After the S&P 500 gained 20% per year from 2009-2014, the stock market has been stuck in a frustrating sideways range for a year and a half now. Within that trading range, we have seen two double-digit declines and two double-digit rallies, all without moving the needle in terms of the overall trend.
What will it take to break out of this range, and for the bull market to resume? And what’s the endgame for all the central banks that keep trying to prop up the global economy, with increasingly more unconventional moves? Let’s explore.
After a huge run, the market needed a breather and that’s what we are getting. The 200% gain in the stock market since 2009 was not sustainable because it left the risk-reward ratio out of balance.
Historically, the annual return for the S&P 500 was 10% against an annualized volatility (or vol) of 15%.1 However, since the March 2009 low, the return has been closer to 20%, for more or less the same vol. In other words, investors have gotten twice as much return per unit of risk than what was historically possible.
Therefore, if history repeats, the return profile will need to normalize so it can get back in line with the volatility profile. This can happen through a prolonged sideways market, a price correction, or a combination of both. So far, we have gotten more of the former and less of the latter. Whether that will continue remains to be seen, but what’s important to remember is that the market doesn’t (and shouldn’t) go up in a straight line. Corrections are a normal part of the market cycle.
Let’s think about what this market needs in order to break out to new highs. A healthy stock market rests on three pillars: earnings growth, valuation, and a supportive liquidity environment. From 2009 through mid-2014, the market was firing on all three cylinders. Earnings growth was strong, liquidity was ample through the incoming tide of monetary easing, and valuations (the market’s price-to- earnings ratio) expanded from extremely oversold levels.
However, since mid-2014, when the Fed began “passively tightening” by ending QE3 (round three of quantitative easing), liquidity conditions have tightened up at the same time that earnings growth rolled over. The resulting one-two punch has weakened two out of these three pillars. No wonder the market has struggled to make progress.
In my opinion, valuations are still reasonable with a P/E ratio of 18 times trailing earnings, but with neither earnings growth nor ample liquidity conditions, there is no catalyst to push valuations higher. In my view, we have to wait for either earnings growth to recover or for the Fed to become more accommodative (which would ease up liquidity conditions and possibly allow valuations to expand). So far, neither is happening, especially now that the Fed is testing the waters for a possible June or July hike.
That’s my view over the medium term. What about the structural environment? When will the global economy start growing again? When will inflation return? How will we deal with the debt burden if we can’t grow our way out of it?
Central bank drivers
I find it interesting just how quickly the markets have become desensitized to central banks’ increasingly unconventional methods of trying to stimulate economic growth. It makes me wonder how this is all going to end.
In the old days—before the global financial crisis (GFC)—central banking was pretty straightforward. The main threat to the economic cycle was usually inflation, so when inflation expectations rose too much, the Fed would just raise rates until the economic cycle slowed enough to break inflation’s rise.
But since the GFC, we live in a world where the threat of deflation and a lack of growth are bigger concerns for central banks. This is because the simple interest-rate policy of yesteryear is asymmetric. That is, there is no limit to how high rates can go, but there is a limit to how low they can go. It’s called the zero lower bound (ZLB). That limit was reached during the financial crisis in 2008.
So, when the Fed and other central banks moved to zero-interest-rate policy (ZIRP) in 2008, that was pretty much unheard of at the time. And when ZIRP proved not to be enough, central banks entered the balance-sheet expansion (QE) era, which was even more unheard of. Since then, QE has become so commonplace that for the European Central Bank (ECB) and the Bank of Japan (BoJ), it’s no longer a matter of whether to do QE but how much.
And now that the eurozone and Japan are continuing to struggle despite these asset purchases, the ECB and BoJ have resorted to NIRP, or negative interest rate policy. Again, this is something that was unheard of back in 2008, but now it has become relatively commonplace. Yet even NIRP doesn’t seem to be helping in the fight against deflation. If anything, NIRP has backfired in Europe and Japan, with those markets down since NIRP was introduced.
A fiscal-monetary fix?
So, it has been eight years since the GFC, eight years of ZIRP-QE-NIRP, and there is still too little growth, too little inflation, and too much debt. More of the same doesn’t seem to be having an effect, so my guess is that the conversation among policymakers will turn increasingly to fiscal policy, and specifically the coordination of fiscal and monetary policy.
If done right, I believe this might finally create a sustainable multiplier effect on the global economy. That is, it could finally create some decent nominal GDP growth (real growth plus inflation), which we need if we are going to grow our way out of debt. The other options—austerity or default—tend not to be popular choices.
But if done wrong, the conversation could quickly turn to the topic of “helicopter money.” Helicopter money is another term for overt monetary financing (OMF), which is the direct funding of fiscal deficits by central banks. I doubt that the U.S. (with its independent Fed) or the eurozone (with is fragmented fiscal structure) will be going down the OMF path anytime soon. But Japan is already more or less doing this, with the BoJ buying up twice the amount of newly issued government bonds per year, while the government runs massive fiscal deficits.
A missing link: earnings growth
We will see how it all ends. What the world needs is higher nominal growth, but an aging population and a lack of productivity growth are major headwinds that limit the developed world’s potential output.
In the meantime, with valuations full and a Fed still inclined to tighten policy, an improvement in the earnings picture remains the key missing ingredient that the markets need in order to break out of this bull market purgatory.
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