As global economies have become more dependent on monetary and fiscal stimulus for growth, the variables of politics have made this market unusually vulnerable to news event risk. It is simply unreasonable to expect investors to “price in” all the dynamic and extreme variables that can impact our economy. Perhaps more now than ever, understanding this market's current upside potential and downside risk is best understood by accepting the bull market's underlying theme.
Every bull market has a theme that drives the broad market higher. It is this underlying theme that makes each bull market different, directly impacting sector performance and rotation. It’s only once the theme has exhausted itself that the bull market finally ends. Thus, when an investor understands the theme that drives the current market, they understand how to navigate its intermediate trend.
Identifying Past Market Themes
More often than not, an astute investor can identify the driving theme of a bull market early in its new advance and use that information to his or her advantage. For example; the bull market that started at the late 1982 low was first driven by a secular theme that virtually guaranteed a long and strong bull market. It was the long-term change in inflation expectations and the trend of interest rates that sparked an expansion of price to earnings (P/E) multiples that fueled the bull market.
Both long-term interest rates and the cyclically adjusted P/E ratio are illustrated in the chart below. After years of increased inflation rates, the trend reversed in October of 1981. Declining interest rates and inflation expectations resulted in an unprecedented expansion of the average P/E ratio from a low below 10 to nearly 50. While some investors still believe it was primarily earnings growth that accounted for the bull market gains, the facts are that earnings only expanded by approximately 320% between 1982 and the year 2000.
If the P/E ratio had not expanded, the S&P 500 would have only reached 365 in the year 2000 based on earnings growth, and the Dow Jones Industrial Average (DJIA) would have only reached 2,465. Instead, because average P/Es expanded by more than 700%, the S&P 500 reached 1552 and the DJIA reached 11,908 by the time P/E ratios began to recede.
Long Term Interest Rates & CAPE P/E Ratio
Source: Robert Shiller online data
While there were a number of cyclical themes during the 1982-2000 secular bull market, none are ingrained in our memories more than the Technology and Internet driven market of the late 1990s. The growing enthusiasm and expectations for all things internet related provided a platform for the Technology sector to drive the market higher, resulting in unsustainable growth in all the major sectors, and a bubble in technology stocks.
In a classic sector rotation model for a bull market cycle, technology loses its leadership as the economic cycle matures. Because Technology was the theme of that bull market, it remained the sector leader throughout the bull cycle and the bull market couldn’t end until the uptrend in technology reached its conclusion.
The theme of the bull market from 2002-2007 was peak energy and emerging markets with a special emphasis on the emergence of China and its increasingly dominant influence on world economies. As a result, both the energy and materials sectors were market leaders throughout the entire five year bull market despite the fact that both energy and materials are considered late cycle sectors; they typically don’t lead the market until near the end of the bull market cycle.
Another consequence of the energy and material sector theme during the 2002-2007 bull market was that both sectors continued their own bull cycle uptrend until May of 2008. By the time these two sectors finally peaked, the S&P 500 had been in a bear market for thirty-two weeks and was down more than 8.60%.
Investors who understood the bull market theme that drove the market higher from its 2002 low, knew that the bear trend could not start in earnest until the uptrend in both energy and materials was complete. Once the energy and material sectors joined the broad market decline, the S&P 500 fell by more than 53% in just forty-one weeks.
So, What Is the Theme of the Current Cyclical Bull Market?
Investors still talk about peak oil, commodities, China and emerging markets. But oil, the energy sector and materials have lagged the S&P 500 for all but brief periods since 2009; they are not leading or pulling the market higher. The same can be said for China and emerging markets.
China is still a factor, but it has nowhere near the impact on our markets that it had pre-2007. In fact, the Shanghai index is only a third of its peak value in 2007 and has been in a trendless trading range for nearly two years. This should be no surprise because history shows us that the leading sectors or segments of one bull market never repeat their leadership in the next bull market.
Early on in this cyclical bull market we believed there was no theme; a characteristic more symptomatic of a prolonged bear market rally than a new bull market. But then a theme became evident when we witnessed the strength of the equity rally off the August, 2010 low, the near vertical rise in commodity prices and persistent strength in gold and then silver.
The strength of all these market segments; equities, soft commodities and precious metals all have one thing in common that has driven them higher; the Federal Reserve monetary policy. The driving theme of this bull market is the abundant excess liquidity provided by the FOMC and their experiment with quantitative easing. Even the beginning of this bull market in early 2009 was preceded by the FOMC pumping liquidity into the system.
Yes, fundamentals have improved from some very low levels and a serious earnings contraction. But, the improving fundamental landscape occurred as a result of Fed action, not the natural forces of a business cycle. Even more, as Fed Chairman Ben Bernanke has alluded to many times; it is still quite possible that economic growth is not sustainable without the artificial support of excess liquidity.
The history of bull market themes suggests that the bull trend in equities is probably not sustainable without the Fed’s support. But, perhaps to truly understand what to expect when a central bank’s monetary policy is the driving theme of the equity market, we should look at the one occasion where circumstances were very similar.
Although it has been called a grand experiment, the Fed’s quantitative easing is not the first effort of this sort from a central Bank. The Bank of Japan has been active at supporting Japan’s equity market via quantitative measures; all in an attempt to jump start their economy, for nearly twenty years. After their loose monetary policy of zero interest rates in the 1990’s had no sustainable economic benefit, the Bank of Japan tried quantitative easing for five consecutive years; from March of 2001 to March of 2006.
While the pace of economic activity did improve during that period, deflation re-emerged in 2007. After yet another effort at quantitative easing in 2010, deflation again re-emerged in the first quarter of 2011 in the reporting just prior to the earthquake and tsunami.
From an economic perspective, quantitative easing didn’t work in Japan and there is little reason to believe it will work in the U.S. From the perspective of the equity markets; investors can expect that when the Federal Reserve is active in supporting equity prices our markets will likely respond positively. However, during the periods between Fed interventions investors can expect our equity markets to weaken and the bull trend to pause.
Such has been the case in Japan for nearly two decades and was so in the U.S. during the period between QE2 and the announcement of QE3. Like Japan, the U.S. economy and equity markets have become dependent on our central banker’s easy money policy and how we will find a way out of this quandary is yet to be written.