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Wednesday, January 27, 2016

The Post-War History of the American Stock Market

Summary
My entire life has been spent in the duration of a single economic event: the rise and fall of interest rates surrounding the interest rate peak of 1981.  Changing interest rates greatly influenced stock prices and economic growth, beginning in the period of optimism following World War II, and ending with the extreme economic cycles of the past 20 years.   The largest changes in stock prices have been the result of changes in interest rates and market psychology, expressed as the Price-to-Earnings Ratio (or PE) for the Standard & Poor’s 500 Index.  The S&P 500 Index is a basket of 500 of the largest companies in the American economy, weighted according to market capitalization.

The American economy has suffered from a succession of economic booms and crashes during the past 20 years.  These uncontrolled economic cycles are very damaging to economic efficiency, to society and to individuals.  Congress and Federal financial regulators must be judged harshly for their failure to stabilize the American economy over this period.

The outlook for the stock market over the next 20 years must be fairly pessimistic, considering the historically low interest rates in the current economy, and the high valuation of the market in terms of the PE ratio of the S&P 500 Index.

Post
In early December, the United States central bank (The Federal Reserve) raised its official interest rate on loans to member banks from zero to one-quarter point.  The Federal Reserve rate had been essentially zero for seven years, as a policy for economic stimulus following the recession and market crash of 2008.   This policy, and the “quantitative easing” programs (i.e. printing money) were successful in restoring market asset values to pre-recession levels, restoring business confidence, and lowering the unemployment rate from over 10% to less than 6%.  This action marks a turning point in the interest rate history of the past 30 years; it marks the end of a sixty-year economic cycle.  Let’s look at the broader history of interest rates and the stock market over that cycle, to see what lessons the past cycle offers, and what the future might hold. 

The history of interest rates in the United States has been surprisingly simple over the past 60 years.  Interest rates were low immediately following World War II, and rose steadily to reach a peak in 1981.  Following the peak, rates fell slowly and steadily, to form a chart as symmetrical as a mountain peak. 
The performance of the stock market depends strongly on interest rates.  The broad peak in interest rates determined the valuation of the stock market over the past 60 years.  Stock market performance in the post-war era can be divided into three distinct periods, based on stock market valuation and behavior.  The combination of rising interest rates, return to full employment in the economic cycle, and relatively high valuation suggest that weak performance should be expected in the stock market in coming years.

This post is about the United States economy and stock market.  Much of the world’s economy is linked to the United States economy, but other areas face different challenges and risks.   Western economies and Japan are at risk for deflation and cyclic recession.  China and other developing economies have invested too much and grown too quickly; these economies face slowing rates of growth, and risk of credit defaults on bad infrastructure investments.  Oil dependent economies will struggle due to the crash in oil prices.  Russia and Eastern Europe will suffer due to the combined influences of the deepening recession, low oil prices, economic sanctions, and economic damage from the war in Ukraine.  All of these events will have some impact on each other, because everything in today’s global economy is connected.

The Interest Rate Peak of 1981
My entire life has been spent in the duration of a single economic event.  That event is the interest rate bubble which peaked in 1981.  Interest rates in the United States began rising in 1955, shortly before my birth, peaked in 1981, and have been falling steadily ever since.


The event is clearly seen in the chart of long-term interest rates, specifically, in the nominal interest paid on the ten-year United States Treasury Bond.

Short-term rates follow long-term rates, as seen in the composite chart of 10-year, 5-year, and 1-year bonds.  Bonds issued by businesses and local governments, and private loans all follow the trend of the Treasury bond, with appropriate adjustments for risk.


The interest rate peak in 1981 was driven by the Federal Reserve, under the direction of Paul Volker.    In the post-Vietnam War period of the 1970s, inflation surged due to repeated price shocks in the cost of imported crude oil.  High interest rates in 1981 tamed inflation, at the cost of one of the deepest recessions in post-war history.   The Federal Reserve, ever vigilant against inflation, lowered interest rates very slowly over the next twenty years.

Interest Rates and the Stock Market
The Treasury bond yield has historically been considered a zero-risk rate of return, because in theory, the government will not default on its debt.  The government can always print more money.  Whatever the actual risk of a government default, the zero-risk yield point is a useful starting point for financial calculations.

Investors require additional compensation to invest in stocks and bonds that are riskier than a Treasury bond; therefore stocks and non-Treasury bonds carry a “risk premium”.  The expected return on these investments is higher than the Treasury bond return.  The prevailing interest rate will be the zero-risk rate, plus a risk premium for a given investment.  Central banks can intervene in the economy by changing the base zero-risk interest rate. 

Stocks and existing bonds compete with new bonds for capital investments.  When prevailing interest rates change, the value of stocks and bonds changes.

The concept is easy to illustrate with a simple example.  Consider a one-year bond with a value at maturity of $1000 which pays 5% at maturity.  The bond holder will collect $1050 in one year.   If interest rates rise, such that a bond with identical risk will pay 7%, the value of the first bond will fall.  Investors can buy a new bond carrying the 7% rate for $981 dollars, and will collect $1050 in one year.  The value of the first bond will fall to $981, because at that price, investors are indifferent to holding the first bond or the second bond.  A two percent rise in interest rates produces approximately a two percent fall in the value of the bond.

High interest rates also impair the profitability of businesses by increasing the cost of borrowing.  Further, the inflationary environment which is causing high interest rates also creates business uncertainty, which impairs the efficiency of the economic system, and overall economic growth.

Stocks and bonds are similar in many ways.  The value of a bond is the sum of the present value of all future coupon payments, plus the present value of the bond at maturity.  The value of a stock is the present value of all projected future cash flows, modified by speculative assessment of the potential growth of the company or the liquidation value of existing assets.  Both stocks and bonds compete for capital with bond investments at new rates.  Therefore, the value of both stocks and bonds vary inversely with changing interest rates, falling when interest rates rise, and rising when interest rates fall.

We can see the how interest rates and stock prices vary inversely by looking at stock prices before and after the interest rate peak of 1981.  Interest rates began climbing in the mid-1950, with the yield on the 10 Year Treasury bond rising from 3% in 1955 to 5% in 1968.  As interest rates rose above 5%, stock prices began a long decline from 1968 to 1982.  An investor in the S&P 500 Index in December 1968 would have lost 63% of his money (adjusted for inflation) by July, 1982. 



When interest rates began to fall, after the peak in 1982, stock prices began to rise.   As interest rates fell from 14% to 5%, stock prices rose.   An investor in the market in July 1982 would have made more than a six-fold gain by August, 2000. 



At the end of the rise in interest rates, stock valuations were cheap, which set the stage for the huge gains in the next eighteen years.  In the mid-j1960s, and again in the year 2000, stock valuations were expensive, which sets the stage for a fall in prices.  Quantifying whether stocks are cheap or expensive is not easy.  Later, we will use the Cyclically Adjusted Price-to-Earnings Ratio (CAPE, or Shiller PE), as a measure of stock valuation, and see how well that measure predicts future stock price performance.

Periods of Market Performance

The following chart shows the history of the market from 1948 to 2015.  The Standard and Poor's 500 Index, shown in green, represents 500 of the largest companies in the American economy, with stock prices weighted according to market capitalization.  The annual profits of those companies (earnings) are shown in red, at the same scale as the index.  The ratio between the prices of the stocks and the earnings, is known as the PE, or price/earnings ratio, shown in brown.  This ratio varies according to the optimism of investors, or their expectations about future prospects of the market.  Long-term interest rates are shown in blue.


This chart is fairly complex.  Stock market valuation can be divided into three distinct periods from 1948 to the present.  Those periods were marked by different movements of stock prices, depending on interest rates, economic growth, and optimism or pessimism on the part of investors.  

1948 – 1965:  Post-War Optimism, Bull Market
The post-war period from 1948 to 1965 was a time of great optimism in the stock market.  Corporate earnings were rising, and expectations, expressed as the price-earnings ratio, were also strongly rising.   Both corporate earnings and the PE ratio approximately doubled.  As a result, the S&P 500 Index increased four-fold over those years, an increase of nearly 9% annually over inflation.


1965 – 1991:  Bear Market and Economic Stagnation
Between 1965 and 1982, stock values fell substantially, and remained low until the 1990s.  Interest rates rose to record levels in the United States, hurting stock values.  By 1982, the S&P 500 had lost 63% of its value.   Most of the decline was driven by rising interest rates and market psychology; inflation-adjusted earnings fell only 7% over this period.  But the market PE declined by over 50%, cutting the value of the S&P 500 Index in half.

Earnings responded slowly to falling interest rates from 1982 to 1991.  Earnings over this period grew by only 13%, or about 1.5 % per year.   Investor optimism began to return, with a 70% increase in the PE ratio for the S&P 500.   The combination of slightly higher earnings and a substantial increase in the PE resulted in nearly doubling the stock index over that period, erasing some of the losses over the previous 17 years. 


In all, the period of high interest rates was not a good time for investors.  From 1965 until 1991, inflation-adjusted earnings had increased only 6%, an annualized growth rate of only 0.2% over twenty-seven years.  The PE ratio had fallen 18 percent; and the inflation-adjusted S&P 500 Index had fallen 13%.  Over twenty-seven years, investors’ only gain was through dividend payments averaging 3.9% annually, with a 13% total loss in market value.

1991 – 2015:  Boom and Bust Economic Cycles
From 1991 to the present, the stock market rose sharply, driven by rising earnings and falling interest rates.  This rise was interrupted by a number of cyclic bubbles and crashes.  Market crashes in 2000 and 2008 were caused by the collapse of investment bubbles in Internet technology and real estate, respectively.   Recessions following the bubble collapse severely impacted corporate earnings.    Unemployment during these years varied inverse with the S&P 500 Index.   

Overall, stocks did well from 1992 through June 2015, with a two-and-a-half fold increase in earnings, and a 50% gain in the PE ratio driving a three-and-a-half fold gain in value, adjusted for inflation.  At this writing, the market appears to be in a third major cyclical collapse, and some of those gains have evaporated.

The following chart shows market parameters from 1991 to 2015.   Note that the scale for the S&P 500 Index has increased substantially (until now, all scales have remained the same).   Also not that the PE ratio, the measure of investor optimism is displayed at the same scale as previous charts, but is now off the chart through much of the period, and remains high compared to most of the post-war period.  This reflects the "irrational exuberance" of investors, which Federal Reserve chairman Alan Greenspan warned about in 1997.  



The Post-1990s Market
The market since 1990 has been marked by three major cycles of growth, and two major market crashes.  The first major growth cycle was marked by extreme stock valuations; the PE ratio for the S&P 500 climbed to historic highs.  This is the time of the “Irrational Exuberance”, which was the phrase used by former Federal Reserve Chairman Alan Greenspan to describe the market.  Nobel Prize-winning economist Robert Shiller appropriately chose this phrase as the title of his book on behavioral economics.

The market crashes of the recent period are correlated closely with economic recessions.  The first crash was caused by collapse of the “dot-com” internet investment bubble, and the second crash was caused by the housing market collapse, (itself driven by poor lending standards and corrupt banking practices).  Both collapses resulted in deep economic recessions.  The United States unemployment rate shows a nearly perfect mirror-image inverse pattern to the price chart of the S&P 500 index.  This close relationship between the stock market and the unemployment rate is much clearer in the post-1990 market than in earlier market periods.

The performance of the Federal Reserve, Congress, and Federal financial regulators must be judged harshly for their management of the United States economy through this period.  The succession of economic crashes is unacceptable in terms of the damage to society and individuals caused by lost savings and employment.  The causes and consequences of these crashes is beyond the scope of this blog post, but the failure of government financial institutions to stabilize the economy must be noted. 


Future Path of the Stock Market
The future path of the stock market depends on interest rates, the economic cycle, and current level of market valuation. 

·         Interest rates have been falling for over thirty years.  Short term rates are essentially zero.  From zero, it seems fairly certain that interest rates must rise, unless the economy slips into a deflationary depression.  Eventually interest rates must reverse direction.  When rates rise, it will be a negative influence on stock prices.

·         Market psychology may take some time to adjust to rising interest rates.  An entire generation has grown up in an environment of continuously falling interest rates.  The expectations of investors and financial advisors have a bias toward falling rates and growth.  Those expectations may meet with disappointment.

·         The post-1990 economy has been subject to extreme cyclic patterns of growth and recession.  In the 1970s, economists believed that appropriate monetary policies might tame the business cycle.  However, subsequent history has shown that the Federal Reserve has been completely incapable of preventing cyclic patterns of over-investment, ill-advised credit expansion, and financial crashes.  In fact, since 1990, recessions and financial crises have been deeper and more damaging than earlier recessions.  It seems likely that cyclicity in the economy will continue.  There is a reasonable likelihood of another stock market collapse in conjunction with the next recession.

·         Economist Robert Shiller earned a Nobel Prize for his work on stock market valuations.  According to Shiller’s work, the valuation of the market, as measured by ten years of earnings history, is a strong predictor of long-term stock market performance.  The current high valuation of the market would forecast relatively weak market performance over the next 20 years.  The “Shiller PE ratio” will be the subject of another blog post.
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      Comment:
      I published an earlier version of this post in February, 2015, when it would have been much more timely.  Unfortunately, I realized I had made an error in my analysis, and deleted the post until I could correct the error. This is the correct post.  My apologies for the delay, and loss of timeliness in this information.

References:
Much of the data used in this posted was prepared by Robert Shiller, and made available on his website: http://www.multpl.com/
Some of Shiller's data was gathered and presented on another site, Open Knowledge Frictionless Data, http://data.okfn.org/data/core/s-and-p-500
I extend my appreciation to Dr. Shiller, and to OKFN.org for making the data available.

FRED Graph Observations
Federal Reserve Economic Data
Economic Research Division
Federal Reserve Bank of St. Louis
Inflation, Treasury Bond Yields
Robert Shiller
Shiller PE, S&P 500 Index, S&P earnings

46 out of 47 economists wrong about direction of interest rates in 2014.    Interest rate chart for 2014, showing steadily falling rates.

Inflation remaining stubbornly low.  Experts worried about deflation.

Sector Weighting of the S&P 500
                Information Tech                              20.7%
                Financials                                          16.5%
                Health Care                                        15.2%
                Consumer Discretionary                    12.9%
                Consumer Staples                              10.1%
                Industrials                                           10%
                Energy                                                  6.5%
                Utilities                                                 3%
                Materials                                               2.8%
                Telecommunications                             2.4%


Peter Lynch and Stock Market Valuation
My early education in the stock market was drawn from the writings of legendary investor Peter Lynch.   Lynch ran the largest investment mutual fund of his time, Fidelity Magellan, and achieved remarkable gains for his shareholders, averaging 29% annual gains from 1977 to 1990.   Every dollar invested with Lynch in 1977 would have grown to thirty five dollars when Lynch retired.  While Lynch outperformed his peers, and generated returns nearly twice the gain in the S&P 500 Index, it should be noted that Lynch spent his entire career in the middle period of post-war stock market performance.  Stock valuations were low, but rising.  As Lynch himself noted, it is easier to make money when stock valuations are low than when they are high.  It was nearly impossible to go wrong by investing during that time.
I applied Lynch’s guidelines with great success in the 1990s.   But Lynch’s advice is clearly dated.  Lynch recommends that an investor should never try to “time the market”.  Lynch recommends buying only those stocks whose growth rate plus the dividend yield is more than twice the current PE ratio.  In 1995, I could find many stocks meeting this criterion.  By the early 2000s, the typical stock had a PE equal to the growth rate.  By the 2010s, a quality stock has a PE that is more than double the growth rate.  Stocks meeting Peter Lynch’s recommended valuation no longer exist in the market.

Much of Lynch’s financial advice is timeless, such as his focus on company fundamentals.  But Lynch’s experience is limited to his envelope of experience, which encompasses a specific set of market conditions.   In particular, Lynch’s advice to never try to time the market needs to be re-examined in light of recent market performance. 

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