All Hail the Roaring 20s

Will we see new stock market highs or another crash?

Stock markets are amazingly resilient in 2020.

Key economic and monetary policy drivers have turned positive.

Stocks are very expensive but are likelier to go up than down.

“We will not have any more crashes in our time.”

John Maynard Keynes, Economist, 1927

“There is no cause to worry. The high tide of prosperity will continue.”

Andrew W. Mellon, US Secretary of the Treasury, September 1929

Comeback Kid

The greatest macro mystery in this time of Covid is the stock market.

How is it possible that stocks bounced back from Armageddon in March to all-time highs in September, in the face of a sweeping global pandemic and an unprecedented economic collapse?

After all, we have had over 30 million Covid cases and a million deaths.

The world economy fell in the spring by more than 10 percent from year ago levels and is expected to shrink 5 percent in total in 2020.

US companies listed on the market saw their earnings expectations drop by 20 percent this year and these are anticipated to be barely higher for 2021.

Interest rates dropped to nearly zero, oil prices actually went negative, and gold, the traditional investor haven in times of crisis, rose by one-half.

Why does this not all add up to a stock market of misery, instead of one that feels like the roaring 20s of yesteryear?

Is this a classic casino market, irrationally pricing corporate futures on a whim, or is there something deeper that we are all missing?

In other words, what is really driving the stock market, and what does that suggest for the near future?

Let’s have a look.

Basic Facts

The following chart shows the Standard and Poor’s price index of the 500 largest publicly listed companies in the US.

We can use this index to tell the story of the global stock market, since it represents almost a third of the global value of all stocks and it comes from the most important price-setting market in the world.

The first point to make is that the past two decades have been mighty fine for stock investors.

The market went up almost four times since 2002, leading to extraordinarily high valuations (the price that investors place on a dollar of expected earnings). The market correction over the past few weeks is probably a natural reaction to that euphoria taken to its extreme.

The second thing to note is that the market responds to crisis. Both during the Great Recession a decade ago and the pandemic now, an accumulation of bad news quickly drove stock prices to bargain basement levels.

The impact of politics and economic policy is not so clear, with the presidencies of both Obama and Trump leading to stellar stock returns during their tenures. It is not obvious from the market result whether Obama’s huge deficits or Trump’s huge tax cut had noticeably different effects.

So, let’s leave partisan politics aside in our quest to understand the market.

The next chart divides this period into bull markets and bear markets, those times when the market either booms (prices rise on average) or goes bust (prices drop).

We can see that the booms last much longer than the busts, though when the bear growls, it has a rapid and dramatic downward effect on prices.

There are five distinct boom and bust cycles over the past 20 years.

The first one peaked in 2007 with the end of economic growth and the arrival of the Great Recession.

The second one started at the nadir of that recession and then continued until 2015, when a slackening economy was again important. As we will see below, monetary policy decisions at the US central bank were also critical factors.

The third cycle was shorter but more exuberant. Prices moved sharply higher as the economy and investor spirits reengaged in the early years of the Trump administration.

The end of that cycle was marked by a one-day flash crash in volatility in early 2018, inaugurating a period of heightened price volatility that is still with us today. This added noise makes it more difficult to pull out a coherent market message and is a sign of heightened risk.

The fourth cycle was even shorter and even more exuberant, a theme in financial history whereby good times in the stock market beget even better times later, often leading to such extremes that we have a blowout in prices and a collapse.

The current pandemic intervened to end this cycle, cutting off the euphoria and causing an incredibly deep but brief bear market and bounce back.

This fifth cycle has now been underway since the end of March and the open question is: whither the market? Will we continue to new highs and a fully-fledged bull market or resume the descent begun during the pandemic?

First Driver

The next charts can help us to find our way towards answering those questions.

First, the relationship between the economy and the stock market:

Though manufacturing is only about a tenth of the economy, it is a great indicator of the other ninety percent. This is because it is global, is highly integrated with other sectors, deals in physical products, and is extremely flexible. When the winds of change blow, manufacturers respond.

The chart shows very clearly that the bear markets of 2008 and 2020 were associated with harsh economic times. Near zero growth from a slowing economy also affected the market in 2016.

Of course, stock markets look ahead, as investors bet on the future for corporate performance, while the economy only moves in real time.

So, it is changes in expectations about the economy that drive stocks, not the actual performance when it finally arrives. This is important to remember this year, with the economy still in partial recovery while stock markets roar ahead in anticipation of higher profits in the future.

Note also that slowing growth in 2019 did nothing to stop the market from rising sharply that year. This is a sign of excessive market sentiment that was finally corrected with the emergent reality of the pandemic in early 2020.

Where does the economy go from here? Well, in a word, up.

Even though there are fears of new pandemic waves, it is clear that the first wave of Covid, almost everywhere, is the truly dangerous one, hospitalizing and killing mostly the elderly and infirm. Second round spikes in cases have so far proven to be a mirage in terms of real risk.

Also, massive unemployment and business bankruptcies are extremely serious but they are sadly now in the back window, one-time victims of a massive structural change in our society and economy.

Just as in 2009, businesses will move on, especially those exploiting technology that replaces physical contact, and the sunk costs of the 2020 recession will not hinder the 2021 recovery.

This is not to say that growth will necessarily be robust, since we will be hampered by government restrictions, risk-averse attitudes, and the eventual tax costs of high deficits. However, there is no reason to expect another repeat recession any time soon.

Overall, a continuing economic expansion is a positive for stock prices going forward.

Second Driver

The next important market driver is monetary policy, conducted in the US by the Board of Governors of the Federal Reserve System (or Fed for short).

The Fed uses two main policy levers these days to affect the economy and markets: interest rates and the size and composition of their balance sheet, as shown in the next two charts.

We can see here that Fed actions are often quite dramatic and long lasting. There is an art to central banking and a large part of it is being emphatic and consistent so that markets respond accordingly.

Rises in short-term interest rates only come when economic growth is solid and financial markets are stable. That coincides with the bull markets after 2002 and 2016.

When economic trouble arrives, the Fed responds rapidly to emerging events. This was especially true in the Great Recession and now with the pandemic, when rate cuts were combined with massive increases in the Fed’s balance sheet.

The policy reaction in 2020 saw a $3 trillion swing in the balance sheet, fully three times the reaction in 2008, and interest rates are back down near zero. This was done consciously to (successfully) avoid a financial crisis, as in 2008, which would have immensely compounded the pain from the pandemic.

Interestingly, the Fed impact can go both ways. The tail end of rate hikes in 2018, combined with a contraction of their balance sheet, helped trigger the 2018 bear market and high volatility. The Fed can certainly hurt the stock market.

Where does the Fed go from here? They have pledged to keep rates flat until at least 2023 and we should expect little change in the balance sheet. On net, that is highly supportive for stock prices.

Other Markets

Even though the Fed has a powerful role, it is not alone in the markets.

The Fed balance sheet totals $7 trillion today — but financial markets are much larger.

Stock market capitalization is almost $90 trillion, bond markets are over $100 trillion, derivative markets are almost $600 trillion, and spot currency markets trade $2 trillion per day.

So, the market reaction to the Fed is the more relevant metric of their success and of their indirect impact on the stock market.

Let’s look at each in turn.

The next chart shows five year real rates, bond yields that are adjusted for the effects of expected inflation.

Such interest rates only rise significantly during good economic times (though they also spike temporarily during crises, as in 2008 and 2020).

We can expect the rates to remain negative for the next year or two, at least, and so pose little threat to higher stock prices for even years after that.

The next chart shows the yield curve, the difference between 10 year bond yields and 2 year bond yields. Note that the right hand axis is inverted, so the most positive yield curve is at the bottom of the chart.

A positive and declining spread is most often positive for stock prices, whereas a negative spread (where 2 year yields exceed 10 year yields) is a danger signal for markets. The latter happened prior to the stock market peaks of 2007 and 2020.

The current shape of the yield curve is not really positive for stocks, but it is also not at a dangerous level.

There is a one or two percentage point adjustment needed in yields (either 2 years down or 10 years up) to normalize the curve. A drop in 2 year yields would imply serious economic weakness, while a rise in 10 year yields would imply a stronger than expected economic recovery.

My bet on continuing economic growth would suggest that 10 year yields will rise over time.

Finally, the US dollar is an outside player in the stock market, usually not of great importance to either the Fed or the stock market.

There is not much of a relationship here between the dollar and stocks. However, from time to time (as in 2015, 2018, and perhaps now), the dollar swings higher in a reflection of relatively tight Fed policies.

If that is happening now, it is a negative for the stock market. So far, however, the uptick in the dollar is very modest and so it should be treated as a neutral for the market.

Outlook

This assessment scores the economy, Fed policy, and real interest rates as positives for stocks, and the yield curve and the dollar as neutral but potentially negative factors.

There is plenty of risk in the market already, given the high historic valuations and the uncertainties related to the pandemic and its associated social crisis.

There is also pending risk owing to the coming US election and the potential for violence and a constitutional crisis of legitimacy regarding the presidential winner.

However, the weight of evidence is for rising stock prices over time and not a decline and eventual crash. That latter scenario requires a change in fundamentals (renewed recession, tighter Fed policy, or a financial crisis) and it will not be triggered merely by pessimistic expectations.

So, even though stocks are near all-time high valuations, and are therefore very expensive for investors, my guess is that they will only become more expensive. Buy high, sell higher.

All hail the new Roaring 20s and on towards the next peak!

Caveat emptor: No one can predict the market with accuracy, so treat this analysis as one plausible way of thinking about the future.