Why All the Gloom in the Midst of this Great Bull Market Run?
Why All the Gloom in the Midst of this Great Bull Market Run?
It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us, we were all going direct to Heaven, we were all going direct the other way – in short, the period was so far like the present period…
A Tale of Two Cities, Charles Dickens
We begin this investment commentary with a nod to Charles Dickens who wrote one of the great opening sentences in English literature in A Tale of Two Cities. And his sentiments remind us of today. Written in 1859, A Tale of Two Cities is a historical novel set in London and Paris before and during the French Revolution with its Reign of Terror. With her knitting needles always busy, Madame Defarge is vividly remembered by all who have read the novel. Looking at our present-day culture, which one pundit has described as “civil war without rifles,” Dickens could be describing American society now. And there are plenty of modern Madame Defarges who spit out their venom daily on social media.
As we will detail in this quarterly investment commentary, it has been the best of times in the U.S. stock market, but many think that we have been in the worst of times for everything else. Will the ubiquitous gloom and doom affect the stock market’s trajectory in 2022?
The U.S. stock market is in the 13th year of one of the greatest secular bull markets of the past hundred years. Since the S&P 500 Index hit its intraday nadir at 666 on March 9, 2009, the returns have been nothing short of sensational. Including dividends, the S&P 500 has advanced cumulatively over 800% since then, notching an average annual return of 18.8%. The chart below tells the story:
Many investors worry that the current bull market is getting long in the tooth, but it should be noted that there were two occasions when a secular bull market lasted four years longer than the current one. The table below compares these three markets:
One of the key questions, of course, is not when this secular bull market will end, but what occurs after it ends. As most experienced investors are aware, the bull market at the end of the 20th century ended in the “internet bubble.” From 2000 to 2002, the NASDAQ Composite fell over 77% and took 15 years to regain the high that it had reached in early 2000. At the peak of the internet bubble, the P/E ratio on the S&P 500’s forward operating earnings exceeded 25, and this rich stock market valuation was the main reason for the “lost decade” between 2000 and 2009 when the S&P 500 Index was down -9.1% cumulatively (including dividends). Many of our clients and friends with long memories do not want to go through this kind of stress and anxiety again and ask whether it might be time to take some chips off the table. In the space below, we catalog the list of problems and challenges that might bring this bull market to an end and juxtapose these issues with reasons why this bull market may continue for some years.
Doom and Gloom
Inflation: The Labor Department reported earlier this month that inflation soared 7% in 2021. This is the highest rate of inflation in 40 years. Core inflation, which strips out food and energy prices, rose 5.5% from a year ago. For most of last year, Federal Reserve Chairman Jerome Powell indicated that the rising level of inflation was “transitory.” In recent statements, he has dropped that terminology, although he, along with many economists, opine that inflation will moderate later in 2022. Others are skeptical that inflation will drop any time soon, as the huge fiscal stimulus to counter COVID-19 over the past several years has injected large amounts of cash in consumers’ pockets. Accordingly, there is heightened demand for many products. At the same time, 11 million workers have dropped out of the workforce, which is one of the key reasons for the supply chain issues. The combination of supply chain constraints impeding the supply of goods and services, and increased demand driven by consumers flush with cash due to the large increase in the money supply and huge fiscal spending, is a textbook recipe for higher inflation. Greater demand chasing fewer products and services. And inflation has the most negative impact on the working and middle classes. So this, perhaps, may be the biggest issue that investors will be watching.
Higher interest rates: One of the key missions of the Federal Reserve Bank is to ensure stable prices. And for several decades, they have succeeded in this goal. But now, with inflation apparently running out of control, the Fed has signaled that it will begin to rein in its easy money policies. Its program of purchasing $30 billion of U.S. Treasury obligations and mortgage securities monthly will end by March. It has also signaled that it plans to raise the Federal Funds rate a minimum of three times in 2022. But raising the Fed Funds rate from 0.25% to 1% is unlikely to counter a Consumer Price Index increasing at 7% annually. It is quite possible that the Fed will need to raise the Fed Funds rate to 2% or higher to counter inflation. In all likelihood, this will cause the yield on longer-dated U.S. Treasury obligations to rise as well. It is not inconceivable for the yield on the bellwether 10-year U.S. Treasury note to rise to 3.5% or higher. If this were to occur, the prices of fixed income securities would drop, and the P/E ratio on the forward operating earnings of the S&P 500 Index could easily decline from its current level of approximately 20.5. This might translate into a correction of 15% or 20% in the stock market. A yield on the 10-year U.S. Treasury of more than 3.5% would cause even more damage to stocks and bonds. Thus, a steeply rising trajectory of interest rates in 2022 is perhaps the biggest fear of investors. A rise in long-term rates could be even more damaging to the prices of stocks with high revenue growth rates but little or no earnings.
Stock market valuation: Over the past fifty years, the average P/E ratio of the stock market, as represented by the S&P 500, has been approximately 16. In the late 1970s and early 1980s, with rampant inflation and exorbitant interest rates, the P/E was 8 or 9. During the blow-up of the internet bubble in 1999-2001, the stock market traded at sky-high P/E valuations of 25-27. With low inflation rates of 1-2%, the P/E has averaged around 19. Over the past several years, the market P/E has fluctuated between 20-25. Currently, the P/E on projected S&P 500’s 2022 operating earnings of $228 is 20.5. With interest rates at rock-bottom levels, this appears not unreasonable. However, with the current high inflation rate and the probability of higher interest rates to counter this inflation, it is unlikely that the market P/E will expand. It is more likely that the P/E will contract. The key question is how far. With an inflation rate of 4%, the Rule of 20 would still indicate that the P/E should shrink to around 16, which would translate to the S&P 500 trading at 3,648 — a 22% market decline. But is the Rule of 20 still valid?
Consumer sentiment: The University of Michigan has been putting out an Index of Consumer Sentiment since the 1940s, which has often been accurate in predicting the course of the U.S. economy. The Index reflects the mood of consumers dealing with their own financial health, the health of the economy in the short term, and expectations for economic growth over the longer term. It is also a general measure of consumer optimism or pessimism. As consumer spending makes up approximately 70% of U.S. GDP, this Index is generally a key market indicator.
The January 2022 Index of Consumer Sentiment was 68.8 — the second lowest in a decade. Among other things, the Index reflected consumer pessimism about the continuing damaging effect of COVID-19. Many Americans thought that with the development of the vaccines and the boosters, the pandemic was coming to an end, but the rapid spread of the Omicron variant has had a negative effect on consumer sentiment. Conflicting advice from the medical profession about the virus and the widely disparate steps taken by politicians in the U.S. has also caused great stress. The stark 50/50 political divide in the nation, exacerbated by social media, is a continuing cause of tension and unhappiness in the body politic. All the above have contributed to the current malaise in the country, which is reflected in the Consumer Sentiment Index. However, it is not at all clear whether this malaise will influence the psychology of investors in the stock market, but it is something to pay close attention to, as investor psychology, as we have written before, is one the three key factors in the behavior of the stock market, the other two being corporate earnings and interest rates.
Geopolitical risks: There are two significant foreign policy concerns which have been simmering for a long time and have now heated up. Both have the potential of involving the U.S., and even drawing the country into armed conflict. The first is Russia and Ukraine. Putin has long been motivated by revanchism, his goal being the annexation or assimilation of some of the former Soviet republics which have been independent nations since the dissolution of the Soviet Union in 1991. His first step in this regard was the invasion of Georgia in 2008, which was not effectively resisted by the West. His next move in 2014 was the invasion and occupation of Crimea, which was part of Ukraine. Leaders in Western Europe and the U.S. reluctantly acquiesced to the occupation and annexation of Crimea, and Russia paid no real price for its aggression. Sensing the same weakness in the West as in 2014, Putin has amassed 100,000 Russian troops on the Ukrainian border with the goal of either occupying more Ukrainian territory or forcing Ukraine to disassociate itself from NATO and the E.U. There are ongoing negotiations between the U.S. and Russia, but open conflict between Russian and Ukrainian troops might have serious consequences for capital markets around the world.
The second challenge is the ongoing effort by China to reintegrate Taiwan as a province of China. Ever since the rapprochement between the U.S. and China initiated by President Nixon and Chairman Mao in 1972, Taiwan has been a sticking point in the relationship between the two countries. Deng Xiaoping, the de facto leader of China for several decades, focused on policies which would cause China to become the fastest-growing economy in the world and bring hundreds of millions of Chinese out of poverty. Deng did not want the issue of the reunification of Taiwan to get in the way of China’s more important policy goals. President Xi’s recent abrogation of the Hong Kong treaty has shown that he is taking a different approach. President Xi has repeatedly sent dozens of fighter planes and bombers into Taiwanese air space, the most recent occurring less than three months ago. The Chinese Communist Party is openly threatening the invasion of Taiwan, renouncing Deng’s policy of peaceful reunification. The 24 million Taiwanese, of course, wholeheartedly stand against reunification. The deputy foreign minister of Japan publicly announced that Japan would intervene militarily to come to Taiwan’s aid in the event of an invasion, and China verbally retaliated by threatening to use nuclear bombs on Japan. Ever since Nixon went to China, the U.S. has supported an autonomous Taiwan and has said that any unification must be peaceful. The entire issue is fraught with danger for the U.S., Japan, and other Asian nations. If China were to misjudge the intentions of the U.S. and its allies in the event of an invasion, it would likely be the most dangerous time for the world since the Cuban missile crisis. Capital markets would almost certainly react negatively.
The Bullish Scenario for 2022
While admittedly there are a catalog of issues and potential problems for investors to worry about, there is also much positive news on which investors can focus. These are the main factors which suggest that the bull market may continue its run in 2022:
- A growing U.S. economy: Leading economists project U.S. GDP growth of 3.5%-4% in 2022. The growth would continue the rebound from the economy’s pandemic-induced contraction in the first half of 2022.
- Higher corporate earnings: Investment houses and research analysts predict that S&P 500 operating earnings will grow approximately 9% in 2022, reflecting stronger revenues and stable margins.Stocks generally do well in inflation: In past inflationary cycles, the worst asset class has been bonds. Stocks have generally done reasonably well, although it is important to concentrate on the industries that can prosper in inflationary times. Funds flow would likely be more into stocks than bonds.
- Historically low interest rates: Even if the Federal Reserve were to raise the Fed Funds rate six times, it would mean a Fed Funds rate of 1.5%-1.75%. By any measure, this would still translate into very low short-term interest rates.
- Continued fiscal stimulus: Despite the Fed Reserve tightening monetary policy, the White House predicts a $1.7 trillion fiscal deficit in 2022. If the Build Back Better bill is enacted, it will mean even more fiscal stimulus. This elevated level of federal spending could bring higher levels of inflation, but it would likely also spur economic growth.
- Stocks with robust dividends: Currently almost 50% of stocks in the S&P 500 have dividend yields which are higher than the 10-year U.S. Treasury note. Investors who need income will likely continue to buy many stocks as fixed income substitutes.
- Inflation may decline in 2022: It is quite possible that inflation will decline in 2022, as predicted by many economists. Supply chain constraints may moderate, more workers may join the workforce, and COVID restrictions may become a thing of the past. Lower inflation would lower the threat of higher interest rates.
If the above scenarios were to play out, investors, as the year progressed, would focus on 2023 S&P 500 operating earnings of perhaps $250. If inflation were to moderate and interest rates were to remain low, as indicated above, a P/E of 20 or 21 would bring the S&P 500 to 5,000 or perhaps 5,250 by the end of 2022. This could produce a gain including dividends of 6%-11% for the Index. Not equaling the exceptional double-digit returns of each of the last three years, but still constructive!
Which Scenario Should Investors Choose — the Bull or the Bear?
The short answer to this question is: neither. Since our firm’s inception, we have encouraged our clients and friends to think of investing in equities as time in the market, not timing the market. Every half dozen years, we repeat a sage quote by Warren Buffett, one of the best all-time investors, from the 2012 Berkshire Hathaway annual report:
“The Dow Jones Industrials advanced from 66 to 11,497 in the 20th century, a staggering 17,320% increase that materialized despite four costly wars, a Great Depression, and many recessions… Since the basic game is so favorable, Charlie [Munger] and I believe that it is a terrible mistake to try to dance in and out of it… The risks of being out of the game are huge compared to the risks of being in it.”
At Bradley, Foster & Sargent, we believe in this approach — stocks for the long haul. We also believe that an investor should own stocks only if the time frame for owning stocks is at least five years and preferably ten years. There are too many macroeconomic, geopolitical, corporate, political, and psychological factors in play to accurately predict how the market will behave over the short term. Assuming the American “experiment” in democratic capitalism endures, the wealth creation of buying and holding great U.S. growth companies for the long haul is remarkable, as the table on the following page shows. We have used the holding period from 2008 through 2021, as it encompasses the year of the Financial Panic when the S&P 500 was down -38.5%:
In this table, we have highlighted 14 stocks that provided outstanding returns over a period of 14 years, but in doing so, we do not wish to imply these stocks were owned in our client portfolios for the entire period nor that each of our client portfolios contained these stocks. The table simply represents the performance of stocks that are typical of our core equity strategy. How long will this bull market last? We don’t pretend to know. But we do know that the empirical data shows that owning these kinds of stock for the long haul is the path to wealth creation. At Bradley, Foster & Sargent, pursuing this goal for our clients is our mission.
Rob serves as chairman of Bradley, Foster & Sargent. He is a portfolio manager and member of the firm’s investment committee and its board of directors.
Rob founded Bradley, Foster & Sargent with Joseph D. Sargent and Timothy H. Foster. Earlier, he was president and CEO of Boston Private Bank & Trust Company, which he founded in 1985, and he spent 14 years with Citicorp, including 12 years in Europe, the Middle East, and Africa. Previously, he served as an officer in the U.S. Navy in Vietnam.
Rob served for seven years on the board of governors of the Investment Adviser Association, the national not-for-profit association founded in 1937 that exclusively represents the interests of federally registered investment advisory firms.
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