pril of 2021 marks an important milestone for financial markets. The S&P 500 bottomed on March 21st of 2020 and has soared upward almost without interruptions ever since.
As this bull market turns 1-year old, we revisited the Strategic Insights we published on March 31 of last year titled “Modern Monetary Theory to the Rescue’. In that publication we predicted that, despite the likely human and economic costs of COVID-19, a money printing binge by the Federal Reserve would ignite explosive rallies in equity and housing markets. One year later, the S&P has risen an astonishing 62% and home prices are up more than 15%.
The question confronting investors now is whether the good times are behind us and is the bull market coming to an end? In answering that question, we need to address a couple of myths and misconceptions that are frequently repeated about the current bull market.
We believe that fears about lofty valuations or accelerating inflation bringing this bull market to a close are overblown. We think investors should ignore these distractions and focus on the catalyst that has historically brought down almost every bull market – a change in Federal Reserve policy.
Probably the most frequently repeated concern about the current bull market is how expensive stock prices are compared to historical averages. By almost any valuation measure, US stock are extremely expensive. Our analysis of historical markets indicates that these highs valuations are likely to depress long term returns. However, history suggests that valuation has virtually no impact on market returns over shorter term, 1-year investment time frames.
We evaluated market returns relative to valuation using a popular measure of valuation - the Cyclically Adjusted Price/Earnings Ratio (CAPE), also known as the Schiller P/E. CAPE compares current market prices to average earnings over the past 10 years. The S&P 500’s CAPE is currently about 37x, far above its post WWII average of about 22x and closing in on its all-time high of about 44x.
Chart 1 plots historical large cap real returns against the CAPE at the beginning of the investment period. In other words, the CAPE for 1950 is plotted against real returns for 1950 to 1960. The strong negative connection between starting valuation and long term returns is clearly illustrated by the chart. The red line marks the average historical return for each level of CAPE. As CAPE increases, average 10-year returns drop sharply.
Historical average returns fall from about 14% for a CAPE of 8x all the way to -5% for a CAPE of 44x. This simple model of long term returns explains about 40% of the total variability of returns over the past 76 years (the R2 on the chart). The model also indicates that, with a starting CAPE of 37x, investors should expect to make no money relative to inflation over the next 10-years. This compares to an average long term real return of about 6.5%.
By contrast, Chart 2 shows that 1-year returns have almost no connection to starting valuation. Investors are just about as likely to lose money when paying 15x as when paying 30x. Even when markets have been at historical extremes above 40x, investors made money over the following year just about as often as they lost money. A model of 1-year returns as a function of CAPE only explains about 3% of historical returns. That means 97% of historical returns have been completely unrelated to the starting valuation.
In summary, US equity markets are expensive. Long term investors should expect disappointing returns over the coming decade. However, history says that this expensive market can keep rising and get even more expensive over the next year.
The next most repeated concern about current market conditions is inflation. The Wall Street Journal has been particularly strident, sounding repeated alarms about the inflationary consequences of the Biden stimulus program and its implications for financial markets. We think the policy shift from President Trump to President Biden has less inflationary impact than the financing mechanism embraced by both administrations (printing money like there is no tomorrow). Prices are undeniably up sharply from the post pandemic lows of last spring. While we may differ about the underlying cause, we agree with the Wall Street Journal that inflationary pressures are rising the US economy. Over the short run, however, increasing inflation has historically had little impact on market returns.
Chart 3 plots 1-year inflation adjusted returns against trailing 1-year inflation. As with CAPE, the inflation rate appears to have almost no impact on returns over the subsequent year. Even at eye popping inflation rates of 8% to 10%, investors have historically been just about as likely to make 40% as lose -40% the following year.
Ironically, higher short term inflation can be a powerful catalyst for stocks to move higher. Rising inflation implies that companies are raising prices. Higher prices typically lead to higher profits and higher stock markets.
There is a limit to the positive impact of inflation on equity markets. Inflation becomes a problem for financial markets when the Federal Reserve determines that inflation is a problem for the economy. When the Fed decides that rising prices are not a temporary spike but are a systemic problem across the economy, they stop their printing presses and drain money out of financial markets. This drop in financial market liquidity simultaneously forces interest rates up and pulls buying power out of equity markets. That combination tends to bring bull markets to a sudden and painful end.
Chart 4 shows that Federal Reserve rate increases have reliably produced market corrections over the past 40 years. The associated market pullbacks were modest in the rare instances that Fed policy perfectly balanced between containing inflation and maintaining economic growth. Deep bear markets have occurred when the Fed hit the brakes too hard, and the economy lapsed into recession.
For example, much of the blame for the 2008 global financial crises and the -56% drop in the S&P 500 has been placed on banks and their poor decisions regarding subprime mortgages. Investors tend to forget that these poor lending decisions only manifested themselves after the Federal Reserve increased interest rates from 1.0% to 5.25%.
The Fed is not the sole cause of market corrections. Unpredictable events like wars and pandemics have also played a role. However, a tightening in monetary policy by the Federal Reserve has historically been the most dependable catalyst for the end of a bull market. Bull markets do not just die, the Federal Reserve usually kills them.
We believe that this bull market will end when the Federal Reserve shuts down its printing press and stops supporting financial markets with hundreds of billions in newly printed dollars. Fed Chairman Jerome Powell has repeatedly stressed that he believes the current spike in inflation is temporary. The Fed’s primary concern is not inflation but the 9 million jobs that were lost to the COVID pandemic. Until these jobs are recovered, we do not believe that the Fed will retreat from its current aggressive policies.
Even at the current torrid pace of job creation, the US will not recover 9 million jobs until the end of 2021. If we are correct about Fed policy intentions, this bull market will not have to worry about a drop in Federal Reserve support until early 2022. That means nearly $900 billion in newly printed money could be injected into financial markets between now and year end. That is powerful rocket fuel to keep pushing equity markets higher, despite high valuations and rising inflationary pressures.
If the Fed had not radically shifted its policy stance in September of 2019, we would be predicting that monetary policy should begin to tighten early in 2022. The bull market could be expected to end soon after. However, in September of 2019, the bond market collapsed under the weight of financing a $1.4 trillion dollar government deficit. Rather than allow interest rates to rise and attract private investors to fund the deficit, the Federal Reserve effectively bailed out the Trump administration by printing money and buying government bonds. The US government has been dependent upon Federal Reserve financing of its deficits ever since.
The COVID-19 pandemic took the US government’s dependence upon Fed financing to new heights. Over $5 trillion dollars has been borrowed and spent in support of the US economy since the outbreak of COVID. US government debt has soared to levels not seen since the end of World War II.
The Federal Reserve financed most of this increased debt through newly printed money. Can the Federal Reserve simply shut off its printing presses considering the level of US government indebtedness? Can the US government finance all this debt without the Fed’s help?
During WWII, the US amassed a comparable amount of debt. The Fed was required to help the government finance this massive debt burden by printing money and buying government bonds.
They continued this policy for about 6 years after the war ended, despite inflation averaging nearly 7% per annum during this period. The need to keep rates low and the US government solvent was considered more important than inflation. As policy makers began recognizing the damage persistent inflation was doing to the American economy, the Fed was granted independence and allowed to stop buying government debt in 1952.
The Fed will likely face a conflict in 2022 between its mandate to fight inflation and the government’s dependence upon its financial support. We cannot predict how it will resolve this conflict. We do believe that this conflict will likely cause the Fed to be slower to respond to inflation than was the case for most of the past 40 years. The longer the Fed takes to respond to future inflation pressures, the longer this bull market could continue to roar.