So much commentary in the financial media, as well as my own missives, are being centered on the short and intermediate term events and trends. Today I’d like to step back a bit and look at the market and the economy from 30,000 feet up. To start off I’d like to point readers to the analysis done by Andy Lees from UBS whose comments to his clients was posted in Barry Ritholtz’s blog (click for link), with a portion of the commentary provided below.
The trend has been going for almost 35 years, so surely that just means that the economy has continued on a similar development path for the whole of that period.
Figure 1. The Wilshire 5000 (1971 – 2008)
That trend, however, has been based off declining demographic dependency ratios, outsourcing, and of course the availability of cheap energy. All of these trends look as if they are set to reverse; the dependency ratio with certainty (with the 2ndry effect of pension funds selling down assets) and the cheap energy & therefore outsourcing, almost certainly.
There are of course other trends such as technological improvements and efficiency gains, as well as debt growth etc., but these are themselves totally reliant on the bigger trends mentioned above; ie they cannot happen in isolation.
The trend is your friend. Theoretically, you should not bet against that trend continuing, and that is what a lot of people will say; why will it be any different this time? The point is betting that the trend will break is, in fact, betting that things will stay the same. The trend in equities is just a reflection of the underlying fundamentals, and given that we know that these are changing, then betting that equities will continue to go up whilst these underlying fundamentals are changing structurally, is completely illogical. It’s not only illogical but it is also expensive, as life and pension funds with liabilities the other side, will tell you.
At some stage, the printing presses will be turned on sufficiently far that the equity fall just becomes a derating rather than a nominal fall, but for now, my bet is that this trend is likely to start to break down.
Mr. Lees was correct in his analysis that the trend would break down and an update to his chart is given below, which clearly shows the trendline from the 1982 lows (red line) has been broken with the trendline from the 1974 lows (white line) still intact.
Figure 2
Source: Bloomberg
Mr. Lees is correct to point out that secular trends in both the economy and stock market have fundamental underpinnings and demographics play a major role. I pointed this out back in March in an Observation entitled, “Change We Can Believe In: The Slow Decline of the U.S. Consumer.” How demographics shape the secular trend was shown in the above-mentioned Observation and is pasted below.
Change We Can Believe In: The Slow Decline of the U.S. Consumer
The core demographic for consumption is the age group that is entering their prime in terms of income generation from climbing the corporate ladder, whose higher incomes translate into greater consumption. The distribution of consumer spending reflects a bell-shaped curve in which the middle-aged demographic represents the largest income brackets while the younger and older populations represent the lower income brackets. This can be seen in the figure below with the middle-aged group (35-44) having higher incomes than the lower (25-34) and upper (>65) age groups.
Figure 3
Source: U.S. Census Bureau
This concept is important as a rising population of the higher income demographic relative to the lower income demographic represents a shift in total aggregate spending. When the higher income bracket population relative to the lower income bracket falls, so too will the rate of change in aggregate consumer spending and vice versa. As a rise in the rate of change in consumer spending increases with the higher earning income’s relative population so too does the stock market which reflects a rise in GDP from the rise in consumption.
This correlation can be seen when looking at the history of Japan in over the last 50 years. Japan’s post-WWII baby boom created in 1990, which was roughly the same year that Japan’s Nikkei 225 index peaked. Since the baby boom demographic peak seen in 1990, Japan has suffered from a rising retiree population and a deceleration of consumption spending as the higher income earners retired and the lower income earners grew in relative numbers. It is no coincidence that the bottom of the Nikkei 225 also coincided with the trough in the relative population ratio of the 35-49-year-old to 20-34-year-old groups, with aggregate consumer spending likely to rise at an accelerated pace over the next decade in Japan as the higher income population grows in relative size.
Figure 4
Source: U.S. Census Bureau
This same concept of the ratio between the higher wage earner and spender (35-49) relative to the lower wage earner and spender (20-34) relating to aggregate consumption and stock prices has also played out in the U.S. as shown below. The figure shows peaks in the relative population demographic coinciding with peaks in real stock prices (S&P 500). Below we see three peaks in the relative demographic ratio with the first coinciding with the Great Depression, the early 1960s, and also at the turn of the millennium. Moreover, we also see that rising real stock prices are associated with rising relative population ratios of the higher wage earner relative to the lower wage earner.
Figure 5
Source: U.S. Census Bureau/Robert J. Shiller
Part of the reason the rising relative population demographic coincides with rising real stock prices is that the greater percentage of your workforce resides in the older age group (35-49) relative to the younger age group (20-34), the more productive is your aggregate workforce. Rising productivity is associated with rising stock prices. Remember the 1990s with the advancement in technology and the explosion of the NASDAQ and general stock market.
Figure 6
Source: U.S. Census Bureau
While there is a positive relationship between productivity and relative population demographics, there is a negative relationship between productivity and inflation. As such, we can connect the dots and then infer that there is a negative relationship between inflation trends and relative demographic trends with productivity trends providing the associating link. The inverse relationship between relative demographics and inflation rates can be seen below as peaks in the smoothed CPI inflation rate roughly coincide with relative demographic troughs and vice versa.
Figure 7
Source: U.S. Bureau of Labor Statistics/ U.S. Census Bureau
With the above relationships established we can begin to look at what the future may hold with relative population demographics holding the key. As seen in Figure 5 above, the relative demographic ratio peaked in 2000 and was coincident with the real S&P 500 peak, and does not bottom until 2015. Because the ratio continues to decline for another seven years we can expect productivity gains to be on a declining trend until 2015, and subsequently, infer that inflation trends will also be with us until 2015.
The conclusion is that the secular bear market we entered back in 2000 will not likely end until roughly 2015, and the secular inflationary trend that began in 2003 will be in place until 2015 as well. This time frame makes sense when looking at the historical script of secular inflationary events that typically last roughly 17 years when excluding the protracted 1879-1920 event. The actual bottom in the year-over-year (YOY) rate of change in the CPI came in 1998 at 1.55%, with the smoothed rate bottoming in 2003 at 2.45%. Taking the average secular inflationary length of 17 years and using 1998 as the disinflationary bottom and you get 2015, also the bottom in the relative demographic ratio which should correspondingly mark the peak in inflation and bottom in productivity gains.
Figure 8
Source: U.S. Census Bureau
With the above analysis presented it is my assumption that we are in a secular bear market for stocks and I’m not the only one. Commentaries from two other analysts are presented below and I recommend listening to the entire BNN interview with Daniel Park back in August of this year (click image below for link).
The Elusive Bottom
David Rosenberg Conference Call Notes (08/14/08)We Are in a Secular Bear Market
With that being respectful of the fact, I believe we're in a secular bear market. I don't even think that's an opinion anymore. I think it's a stylized fact. If you saw it, Rich Bernstein put out his performance asset mix table. Out of all the asset classes, stocks, cash, bonds, commodities, the only one to have a negative inflation-adjusted return over the past 10 years is the S&P 500. So I think we have to be honest about this. If it's something like a 1929 and 1955 or 1966, 1982 type of secular bear market, I think this one actually started in 2000, it doesn't mean that you don't get cyclical bull markets along the way. We actually had a cyclical bull market in the context of a secular bear market that actually took the S&P to a new high. Of course, as I said before, half of that was unprecedented leverage, the stone process of unwinding.
I think that it is important now to recognize for our clients that we have a cyclical bear market being overlaid into a secular bear market. I think the message that we're trying to send is that there is a different investing style and strategy for every part of the business cycle. One part of the business cycle is all about adding ... data and risk to maximize your turns. Then there are times when it is all about preserving your capital and focusing on income, earnings, stability and dividend growth. I think that's where we have been, and I firmly believe that's where we will continue to be, at least over the course of the next 12 months.
BNN: The Street (08/21/2008)
Danielle Park, portfolio manager, Venable Park Investment Counsel.
The number one thing people have to get is that we are in a fundamentally different climate now than we were 82-99. And it means you can’t do the same old stuff and expect to do well. You can’t buy always, you can’t hold always. You have to have a strategy that exposes you to the expansionary part of each business cycle, and protects your capital when it turns down…
We are off about 20% in the U.S. from the peak, I think we are halfway through what we could see, and in Canada, I think we’re lucky if we’re halfway through.
Under the assumption that we will continue to be in a secular bear market the question becomes, what is the next seven years to look like? We can compare the current environment to either the late 1920s stock market peak and Great Depression or the stagflationary 1970s. The comparison of both events with the current is shown in the figure below that measures the peak in real stock prices normalized to 100, with the time frame shown 12 months prior to the peak until several months after the eventual bottom in real stock prices. Seen below, the Great Depression saw real stock prices peak in September 1929 and bottom in 1932 resulting in an 80.6% drop in real stock prices over three years. The stagflationary 1970s saw real stock prices peak in December 1968 and bottom in July 1982, a 62.6% decline over 14 years. So far the current environment more closely resembles the 1970s secular inflation event as the peak in real stock prices occurred in August 2000, and we have breached the lows set in 2003 in real terms (data shown below is only updated until August 2008) and are still declining.
Figure 9
Source: Robert J. Shiller
The price action in the current secular bear market is not the only factor that leads me to believe we will go through a prolonged inflationary plunge in stock prices rather than the short and acute action seen during the Great Depression. The action of the Fed itself in the current experience relative to its action during the Great Depression also lends evidence to the 1970s prolonged correction rather than the short acute correction seen in the 1930s. As the market began to sell off in 1929 and 1930 the Fed was still slowing the money supply and didn’t begin to reflate until 18 months after the peak seen in the stock market. It took 15 months after the Fed began to reflate in late 1930 before the market bottomed.
Figure 10
Source: Standard & Poor’s/St. Louis Fed
However, in the current environment, the Fed's reaction time has nearly been cut in half as the Fed began to reflate only 11 months after the market's peak with the actual bottom in the money supply's growth rate occurring only 6 months after the market's peak. Because the Fed's reaction time has been much sooner than during the Great Depression we are likely to see asset inflation rather than deflation.
Figure 11
Source: Standard & Poor’s/St. Louis Fed
I would like to point out that nominal stock prices bottomed in 1974, though real stock prices continued to decline until 1982. Moreover, the S&P 500 lost 42% of its nominal value from January 1973 to September 1974, proving that you can have significant ASSET DEFLATION within the context of a SECULAR INFLATION environment.
Figure 12
Source: Robert J. Shiller
The asset deflation that occurred during the 73-74 bear market and 73-75 recession gave way to significant asset inflation that saw the market up 62% in just over a year and a half. This can also be seen below which shows the S&P 500’s deviation from its 10-year moving average, which turned positive after the end of the 1974 bear market.
Figure 13
Source: Standard & Poor’s
During the early 1970s experience, the stock market bottomed 20 months after the 1973 peak. I am using the 73-74 bear market as a good comparison to the current situation and a 20-month correction would place the bottom in the stock market in June of 2009. From there we are likely to see asset reflation from all of the Fed printing going on with nominal stock prices rising while real stock prices continue to decline.
If I am correct in assuming that we are still in a secular inflationary environment as well as a secular bear market, then the trends in place will continue until roughly 2014-2015. Looking at the 1970s secular inflation episode showed that commodities were not immune to the sell-off in the 73-74 bear market, though they outperformed paper assets by a significant margin until the secular inflationary environment peaked later in the decade. We can thus expect hard assets to continue to outperform paper assets once reflation takes hold, while some more pain may still be in the cards in the short run.
Regardless of whether we follow the Great Depression event or the 1970s stagflation decade, there is a consequence to creating money out of thin air, and that is a sizable move in gold and a devaluation of the currency. While gold corrected 23.7% from 1930 to 1931, it later rose nearly 120% as the Fed’s reflation campaign began to take traction. The reflation campaign of the middle 1970s saw the dollar index plunge the rest of the decade, something we are likely to witness as well as a consequence to run away deficits and Fed monetary expansion.
Figure 14
Figure 15
Source: Bloomberg
While commodity bulls have been shaken to the core (or any bull for that matter) they are no different from those in the middle 1970s. Marc Faber in a Bloomberg interview pointed out that during the 73-75 recession people thought and acted as though the world was going to end, quite similar to the current environment. The key is to get the big picture right or the secular environment trend. Within the context of a secular trend are cyclical moves. For example, as Daniel Park points out in the interview above, we got a cyclical bull stock market from 2002-2007 in the context of a secular bear market that began in 2000, and we are now in a cyclical bear market within the context of a secular bear stock market. There is no doubt that we are in a cyclical bear market in commodities (and virtually everything), though I would maintain this is within the context of a secular bull market that began in 2001 and not likely to end until the middle of the next decade. At least that’s how I read the tree leaves when browsing the historical data.
