Have We Missed the Great Bull Market?

America's recovery from the global recession and subsequent bull run are based on solid economics

John Rekenthaler 21 June, 2018 | 7:07AM
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Dow Jones Hits 26,000

This may not be the best stock bull market in modern US investment history; the 1950s and 1990s are formidable rivals. By any standards, though, tripling one's money in real terms, in less than a decade, rates as a great success. That this gain occurred during a period of low volatility, with few large reversals and subdued inflation, heightens the achievement.

Yet almost nobody called it. Somebody, somewhere, advised near the market's bottom that investors load up on stocks. Not many, though. The best example that I can recall was GMO's Jeremy Grantham, who said in January 2009 that while stocks were not "dramatically cheap," they were worth buying, as he expected them to generate a 65% real return over the next seven years. Half correct; stocks rose 130% for that period.

In hindsight, 2009's economists had the right starting point. They believed that a single, overwhelming economic trend would drive the next decade's stock market results. Unfortunately, they were unable to identify that trend, emphasising instead two predictions that did not materialise.

GDP Growth into Corporate Profits

The consensus economic belief emerging from 2009's rubble was the arrival of the "New Normal". For decades, the United States had hamstrung its economy through deficit spending, aided and abetted by consumer borrowing. That bill had come due. To pay it, the nation would be forced to tighten its belts by cutting spending and strengthening its balance sheet. Those actions would depress GDP growth for years to come, thereby impairing stock prices.

That forecast was broadly accurate. Not once during the recovery did annual real GDP growth, as measured from one calendar year to the next, reach 3%. Such a figure was once commonplace. For example, during the seven-year stretch from 1983 to 1989 and the five-year period of 1996 to 2000, GDP growth always exceeded that mark.

What the forecasters overlooked was that GDP growth doesn't much matter. They all knew that to be so. Seven years before, the book Triumph of the Optimists, written by three London Business School professors, had shown, to much acclaim, that there is little correlation between a country's overall economic growth and the performance of its stock market.

The reason that GDP growth tends to be immaterial is that, although it signals increased activity, there's no telling who gains from that activity. It might be oligarchs, who scoop the nation's output into their offshore bank accounts. It might be labour, which devours all those benefits in the form of wage increases. It might be empire-building CEOs, who plough their companies' cash into unprofitable new ventures. There are many ways to spend GDP growth besides increasing corporate profits.

In the case of the US, however, every penny of GDP growth went into boosting corporate profits. And more. Benefiting from a historic advantage over labour, which kept their costs low, and refraining from making large capital investments, which kept their margins high, US companies have made money like never before.

Ultimately, stock prices are determined by two factors: corporate profits and inflation. The New Normal greatly underestimated the benefit of the first of those items.

QE Fears Overblown

At the same time, fears about quantitative easing overestimated the hazard of the second. Exiting the 2008 financial crisis, global governments wished to stimulate their economies but had difficulty doing so because their short-term interest rates were near zero. They turned then to an unconventional approach: so-called quantitative easing, whereby their central banks would purchase government bonds in the open market. This would have the twin advantages of supporting bond prices and increasing the money supply.

To critics, of which there were many, the cure was worse than the disease. Flooding the money supply to an even greater extent than was already being done through short-term rates would inevitably bring inflation – if not sooner, then surely later.

That, obviously, has not occurred. Bond prices, far from being in a temporary "bubble", remain firm; the dollar is stronger against the euro, British pound, and yen than it was when that passage was written; banks have suffered no fresh crisis; consumer confidence has been fine; and business activity has steadily risen. None of the quantitative easing warnings have come true.

Much of the argument against QE was politically motivated, which meant that portion of dissent was useless. The informed critics cannot be fully absolved, however. Once again, they had not upgraded their software. By the end of last decade, it had become clear that the traditional link between money supply and inflation had become tenuous. Those who warned against quantitative easing should have beaten their drums less loudly.

Why the Numbers Matter

1) Economics matters, greatly. The combination of persistently high corporate profits and quiescent inflation fully explains today's Great Bull Market. The market's gains owe to numbers, not to sentiment.

2) Getting the economics right is a very difficult task. Doing so requires being correct about many things.

3) Too often, economic forecasts become groupthink. Following the 2008 financial crisis, too much attention was paid to the New Normal and quantitative easing critiques, while too little attention was paid to alternative views.



The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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John Rekenthaler

John Rekenthaler  John Rekenthaler is vice president of research for Morningstar.

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