Why Talk of a Secular Bull Isn't Just a Bunch of Bull
This is how beat up the American stock investor’s psyche is: Even though the Standard & Poor’s 500 had nearly doubled from its March 2009 lows by year-end 2011, and even though the major equity indices had their best first quarter in decades the first three months of 2012, money kept flowing into bond and out of equity mutual funds. But there is a silver lining. History shows secular bull markets in stocks tend to start when things look their worst—when the individual equity investor has given up. This is among the reasons why Steve Auth, Federated’s chief investment officer for equities, believes we are in the early stages of a secular bull, an out-of-consensus view that’s gaining traction on Wall Street.
The start of the last two secular bull markets—1932 to 1965 and 1974 to 2000—shared some common themes. Economically, things were a mess. Unemployment was extremely high, the economy was shrinking dramatically and the financial system was in crisis—more so at the start of the Great Depression than in the mid-to-early 1970s. But the latter period had to deal with some systemic issues. The bankruptcy of Penn Central raised questions about the role of banks in the corporate commercial paper market. And Franklin National Bank’s ill-fated foray into Europe forced the Federal Reserve in 1974 to step in to protect the deposit certificate market that helped finance global trade.
Both periods also saw the country’s political establishment tack decidedly to the left. Franklin Delano Roosevelt’s election in 1932 ushered in the New Deal and the era of Big Government and entitlements with which we are now wrestling. And the fallout over the Watergate scandal not only brought down a Republican president; it also spawned substantial Democratic gains in Congress in 1974 (newly elected House and Senate members, known as “Watergate Babies,’’ tended to be more liberal than the existing Democratic caucus), as well as the 1976 election of President Jimmy Carter.
Interestingly, these same characteristics very much can define the 2006-to-2009 period. Democrats regained control of Congress in the 2006 midterm elections, with San Francisco liberal Nancy Pelosi becoming Speaker of the House. Two years later, President Barack Obama won a convincing victory over his challenger, U.S. Sen. John McCain. During this span, the housing market collapsed, the economy cratered, unemployment soared to its highest level since the early 1980s and the financial system faced its toughest test since the 1930s.
In other words, the same economic and geopolitical conditions that ushered in the start of the prior two secular bull markets were in place in early spring 2009 when a new secular bull arguably began.
Bonds vs. stocks
Of course, history is a guide, not a guarantee. So what are some other characteristics that potentially signal a secular upturn for equities is underway, and the recent run-up from the 2008 meltdown is not just a shorter-term cyclical bump in a still secular bear market?
One of the most compelling arguments comes from the side of the investment aisle that has been extremely popular during, through and in the aftermath of the global financial crisis—bonds. Over the last five years, bond funds have had $1 trillion of inflows, cumulatively running about $750 billion above the normal pace. Over the same period, equity funds have not seen any inflows. Forget for a moment that this leaves investors extremely underweight equities, itself a strong argument for stocks over longer periods.
Let’s first consider why bonds have been so popular, and performed so well. Ever since President Carter appointed Paul Volcker chairman of the Federal Reserve and President Ronald Reagan left him there to pursue a monetary policy aimed at driving down inflation, the country has been living in a disinflationary world, with interest rates trending down. This has represented a very good environment for bonds, particularly over the last dozen years, when investors—shell-shocked by the damage done by the dot.com collapse in 2000 and the global financial crisis eight years later—largely abandoned equities for the relative safety of fixed-income investments. Short of a renewed global recession, interest rates really can’t go any lower—and arguably would be higher without unprecedented intervention by the Federal Reserve. The same holds for inflation, unless there is a deflationary spiral that few foresee.
More fundamentally, what goes down eventually comes back up. Research by BMO Capital Markets notes that the 2000s represented a “lost decade” for equities, with the compounded annual return on stocks declining 1.7% on average—the worst average return for stocks in any decade since 1930. Bond returns, on the other hand, generated compounded average annual returns of 5.4% over the same period, an above-average performance that caused bonds to outperform equities by an average 7.7% in the 2000s, the largest differential on record, according to BMO. BMO notes, however, that in the other two decades in which bonds outperformed equities (the 1930s and the 1970s), stock returns outpaced bond returns in the following two decades by an average of 10%.
This isn’t Armageddon
It’s not just that investors have been spooked by—and away from—equities (the 12-month average trading has plunged from its 2010 peak of 18 billion to below 11 billion, and trading volumes among all U.S. exchanges in April 2012 were 50% below 2008 levels). The economy of the past decade really was nothing like it was in the 1980s and 1990s. Job growth, when it occurred, was more modest in the 2000s. So was economic growth. Layered over this were a flood of corporate and executive scandals—Enron, Tyco International, Bernie Madoff. And topping it all off was the worst recession since the Great Depression, a meltdown of the global financial system that left many fearing that the world’s economy was on the precipice of Armageddon.
Perhaps it was. But that’s not the case any longer. Whatever your political/ideological bent, the reality is that global governments and central banks stepped in with unprecedented and coordinated actions, unfreezing the credit markets, spurring growth and getting the wheels of commerce to start grinding again. The legacy costs of this massive intervention remain to be determined, particularly here in the U.S., which ran up record debt and now faces a fiscal cliff of tax increases and spending cuts at the end of 2012 that various estimates conclude could slash from 3% to 5% off nominal gross domestic product (GDP), potentially sending the country back into recession. Most informed observers believe it is unlikely to get that far regardless of which party wins in November, though the acrimonious relations between the two major parties and the White House and Congress could make for some tense moments in the markets. But if it’s a Republican sweep, the potential exists for the adoption of extremely pro-growth policies and the end to various government programs and regulations that seem only to be adding to costs and uncertainty.
Before digressing too much from the case at hand, the point is Armageddon didn’t happen and short of government fumbling the ball after this fall’s elections, it most likely won’t. The economy is and should continue to get better. Job growth has picked up. Consumers have been spending and are now exhibiting the willingness—if not the need—to borrow again from lenders that appear more willing to oblige. Housing is showing signs of picking itself up off the ground. Manufacturing has been expanding with little indication of a pullback or capacity restraints. In short, what the Great Recession appears to have done is wring all of the excesses out of the economy—and more—leaving up as the only way to go.
Europe is a mess but so what?
Of course, every secular market has its cyclical bumps—we could be going through one now, a sort of sideways market that will see some pullback, followed by some push up. This really has been the case since the spring of 2009, in which run-ups in stock prices have been followed by sell-offs. Concerns about a Greece default and severe slowdown in domestic hiring spawned fears of a double dip and a market sell-off in the summer of 2010. The market behaved in a similar fashion the following spring and summer after the Japanese tsunami, a new round of euro worries and debtceiling showdown raised fears of potential recession again.
This year, it’s euro worries, round three, and the aforementioned looming fiscal cliff. These ups and downs have generated a sort of risk-on, risk-off rollercoaster, with uneasy stock investors rushing to the exits and into the haven of Treasury securities at almost every seeming negative surprise, be it unexpected jumps in jobless claims, spikes in Spanish or Italian bond yields, or disappointing reports suggesting China’s economy may be slowing too much. These swings in market volatility have tested the convictions of even the most optimistic investor. Notably, however, with each new aftershock, the waves of volatility have gotten smaller, suggesting a diminishing hangover from the 2007-09 recession and market meltdown.
This is not to downplay the significance of what is happening in Europe, nor to underestimate the role the Fed and other central bankers have played in keeping periodic panics from deteriorating into something worse. Unprecedented easing has helped prop up the Western economies, forestalling a potentially far worse U.S. recession and, in the case of Europe, a possible refreezing of the credit markets. Until the markets settle down and the aftershocks diminish into ripples, investors may be better served by focusing more on equity than on index selection—that is, on individual stocks over sectors or ETFs. ISI Global recently noted that cross correlations within the S&P 500 hit a 10-year record low after setting a record high just nine months earlier, and that the cross correlation between asset classes also is low. Low cross correlations are associated with stock-picking strategies.
Focus on the fundamentals
The biggest forces behind a budding secular bull are the fundamentals, both in a global macro sense and among various equity metrics. It’s conceivable that, at some point in 2013, the U.S., eurozone, China and Latin American economies will all be expanding at the same time. China’s real estate crisis isn’t anywhere near as big as some make it out to be, and its authorities appear committed not only to further easing, but also to doing whatever it takes to keep their economy growing. As essentially a one-party autocracy, China also has wherewithal to act in its interest without the sort of internal debates and gridlock that mark what’s happening in Washington these days.
Europe would appear to be more problematic. Clearly, the peripheral southern countries have some work to do, and some pain to suffer. But their overall impact on the eurozone economy shouldn’t be overstated, and the evidence suggests that the rest of Europe is more likely to grow than contract in coming years. The European Commission is forecasting slight eurozone growth in the second half of this year, followed by modest expansion in 2013. As for the U.S., expansions—the point at which GDP has recovered to where it was before a recession begins, which in the current case was in the summer of 2011—historically have tended to last roughly five years trough to peak in the post-World War II era, and eight years in the past three decades. This would suggest the current expansion is still in the relatively early stages (GDP troughed in the spring of 2009).
Then there are solid corporate fundamentals. Balance sheets are strong, with cash and equivalents at or near record highs. After another quarter of more profit beats than misses during Q1 2012, forward earnings on the S&P 500 now stand at $110 for 2012, a record high. Since the start of this expansion, JP Morgan research shows the corporate share of GDP has grown at its fastest pace since WWII, and each expansion with rising corporate share is associated with a secular multiyear bull market. Moreover, valuations are very attractive, with price-earnings multiples at levels that historically have been associated with bull markets. Equity risk premia, a measure of relative valuation, is at 60-year highs. Finally, as we’ve previously noted, the appetite to own equities seems to be at an all-time low, coupled with the historical underperformance of equities versus credit. Take it all together, and the case for a secular bull market seems far from far-fetched; it seems quite reasonable.
- Secular bull markets typically start when the economy is a mess, the political environment has shifted to the left and individual investors have abandoned stocks. Such were the conditions in spring 2009, when a secular bull market arguably was first taking flight.
- From a contrarian perspective, the appetite to own equities is very low—a long-term positive for stocks. Over the last five years, a period in which equities generally underperformed bonds, bond funds on net have had $1 trillion of inflows while equity funds on net have seen outflows.
- Armageddon didn’t happen and, short of government fumbling the ball after this fall’s elections, most likely won’t. It’s conceivable that, at some point in 2013, the U.S., eurozone, China and Latin American economies will all be expanding at the same time.
- Led by strong balance sheets and both cash and earnings that are at or near record highs, corporate fundamentals are solid. And stock valuations are very attractive, with price-earnings multiples at levels that historically have been associated with bull markets.