Secular versus cyclical factors in equity markets
Continuing where I left off yesterday, it’s clear that the global economy is growing now. We see growth in the US, Europe, Japan, and in emerging markets. Economic growth is the norm, not the exception. And over the longer term, markets will rise to reflect that growth. That’s what I mean when I say market and economic momentum is up and to the right. Here’s the problem; there are periods of time when economies and markets fall out of bed. And sometimes the upheaval is so great, it turns into a generational divide – a depression and/or secular bear market. I believe there is a good case that we are still both in a depression and a secular bear market and I want to explain how that matters below.
Yesterday’s post was about cyclical factors in markets. The gist of the post was that we suffered a big cyclical downturn in 2007-2009 that could have been foretold because of financial fragility and excessive leverage, particularly in the mortgage sector. But eventually, the cyclical agents took over as they always do – and we resumed the normal upward path in the economy and markets. In the US, we have been on that path since 2009. In Europe, after a double dip, growth is just beginning anew. The question in the post was whether markets were vulnerable because they were overvalued. I said yes but that the true extent of that vulnerability won’t manifest itself until policy accommodation and/or general economic weakness expose it. But the vulnerability is there again, just as it was in 2006-2007. We are just waiting for a trigger.
That’s the cyclical perspective. But there is also the secular perspective. And this is what matters most.
The question everyone is asking is “where are we in the secular market and economic cycle? Are we in a new bull market bolstered by generational lows in debt service costs or are we still in a secular bear market burdened by high private debt levels.”
I don’t think it’s any secret that I believe the latter is the case and not the former. And this is important when thinking about macro analysis at market turns.
First, let me say that this cyclical upturn, while weak, is better and longer than expected. We have to acknowledge that. In 2009, I was writing about a fake recovery predicated on cyclical stimulus and regulatory forbearance that I didn’t see lasting more than four years because of deficit fatigue. But, here we are 5 years into recovery despite the biggest fiscal adjustment since the 1950s. I think that’s pretty impressive and we should give kudos to US policy makers for engineering an enduring cyclical recovery given the circumstances.
Nonetheless, problems remain. And here is the main one in a chart from 2012 below.
What we see here is the positive impact of record low interest rates on debt service costs. It has reduced them to generational lows and given liquidity to the household sector, stopping the deleveraging that began in 2007. But the debt levels have not receded nearly as much as a percentage of income.The numbers look like this: Personal income has grown from $11.995 billion in 2008 to $14.135 billion in 2014. In that time frame, household debt has declined from $13.754 billion to $13.105 billion. So household debt to income has declined from 114% to 92.7%. The discrepancy between lower debt service costs and still elevated household debt levels highlights my problem with mainstream policy frameworks and their lack of regard for debt and credit aggregates or financial system fragility.
So what I anticipate will happen in the next cyclical downturn is that household debt levels will still be high as income erodes. And deleveraging will begin anew. The lower income from recession and the lack of credit growth will mean materially lower profits for companies, which will hit them with a double whammy by lowering both the earnings themselves and by lowering future earnings expectations and earnings multiples. That is the hallmark of a secular bear market, not a secular bull market. And what it means is that the market selloff will be significant.
Two more things here on secular versus cyclical factors. The first is a question regarding the cyclical low of 666 on the S&P 500 in March 2009. With the S&P 500 at 1897 in March, investors were looking at nearly triple their money in the last 5 years. That’s a big return. But true secular bear market bottoms are rare. Just because the cyclical low was put in 5 years ago doesn’t mean that is the low for the cycle. And this is what everyone should be trying to figure out because your portfolio will depend on it over the long-term.
Here’s what John Authers wrote in this regard last month in the FT:
On long-term measures of value such as the stock market’s ratio to the total replacement cost of its assets, known as Tobin’s q, 666 looked cheap, but at only 14 per cent below its long-term average it was nowhere near as cheap as at the great market lows. In all those four cases, q was more than 50 per cent below its average. Comparing 666 to cyclically adjusted earnings yielded a similar result; the S&P was cheap, but far less cheap than at other great lows.
Cyclically-adjusted P/E ratios were showing modest undervaluation at 666. Fair value was perhaps 750-800 at the time.
Arguably, the huge stimulus from policy makers meant that the bear market did not overshoot as drastically to the downside and so that makes 666 more of a reasonable secular low. The two things working against that view are first that the market’s cyclically adjusted price-earnings ratio is already well out of line with the norm just 5 years into this bull market. It is more than 50% above mean. Second, if you believe the secular bear market in stocks began in 2000, a secular bear market low just 9 years later is a very short secular bear market by previous standards. It’s hard to believe that we were able to move forward – especially given the high levels of private debt – into a new era after only nine years. But this is what we have to believe if we think that we are in a secular bull market right now.
More likely, we are in a secular bear market in which the recession-induced falls in the market will be severe enough to eventually bring the market to 666 or below in inflation adjusted-terms. That might be 750-800 when the next recession hits, 60% below prevailing levels today.
The last bit here to remember that there is no correlation between economic growth and market return. When one graphs the quarterly GDP numbers against market return the R-squared is a paltry 0.0146
Even over economic cycles, there is scant correlation between trend growth in GDP and market returns. Real GDP growth in the 1970s at 3.14% annualized was comparable to GDP growth in the 1980s at 3.19% annualized, which was comparable to the real GDP growth rate in the 1990s at 3.04%. But the market returns were vastly different between the 1970s and the 1980s and 1990s. This point goes to valuation. When a cyclical downturn hits, it has two effects on markets. One, it reduces earnings that underlie the prices of shares. Two, it also reduces median forecasts for future earnings and the price/earnings ratios that result from these. So, recessions reduce earnings and they reduce earnings multiples. When earnings multiples are high, this combination is toxic and it is this fact that most creates the secular bear market, not an altered growth path in real GDP. It’s simple: if you hit an economic air pocket when multiples are high, you lose a lot more money in the subsequent downturn. If earnings multiples are already low, you don’t lose nearly as much value.
Right now multiples are high. In fact, they are very high. And that is why future appreciation will be limited from these levels. The bottom line is that irrespective of whether the long-term trend is up and to the right, deviations from that trend can be severe and long-lasting. Right now, we are in a cyclical bull market. But I believe for the reasons I outlined above that the market is not in a secular bull market. We are still in a secular bear market. When the economy turns down, the still elevated levels of household debt will become problematic. and this will reduce credit, weaken the real economy and reduce earnings and earnings multiples significantly. The fact that real GDP growth declined significantly to 1,38% annualized in the 2000s is one more reason to expect multiples to contract.