Load of old bull!

“I’m going to hit you so hard that when you wake up your clothes will be out of style” (Brandon Walsh, The Goonies 1985)

Out of the depths...

If the level of the S&P 500 is the number that best describes the degree of US economic virility, then the moment that it sunk to 666 on March 9th 2009 surely needs little further context. Unsurprisingly, there was no one calling for this point to mark the beginning of a decade long record bull market in stocks, returning well over 400% (including dividends). Quite the reverse. Many well respected talking heads were calling for further sharp losses. One hedge fund manager even admitted to advising some well off clients to buy shotguns to protect themselves against inevitable social unrest if the market fell any lower. This week we look at some of the real reasons why the stock market has risen so far for so long and whether it can continue.

Why?

Stock markets are primarily based on the path of corporate profits. Most years corporate profits grow, much like the underlying global economy, so share prices and total returns follow suit. There are other factors that go into it of course – the amount of money investors are willing to pay up for today’s corporate profits is based on an estimation of the value of all future profits, factoring in as many of the related risks and opportunity costs as is feasible. Nonetheless, when looking for explanations for why stock markets make significant and sustained moves, corporate profits are usually your starting point.

This focus allows us to sideline some of the more common explanations for this record Bull Run which tend to revolve around a combination of central bank largesse (QE), share buy backs and, latterly, President Trump. In reality, the strength and length of this bull market has its origins in the severity of the downturn a decade ago. 

The related decline in US corporate profits in 2008/09 was the largest proportionate fall on record, larger even than that seen in the Great Depression. Rolling “as reported” four quarter earnings fell by over 90% between mid 2007 and early 2009. However, the cause of this dramatic fall in earnings was also the seed of their dramatic bounce. Write downs of financial assets at banks, insurers and some large manufacturers with substantial financing departments trounced corporate earnings as they travelled from balance sheet through the profit and loss statement. However, when the write downs stopped, some very large negative items disappeared from profit and loss statements resulting in a proportionally faster rise in corporate profits – a 90% fall was followed very swiftly by an 800% rise in corporate profits the next year. US corporate profits are now 15 times, or c.1400% higher than the low point reached in 2009, as companies have benefited from a world economy that has consistently confounded its many detractors.

QE certainly played a role in helping the economy find its feet again and, in lowering the discount rate for stocks, has surely supported valuations. However, the absence of the kind of stock market exuberance that characterised the end of the last millennium suggests that this has been a supporting rather than centre stage role. For their part, share buybacks can only feasibly explain a tiny proportion of the returns. Meanwhile, this US administration has certainly presided over a jump in corporate profits, but there remains justifiable scepticism as to whether the recently enacted tax bill has changed the trend in economic growth or corporate profits, which is the more important point to consider for investors.

What next?

You might argue that the record breaking nature of the recession experienced by the US and world economy between 2008 and 2009 always suggested that the recovery from those depths could be similarly record breaking in nature. The fact that private sector scar tissue and a suitably chastened banking sector are only just starting to more visibly recover is among the factors suggesting that there is scope for this recovery to go further yet – the wild cyclical hubris that tends to precede the worst recessions remains substantially absent so far. Recessions and bear markets tend to go together - while the economy continues to grow, the Bull Run should continue.

As always humility and, its investing counterpart, diversification are appropriate here. Our ability to accurately call recessions is very limited. The International Monetary Funds’ analysis of recessions in the developed world since 1960 only managed to find triggers for half of their sampled recessions – the remaining half were unexplained. Even so the indicators that have traditionally been of some use in predicting recessions, from the ISM manufacturing survey to the US yield curve are not currently flashing amber, suggesting that there is room for this bull to run further yet.

While it is almost impossible to predict when this bull market will peak with any degree of certainty, history also shouts of the rewards that have accrued to the long-term approach. The chance of the market going up or down on any given day has historically been equivalent to a coin flip, roughly 50-50. However, over the long run, investors have been much more likely to experience a positive return, with rolling 1- and 5-year returns positive 80% and 90% of the time, respectively.

How to prepare for the end

In such a context, designing a portfolio that is designed specifically to weather recessions and bear markets is one of the most common, but understandable, investing mistakes. The truth of the world economy and its related capital markets is that growth is the norm not the exception. Recessions have been becoming less frequent and severe over time in spite of appearances and much commentary. Long term investors should simply ignore recessions and focus on the prospects for growth, which remain reliably founded on man (and woman) kind’s continuing restlessness and ingenuity. For those oriented to the short term, stocks should always be relegated to a fringe part in portfolios. Our continuing tactical tilt towards developed and emerging stocks nonetheless argues that there are attractive returns still to be gleaned from stocks in the next 6 – 12 months.