Of late, it has been fashionable, to debate the impending death of equities as an asset class. These arguments/deliberations follow a “lost decade” for US markets, where equities have badly underperformed government bonds. Even allowing for the fact that equities are the riskiest component in the capital structure, the underperformance versus government bonds seems quite extraordinary.
But what has gone so wrong resulting in the reduced appeal of this once much-loved financial asset? Ironically, the current plethora of negative comments regarding equities coincides with the 30th anniversary of the emergence of one of the most powerful secular bull markets in US financial market history, that lasted from August 1982 to March 2000.
Our attitudes towards equities as an asset class are heavily shaped by the events of the 1982-2000 bull market. A major obstacle for equities in 2012 is the unrealistic belief that the economic and financial dynamics behind the 1982-2000 secular bull market need to be replayed to produce a better era. Such outcomes are, however, unlikely, given the different prevailing economic and financial conditions.
The Economic and Financial Backdrops in 1982 and 2012
Cheap equity valuations are often catalysts for bull markets. In August 1982, the valuation of US equities in absolute terms was cheap, but comparative valuations versus bonds were more neutral. The backdrop for equities was not particularly congenial: Mexico was on the verge of a sovereign debt default; long-term US government bonds were yielding 13%; the then US economy was in a prolonged recession that began in July 1981 and US corporate profitability in 1982 was appalling due to poor labour productivity across the economy.
The current economic and financial backdrops for financial assets are different to those in 1982: the US economy has been growing for the past 3 years, while yields on long-term government bonds, partly capped by the Fed via Operation Twist, are at all-time lows. The current valuation of equities versus bonds appears cheap. Yet, in terms of absolute valuations, equities are currently not as cheap as in 1982, but they are clearly not over-stretched. Meanwhile, profitability at US companies is impressively high, underpinned by ruthless fixed cost control and high labour productivity. Sovereign debt fears are, however, currently more widespread than 1982, but these fears are largely confined to the Euro zone.
Disinflation and Rising Profitability: Profound Bullish Consequences
Rising and unanticipated inflation had been the undoing of US financial markets in the 1970’s, helping to depress equity valuation metrics. In 1982, US inflation entered a period of prolonged secular decline. The two most important consequences of this were lower bond yields and sustained p/e multiple expansion for US equities.
Rising p/e multiples are a necessary but insufficient condition to support a secular equity bull market. Also required, is a more improved corporate sector performance. US corporations eventually became more profitable due to productivity enhancements. Equity valuations were then boosted by better predictability of corporate profits due to the onset of the “Great Moderation.” Equities had seemingly entered a near-perfect environment, particularly after 1994.
Post-1982 Landscape Bred “Event-Driven” Fed Intervention
Don’t fight the Fed! We all know this slogan. The Fed succeeded in restoring risk-taking in the aftermath of Black Monday (1987), the Tequila Crisis (1994), Asian Financial Crisis (1997) and LTCM bailout (1998). The initial effect of Fed intervention was to upwardly-bias, albeit temporarily, long-term equity expected returns: injections of liquidity would always seemingly put a floor in equity prices.
“Event-driven” intervention by the Fed thwarted the credible creation of new long-term expected returns on financial asset classes by creating moral hazard and preventing much-needed periodic re-pricing of risk. Courtesy of the Fed, equity market valuations were never allowed to flirt with levels normally associated with the troughs of major bear markets. Against this backdrop, it becomes very difficult to argue for the onset of a new secular bull market. It helps to explain why people may have become much more cynical about equities, because the Fed has played an increasing role in shaping valuation metrics.
1982-2000 Experiences Will Not Be Replayed
Under normal circumstances, the long-term returns on equities should be closely related to the aggregate asset growth of the corporate sector. The future growth of corporate profits will therefore be critical in shaping equity market returns.
Two tranches of quantitative easing by the Fed indicate we are currently not in normal times. The world economy remains very much on life support via ultra-easy monetary policy. Removing this prop will adversely impact real economic activity and financial markets. The valuation of US government bonds in the current environment is rich due to risk-aversion and Operation Twist. Meanwhile, attitudes towards equities cannot re-normalise until the US economy escapes the grips of a powerful liquidity trap.
A Liquidity Trap Differentiates 1982 and 2012
There is no strict definition of a liquidity trap, although it usually refers to situations whenever monetary policy is seen to be impotent. High levels of cash hoarding and a decline in the velocity of money are common features of a liquidity trap, along with very low levels of inflationary expectations. There is also a floor in long-term interest rates, indicating that the private sector is unwilling to buy more government bonds at that point. The implications for financial asset returns need to be appreciated.
Under liquidity trap conditions, the returns on government bonds will be positive until the floor in long-term interest rates has been reached. Once reached, investors will be reliant on coupon payments for total return. The implication for equities will depend on the performance of the corporate sector. In the case of Japan, after the bursting of its bubble economy in 1989, the predictability of corporate profitability collapsed due to problems in the banking system and a general reluctance to engage in restructuring. Japanese equities have struggled since 1989.
In contrast to Japan, US corporate profitability has rebounded impressively since 2009. The earnings yield on the S&P500 is currently around 7.7%, much higher than the yield on government bonds, hinting at much higher future total returns. The historic average S&P500 earnings yield over the past 50-years has been 6.1%, indicating that equities are currently slightly cheap versus their long-term absolute valuation.
Can US Equities Return to Favour?
The outlook for US equities over the next few years will be determined by the following factors: 1) the stance of US monetary policy; 2) the future path of US government bond yields; and 3) the ability of the corporate sector to maintain high profits.
The Fed has indicated that it will maintain short-term interest rates at “exceptionally low” levels until late-2014. By that time, the support for US government bonds under the auspices of Operation Twist should have ended, possibly putting an upward bias on yields. Rising bond yields from all-time low levels need not necessarily spell disaster for equity prices, particularly if the increase is due to a higher real return demanded by investors (indicating stronger economic growth). Furthermore, any rise bond yields needs to be placed into context in terms of the performance of the corporate sector. If corporate profits can be preserved at high levels, then the timing of any turbulence to equity markets stemming from rising bond yields will be delayed.
How Long Can US Corporate Profitability Remain Elevated?
In my opinion, the outlook for US equities hinges critically on the ability of the corporate sector, over the coming years, to maintain high levels of corporate profitability. The current level of after-tax profits’ share of GDP is, however, at an all-time high. Post-tax margins were already very high even before the onset of the Great Recession. Financial markets, therefore, are in uncharted territory in terms of being able to judge the sustainability of these elevated profit margins.
Continued Labour Under-payment Helps Margins
The inception of the World Trade Organisation has reduced the pricing power of US corporations. In recent years, a major increase in the global labour supply has put the onus of profit creation on keeping the cost function under control. In the US and other developed economies, this has invariably meant real wages lagging productivity, thereby boosting profit margins. A key future factor will be whether the global supply of labour can still succeed in keeping US real wages suppressed.
Three years after the end of the Great Recession, we are still trying to gauge the new and likely potential growth rates of the developed countries. This is seen as a particularly difficult task following a period where financial excesses have been replaced by repression. My best guess is that potential GDP growth which has been lowered across the developed world will result in stubbornly high unemployment. This will also suppress workers’ compensation share of GDP.
Is this a good outcome?
The high level of corporate profit margins prior to the Great Recession was also partly attributable to real wages wage being suppressed. Households filled this void through exposure to higher leverage, but this option however is no longer available in the post-Great Recession world. Non-availability of this option should imply slower top-line growth at corporations, but this result is not a particularly good outcome for corporate profits. The lack of organic top-line growth and pricing power in developed markets could force companies (once again) to buy growth through mergers and acquisitions or to expand further into developing markets.
The 1982-2000 Bull Market Did Not Require Extreme Income Distribution
The fixation with maintaining high profit margins produced unsustainable economic and financial imbalances in the last US expansion. More importantly, it failed to produce sustained p/e multiple expansion. Ironically, more balanced workers’ compensation and profits growth would have enhanced the sustainability of economic growth. The 1982-2000 bull market did not see such extreme gaps between corporate profits and workers’ compensation shares of national income.
In the meantime and in summary, US equities currently appear cheap against a richly-valued government bond market. In absolute terms, they are slightly cheap versus historic norms. Rising bond yields, when they occur, should not de-rail equities, as long as a high profitability at US corporations is preserved. The worst outcome, though unlikely at present, would be rising bond yields coupled with badly faltering profitability.
