% GDP growth model:
For those who are interested in the actual underlying numbers, I have put them into the table below for reference:
The real issue that I see presently as the equity markets trade ever higher is financial market stability. The DOW traded in the upper segment of this range at .98 times GDP in the summer of 2007, and the result was a reach for yield that was unwound in a bloodbath in 2008. The longer the Fed tries to prop the market up beyond the range which can be supported by real economic growth, the more likely an even more precipitous decline some time in the future.
May through September 2013 may not rhyme exactly with 1946. The current powers in Washington are bickering over implementation of how to lower spending relative to GDP, and prolonging the government overhang on the private sector. In addition, the Fed QE3 policy is stated to be in place through the remainder of this year - so perfect alignment with May 1946 looks unlikely. It could be September 2013, or later before the market cools from the Fed monetary "Red Bull" to use a term coined by Pimco's Bill Gross.
But the re-alignment of fair value in the equity markets is, in my opinion, inevitable. It is hard to put a GDP valuation of the equity markets today rationally above where the equity markets traded in 1946-1950. In that point in time, the country had its act together. At that point in time, there was a national plan and a sense of urgency to meet the objectives of the plan. So, the longer the Fed is out on the gangplank alone propping up the stock market without suitable job growth which will grow GDP at the rate required to amortize the debt - the harder the eventual fall will be. In all likelihood, the fall will be at least 20%.
Based on this analysis, I reiterate my current portfolio recommendations:
- It is time to get vigilant in your corporate credit portfolio holdings by shifting back to quality (LQD) and away from junk. (JNK) (HYG)
- Treasuries are better than cash in a deflation scenario, so you can underweight cash, and move money out of risky assets and overweight quality - and in the coming 2-3 years be better off. Treasuries across the entire term structure are very unlikely to go down in price by any large measure anytime soon because the Fed is in repressive interest rate mode - meaning they intend to continue to use member bank balance sheets to fix the pricing of U.S. government debt - not to drive loan growth. (GOVT) (IEI) (IEF)
- Don't get caught over-extending on the risk curve at this time. I would scale back on aggregate equity indexes, especially as the signs of economic weakness continue to show. If you try to time the impending market move, you will very likely get caught in a trade which will take years to get your money back again.
- Stock selection is the only way to play equities at this time. Use the energy and commodity market pull-back to continue accumulating hard assets and food companies, as food and energy prices are the primary market that consumer price inflation will materialize in the coming years, and stocks in this case should appreciate in value.