A year ago, at the beginning of an article on Seeking Alpha called "A Market Manifesto for 2015 and Beyond," I wrote that "the current strains on normal relationships suggests commodities and interest rates will bottom in late 2015 while stocks continue to rise" and that "this will be followed by an oil shock, a peak in stocks, and a brutal global contraction in 2016-2018." I concluded the article by saying that "it looks as if the cycle (earnings, commodities, inflation, and interest rates) will bottom over the course of 2015 (while stocks and the general economy continue to rise), oil will spike in 2016, stocks will peak in 2017, and a severe economic collapse will be in place by 2018. I would not expect these targets to be off by more than six months."
The slushiness of the stock market of 2015 and the plunging cold of crude prices have not altered this general outlook. I continue to believe that over the short-term (from the beginning of this year to the first half of 2017), we will see a market surge followed by a knuckle-whitening crash comparable to what we experienced in the early 1930s. That surge will consist primarily of a revival in stocks, oil, and short-term rates, and a mild rise or stabilization in non-energy commodities and consumer inflation.
These claims are based on an analysis of market history going back as far as the '70s (in the case of gold, oil, and interest rates, the 1970s; in the case of stocks and the broader commodity market, the 1870s). First, let's talk about why the bull market in stocks that began in 2009 is not yet over.
Symptoms of a Dying Bull
Everybody knows a crash is coming. The question is, when will it come, and will it impact long-term returns? There are a few conditions that typically manifest themselves as a secular top takes form, and none of those conditions have yet gone much past the larval stage of development.
For example, we ought to see a flattening yield curve, and preferably a curve flattened by a strong revival in short-term rates. We ought to see a near-doubling of crude oil prices (80%, if we follow Stephen Leeb's rule). And, we ought to see a synchronized rise in growth rates in stocks, commodities, and interest rates. So far, however, we have only seen a quarter-point rise in the Fed rate, new lows in oil prices, and the beginnings of a resynchronization between stocks and commodities.
More importantly, in my opinion, we ought to see a major divergence in the long-term growth rates of earnings relative to two factors: the long-term growth rates in commodity prices, especially industrial metals prices, and the earnings yield. Now, that divergence is almost certainly here: commodity prices are roughly where they were in 2009, while earnings are over 1000% higher. Secular bull market tops usually do not form until seven or eight years after the previous crash that lays the groundwork for the subsequent divergence, so we are getting very close, but the most reliable models that I have been able to come up with point to the fourth quarter of 2016 as the earliest possibility for a peak, and the cyclical factors mentioned in the previous paragraph seem to confirm that, so far.
That is the gist of my argument. And, it probably does not make too much sense without a bit of historical context. So, let's create some context.
A Price History of Capitalist Markets
First, there is what I call the "Great Convergence," in which, over the last century or so, long-term rates of inflation for goods and services, bond yields, and stock yields have converged with one another. In almost every instance, we see that most of the converging was done by the commodity and consumer prices and interest rates, while the earnings yield has remained effectively within its historical range. I assume that the cause of this convergence was the establishment of the Federal Reserve back in 1914, although this side-effect of central banking is not described, as far as I know, by any school of economics or banking.
This convergence in inflation and yields, however, coincides with another relationship between yields and commodity prices. As you can see, real commodity prices are highly correlated with the earnings yield. Prior to the establishment of the Federal Reserve, it was nominal commodity prices that were highly correlated with the earnings yield.
What is curious about this relationship is that back in the 1920s, Keynes wrote about something he called "Gibson's Paradox," which was the correlation, as early as the 1730s, between long-term government bond yields and wholesale price levels in the United Kingdom. By the 1960s, economists began to notice that this correlation had broken down and by the 1980s, most people had lost interest. The problem, however, was most likely that there was a lack of stock market data when Gibson first remarked on this relationship (and Tooke, purportedly, before him) and that there was and is no theoretical justification for regarding the earnings yield as a significant economic factor beyond the narrow confines of security analysis.
The simple point I wish to make here is that, despite what the schools of economic thought may or may not say about the broader significance of the earnings yield, market history suggests that it is quite consequential. Now, the earnings yield, of course, is nothing more than the ratio of annual earnings to the current stock price expressed as a percentage. It is the inverse of the P/E ratio. But, a natural question to ask, in light of its significance, is, which element plays the more decisive role, stock prices or earnings?
And, that is a difficult question to answer, but we will start with the simplest part first. For as far back as we have data (to the 1870s), it is clear that, over cyclical durations (I observe a cycle as lasting roughly five years from peak to peak), earnings have always played a more consistent and decisive role in changes in the earnings yield. But, over much longer durations, the relationship is different.
Prior to the establishment of the Fed, earnings were as strongly correlated with the earnings yield as commodity prices were. But, once the Fed was established, stock prices increasingly came to dominate the long waves of the earnings yield. Thus, the falling earnings yields of the 1920s, 1950s-60s, 1980s-90s, and 2010s were primarily caused by bull markets in stocks. Since the establishment of the Fed, the only period in which a long-term drop in the earnings yield was caused by a fall in earnings was the Depression of the 1930s.
So, since commodity prices are so closely tied to the earnings yield, and long-term movements in the earnings yield over the last 100 years have almost always been determined by stock market performance, we often tend to find an inverse correlation between stocks and commodity prices (and inflation more generally). So, the bear markets in stocks of the 1910s, 1970s, and 2000s were great for commodities, and the bull markets in stocks in the 1920s, 1950s-60s, 1980s-90s, and 2010s were terrible for commodities. Again, the only exception to this is the post-collapse recovery of stocks and commodities in the late 1930s-40s.
The key point to keep in mind for now, however, is that the relationship between commodities (and inflation more generally) and the earnings yield has remained fundamentally stable, even though there has been a structural rise in inflation over the last 100 years and that that has coincided with a radical change in the relationship between stock prices and earnings. In fact, the only change in the relationship between commodities and the earnings yield has been the transition from nominal to real prices. Qualitatively, there is no difference.
Now, however, is a good time to mention Kondratieff. Nikolai Kondratieff was a Soviet economist who was executed by Stalin for having contradicted the Party line about the imminent doom of capitalism. Kondratieff's conviction appears to have been at least partly rooted in his observations of historical price behavior. He pointed out that the global/capitalist economy going back to the early 1700s had been through a number of long waves which saw long-term correlations in things like interest rates, wholesale prices, and commodity production levels. These factors peaked about every 60 years; thus, there was good reason to believe that the deflation of the 1920s-30s was not the eagerly anticipated collapse of capitalism but rather the normal operations of the long wave.
And yet, just as the Gibson Paradox seemed to vanish, so did the regularity of Kondratieff's long waves. But, if I am correct about the earnings yield unlocking the mystery of the missing paradox, I may also be right about the earnings yield unlocking the mystery of the missing long waves. The lack of long-term stock market data makes it impossible to be sure, but it seems highly likely that after the establishment of the Fed, the duration of the long waves was halved. Thus, we have peaks in the earnings yield and inflation around 1870, 1920, 1950, 1980, and 2010.
Since the 1910s, these yield-inflation long waves have consisted of roughly two decades of disinflation and falling yields and one decade of rising yields and inflation. We might assume, therefore, five years after the last long wave peak that the next 15 years will be dominated by low yields and low inflation.
And, since the last sixty years have consistently seen a negative correlation between stock market performance and the yield-inflation long wave, we might also ink in another 15 years of booming stocks, right? Unfortunately, I do not think so. The likely outcome is a 1930s scenario of a steep, persistent decline across the board which may be followed by powerful bear rallies but only off of very, very low bases.
Let's focus on the three (now, four) long waves since the 1910s and how stocks related to each of them. In each of the initial downturns in the yield-inflation long waves (i.e. the 1920s, 1950s, 1980s, and 2010s), stocks experienced some of their most spectacular booms. In each case, however-although the jury is still out on the current one-after the initial seven- to eight-year boom, the stock market performance slackened to some degree. We know what happened in the 1930s, of course. In the late 1950s and 1960s, stocks continued to rise but at a diminishing rate. And, after the initial peak in 1987, stocks continued to rise but did not regain their feverish growth until the late 1990s. The question is, then, if we accept that the next, say, decade will see less spectacular growth in stock prices than we have been accustomed to over the last seven years, should we expect a relatively benign outcome (the 1960s), a benign pause followed by a resumption of the boom (the 1990s), or hell on wheels (the 1930s)?
Probably the simplest and most popular way of predicting long-term stock returns is Shiller's P/E10, or CAPE, ratio. As many readers will know, he calculates this by taking the current stock market price and dividing it by the ten-year average of earnings, and he has shown how, over the long term, it is negatively correlated with 10-year market returns. That is, when the P/E10 is high, one can generally expect the subsequent decade to see a weak stock market performance. The problem with this method of predicting markets is that what it gains in simplicity, it loses in precision. But, I think I have found a way to solve this problem.
The key is earnings growth and how it relates to all of the factors we have been talking about above. Earlier, I stated that before the establishment of the Fed in 1914, earnings were as correlated with the earnings yield as commodity prices were. And, as it turns out, there is a very close relationship between earnings and commodities prices, as well, particularly industrial commodity prices (for example, energy, base metals, timber) and most especially base metals (iron, copper, nickel, aluminum, etc) prices.
So, if we look at the cyclical fluctuations in earnings and commodities, we can see that over those sorts of durations (I calculate a cycle as the change of a factor relative to its 36-month moving average), earnings growth and base metals inflation have been virtually inseparable at every stage of the way. Of course, we know that they do not move perfectly in tandem, because we know that E/P (earnings/stock prices, or the earnings yield) equals commodity/consumer prices (that is, real commodity prices), and that earnings/commodity prices would then equal stocks/consumer prices (i.e. real stock prices). It is the difference in the growth rates in earnings and commodities that would account for the ability of that ratio to approximate real stock prices.
Recall also that, under the terms of the "Great Convergence" of yields and inflation levels discussed above, long-term commodity inflation tends to shadow the earnings yield. Both real commodity prices and long-term commodity inflation correlate with the earnings yield in a way that is reminiscent of the pre-Fed era's "Gibson's Paradox." I mention this again, because earnings have also been subjected to the diktats of the Great Convergence but with a twist.
At every peak of the long wave (over the last century, peaks in yields and inflation that occur about every thirty years), earnings growth peaks, too. That fits in perfectly with everything we have said so far about long waves and the relationship between stocks, commodities, earnings, and the earnings yield. But, for some reason, long-term earnings growth rates have also experienced a single spike at the trough, as well, often a spike that towers over the long wave peaks. What is more, those spikes have always occurred during stock market booms, more specifically at the precise conclusion of secular bull markets.
Earnings growth, which has tended to mirror commodity inflation and the earnings yield fairly reliably for the last 150 years, experiences a single, massive divergence once in every long wave. This occurred in the first decade of the 1900s, the 1920s, the 1960s, and the 1990s. In each case, the following decade saw not only lower long-term returns but also multiple stock market crises.
What accounts for these anomalies? In most instances, it is simply a statistical side-effect of a previous earnings crisis. Although earnings may indeed be high at stock market peaks, the spike is primarily caused by a shock that creates a very low base from which the earnings growth rate can then spike. Thus, in the mid-1890s, early 1920s, late 1950s, and early 1990s, earnings fell very low and then recovered. When we look at long-term growth rates, however, it looks as if a massive earnings boom is occurring.
Whatever accounts for these crises, they mark the final seven or eight years of a secular bull market. No long-term stock market boom in American history has concluded without one of these earnings spikes occurring at the same time.
Where We Are Now
And, that is precisely what we are experiencing now. In 2008-09, we experienced the greatest crisis in earnings since the 1920s and '30s, just as we were coming out of a long wave peak, not unlike the early 1920s. Earnings, commodities, and stocks all quickly recovered, but earnings much more so than commodities, and stocks kept plowing ahead, just as in the mid-1920s. Although stocks have hit a soft patch in the last six months, that has been nothing like the shellacking commodities have received. Thus, mathematically, we are left with a long-wave divergence in the relationship between earnings growth on one side and commodity inflation and the earnings yield on the other. Indeed, statistically, earnings growth is increasingly resembling the stock market boom, and this has always been a signal that the boom's days are numbered.
The period between the initial earnings crisis and the conclusion of the subsequent boom is always about eight years long, so we are getting close, but there are still some cyclical i's that need to be dotted and t's that need to be crossed. At the end of a secular bull market, stock market peaks always coincide with a brief resurgence in commodity prices, interest rates, and earnings growth. And, that is what I believe we are waiting for now and what will occur over the course of 2016, especially in the crude oil market. So, let's briefly talk about market cycles as opposed to supercycles and long waves.
The Cyclical Outlook
Generally, over cyclical durations, the earnings cycle sets the tone for the rest of the market. Fluctuations in the earnings yield, industrial metals prices, and short-term interest rates are each highly and consistently correlated with the earnings cycle. Long-term interest rates, other commodities, GDP growth, and stocks also tend to be positively correlated with the earnings cycle but with less consistency. Gold, for example, often leads the cycle while oil lags. Over the long-term, stocks tend to positively correlate with the earnings cycle, but over any given cycle, the relationship actually tends to be strongly negative, the reason being that severe earnings crises tend to weigh more on the long-term relationship. In other words, during secular bull markets, stocks tend to inversely correlate with earnings and during secular bear markets positively correlate with earnings. One other important cyclical relationship is that between interest rates and the yield curve spread. During stock market booms, the spread is dominated by long-term rates, and during secular bear markets, short-term rates dominate.
One of the most useful predictors of cyclical fluctuations is the gold/oil ratio, because of the way in which gold leads and oil lags the core elements of the cycle. When the gold/oil ratio is peaking, especially during secular stock booms, the earnings cycle is likely to peak in about sixteen months. When the gold/oil ratio reaches extreme levels, this often implies an 80%+ spike in oil in twelve months (using end-of-month prices). Based on the spike in the gold/oil ratio in 2015, I have been arguing that the market cycle is signaling an oil "shock" and a reversal in the downward slide in commodity prices and earnings growth in 2016. If we take the average price of WTI for the final six months of 2015 as a base ($44) and add 80% to it, we get a figure of about $80. If we use the closing price for 2015 of $37, we come up with about $65-$70. We will see how far oil slides, but at the moment $70-$80 looks like a realistic target for crude by the end of the year.
In the larger scheme things-how oil fluctuations relate to the stock market-the irony is that the lower crude oil falls, the lower the rebound needs to be in order to qualify as a "shock." So, if crude prices do hit $20, however unlikely I may think that is, they only have to get back to $36 in twelve months' time. Eighteen months ago, crude was at $100. It will not take much for a bounce to occur, and the market is set up for a rebound.
When that rebound happens, the mood in the market will change dramatically. Stocks, earnings, and inflation are going to look a lot better, and the Fed will be racing to raise rates in such a way as to reassert control over the yield curve.
Last year, I concluded my article in a similar way:
"So, this year, I will be keeping an especially close eye on when and where the gold/oil ratio tops out, how low long-term interest rates will fall, and for a cyclical trough in industrial commodities (not just the metals but raw materials and energy). Sometime near the end of the year, I suspect we will start to hear less about 'supply gluts' and more about 'overheating' and the dangers of inflation returning. If not then, then early next year, the Fed will probably all of a sudden find itself raising rates faster than it had anticipated. When short-term rates rise significantly faster than earnings, recessions have always followed. With rates at zero-point-zero-eight, or wherever they are at the moment, even raising rates to 0.25% would be, assuming that relationship holds, catastrophic."
It is now "early next year" and my suspicions about talk of overheating or the danger of inflation returning seem to have been ill-founded. The gold/oil ratio, however, is screaming for a cyclical revival, and I continue to trust that a warm breeze of inflation is coming soon and that the stock market will not enter a secular bear market until after that revival has occurred.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.