Live long enough and you will experience a number of bear markets. This author can remember the gloom of 1973–74 (when the UK market had a dividend yield of 12%) and 1987’s Black Monday, when the Dow fell 23% in one session. But it is not these sudden crashes you need to worry about. It is the long slow declines that devastate your portfolio; Japan’s Nikkei 225 index is still only half its end-1989 level. Many rallies over the last 30 years have petered out.
For American investors, the alarming falls in the last few weeks only offset what was a very good year in 2019. If you had ignored the financial news for the last year and glanced at your portfolio for the first time today, you would find the S&P 500 was 0.1% higher than it was 12 months ago. Disappointing, you might reflect, but nothing to panic about. Tech stocks, as represented by the Nasdaq index, are up 7.3% over the same period. Looked at over a longer period, the S&P 500 is more than four times the March 2009 low of 666.
So the bigger question is not — will the equity market fall another 20% from here? It is — will it fall substantially and stay down? And this is a genuinely interesting debate. Japan’s problems stemmed from the economy’s descent into a long period of sluggish nominal growth, linked to its ageing population. Both its short-term interest rates and long-term government bond yields fell to historically low levels and stayed there.
There are worrying parallels in Europe and the US. Record low rates, and quantitative easing, were introduced in response to the financial crisis of 2007–09. These were expected to be temporary. Europe (including the UK) has never managed to reverse these policies. The US began to try with the Federal Reserve pushing up rates at the end of 2015, edging them up to 2.25–2.5% by the end of 2018. The 10-year Treasury bond yield climbed above 3%. Things looked like they were returning to “normal”.
But then everything reversed. Fed rates are back down to 1–1.25% and are expected to fall further. For a while on March 9th, every single Treasury bond yielded less than 1%. At the time of writing, German 10 year bonds yield MINUS 0.76%. these are Japanese levels.
There are two ways of looking at this. The most common view over the last 10 years is that low cash and bond yields mean there is little alternative to holding equities. Even if you expect no capital growth from equities, the FT All-Share index yields 5.2%.
The alternative view is that those low bond yields are telling us something bad is coming: a recession or a prolonged period of Japanese-style deflation. After all, low yields haven’t stopped Japanese equities from being in the doldrums. If the Japanese template prevails, corporate profits will not grow and some businesses will struggle to repay their debts.
Up until this latest stockmarket fall, one could argue that bond and equity markets were telling different stories, with the former pointing to sluggish growth and the latter being much more optimistic.
This debate affects one of the author’s favourite measures: the cyclically-adjusted price-earnings ratio or CAPE. As calculated by Robert Shiller of Yale, this takes corporate profits and averages them over 10 years to even out the fluctuations. As of February 7 (the latest data on his website), the CAPE of the US market was 31.5. Knock off a bit for market falls and call it 28. That is well below the 1999 peak of 44.2 but not far below the 1929 high of 32.6. Both levels preceded substantial market falls.
The problem with relying on the CAPE as a signal for investors is that it has been high for an extended period. The low in 2009 was just 13.3, but the ratio was below that level for more than a decade from the mid-1970s to the mid-1980s. The reason for that is that profits rebounded quickly from the 2008–09 recession and have manitained a high share of GDP by historic standards. The big tech companies in particular have strong, quasi-monopoly market positions.
So for the pessimistic case to be right, we have to expect profits to be squeezed. That would require regulation to break up the tech monopolies, or some new competitors to disrupt tech models as happened with Nokia and Blackberry a decade ago.
If this author knew the answer to this question, he would be filing from his luxury yacht. But investors need to decide: are they optimistic believers in corporate power or pessimistic prognosticators about a Japanese-style slowdown? Depending on which camp you believe, this is either a buying opportunity or just a terrible omen of what it is to come.
Recent developments give hints in both directions. The coronavirus outbreak suggests that more of us will be drawn into interacting online, via Amazon or Facebook, or watching films on Netflix, rather than go to the cinema. Good news for the corporate giants. But the Opec row suggests that other industries could be caught up in deflationary bloodbaths as producers cut prices in an attempt to seize market share.