The United States equity market has increased around 180% since its March 2009 low. Yet, the jury is still out on whether the market is only part way through a new long-running bull market or whether it merely has enjoyed a cyclical rally within an ongoing secular bear market that began in 2000. Despite the market's strong advance, the S&P 500 has yet to break above its 2100 peak in inflation-adjusted terms. The market had been poised to break to a new high, but the recent correction has short circuited every attempt.
The bullish case for the market rests largely on three major ideas: there is little reason to expect a United States recession any time soon; the Federal Reserve's move to tighter monetary policy will be gradual; and valuations while high, are not at an extreme. The bearish case is that profit margins are more likely to fall than rise from current elevated levels; the move away from zero short-term interest rates could cause more damage than generally expected, and there are still many troubling economic and financial problems, both domestically and globally.
The two longest-running bull markets during the past hundred years occurred between 1949 and 1968 and from 1982 to 2000. Thus far, the real S&P 500 has broadly tracked the profile of those two earlier bull runs. There were many differences in the economic backdrop to the two previous cycles, yet both lasted a broadly similar time. In this report I examine the drivers of those two long bull markets for clues about how the current cycle might play out in the coming years.
The Economic History
It is well known, the current economic recovery has been the weakest on record, reflecting the severe financial damage from an extreme credit boom and bust cycle. Thus, the trend in real GDP has fallen far short of that during the other two bull markets. However, it should be noted that the path of real GDP in the 1980s-90s also lagged that of the 1950s-60s, yet that did not lead to a weaker equity bull market. The point is that the market trades off corporate earnings and not real GDP.
The trend in real corporate earnings during the current bull market has far surpassed the comparable periods of the other two cycles. Even a 10-year trailing average of earnings has done well in the current cycle.
The fact that earnings have performed so well in a disappointing economic growth environment of course reflects the impressive gains in margins. Therein lies the question of how long it can continue.
Operating margins for the S&P 500 began the current cycle at around the same level as in the previous cycle, but the subsequent profile has been very different. In the earlier cycle, margins fluctuated in a relatively narrow range for five years, followed by a more pronounced up and down cycle over the next five years. The final nine years of the bull market was marked by a steady rise in margins, ending at a level far above their earlier average. In the current cycle, margins quickly surged and have held at a record level. Looking at domestic non-financial EBITD margins, a broadly similar picture becomes clear. Margins currently are well beyond the levels at similar points in earlier cycles.
Companies are making every effort to sustain high margins by keeping a tight lid on labor costs, but it will be hard to achieve further significant gains from current levels. Thus, the market will not have one of the important supports that sustained the later stages of the earlier secular bull markets. But, that does not preclude a continued advance in equity prices over the next several years if there is a rise in earnings multiples.
Most asset inflation depends on the fuel supply of abundant liquidity. And this cycle has been supported by the most aggressively stimulative monetary stance in modern times. Yet, there has not been any obvious correlation between the trends in real short- and long-term interest rates and the secular moves in equity prices.
Interestingly, inflation expectation is one indicator that has moved closely in tandem with long-run equity cycles. One measure of inflation expectations is in the process of forming a bottom and the future trend is more likely to be up than down, given the Federal Reserve's previous 2% inflation target. While interest rates do not appear to have a direct correlation with equities, the trend in inflation expectations presumably represents a driver of investors' views about the future direction of nominal interest rates.
Importantly, the trend in inflation expectations also has a close inverse correlation with the equity market's price-earnings ratio. The relationship is especially clear using a cyclically- adjusted price-earnings ratio, based on a 10-year moving average of trailing earnings. Thus, if inflation expectations are headed higher over the next several years, it is reasonable to expect that the price-earnings ratio is more likely to fall than rise from current levels. This is especially true given that the price-earnings ratio has been tracking far above the levels of the previous bull cycles, and above its historical average.
A final issue to consider is investor exposure to equities within their investment portfolios. Using the Fed's flow of funds dataset, one can track equity holdings as a percent of total financial assets for the household sector and for life insurance companies and pension funds.
In the case of households, the commitment to equities already is above the peaks reached in the 1950s-60s bull market and at the level not reached until the final stages of the 1980s- 90s cycle. For financial institutions, equity exposure was understandably very low after WWII and was still only 20% of financial assets when the bull market peaked in the late 1960s. The 1980s-90s period is a more relevant benchmark for today and current equity exposure is tracking that period. If the household and institutional sectors are added together, equity exposure already is very high by the standards of the previous two cycles, surpassed only by the final bubble years of the 1990s.
No two economic or financial cycles are ever the same, so history can only ever provide vague clues about how the future may play out. The 1949-68 bull market began post WWII, when deflation was still a big possibility, but there was enormous pent-up demand to fuel an economic boom. The 1982-2000 cycle was driven by a steady drop in inflation, coupled with corporate restructuring, technological advances and soaring credit growth. The current cycle is very different from both periods: the credit cycle has been and is likely to remain very muted, the global economic backdrop is troubled, and there are huge uncertainties about the long-run implications of current extreme monetary policies. Notwithstanding those words of caution, one can draw some conclusions about how the current equity cycle stacks up against the two previous long-running bull markets.
The U.S. equity market currently is tracking the paths of the previous two secular bull cycles in inflation-adjusted terms. However, in both of those earlier episodes, the equity market suffered multi-year periods where real equity prices tracked sideways. Thus, a period of flat or even lower prices over the next several years would not be inconsistent with an ongoing secular bull market. On a more positive note, there is little reason to fear a recession in the U.S. any time soon, and economic downturns contributed to periods of equity weakness in the previous two cycles.
Earnings gains have far surpassed the previous cycles this time around, despite a weaker economic performance. The question is whether the remarkable rise in profit margins can be sustained over the long run. In the earlier cycles, margins were slow to improve but eventually underpinned the bull market. The front-loading of margin gains in the current cycle means that profits are unlikely to provide the same support in future years.
Inflation expectations have been more correlated than interest rates with secular equity cycles. With inflation expectations more likely to rise than fall over the coming years, this does not bode well for the future trend in equity prices.
Valuations are already far above the levels reached at a similar point in the earlier cycles. Absent a major bubble, this will limit the market's upside.
Equities are the asset of choice in the current low interest rate environment. However, equities already account for a historically high share of financial assets for the combined households and institutions. While the share devoted to stocks could rise further, the upside is limited relative to what occurred in the two earlier long bull markets.
In sum, five-and-a-half years into its bull market, the case for an extended strong upcycle in equity prices is rather tenuous. Compared to the past, the market is expensive, profit margins are elevated and investors have already committed a lot of their financial resources to stocks. None of this means that the market is headed for a crash or that we are still in a secular bear phase.
What then is the answer to the question posed by the title of this report? It seems too bearish to argue that the market remains in a secular bear phase because it would imply a retest of the March 2009 lows. That would require a major new economic and/or financial crisis within the next few years, and while not impossible, one should attach a low probability to such a scenario. At the same time, a projection of minimal gains in real stock prices is not really consistent with a secular bull phase. This leaves us with a secular sideways market, albeit one with some major cyclical swings. The past five-and-a-half years have been a buy-and-hold market and that phase has ended. A more challenging cyclical environment likely lies ahead.
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The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.