The demands and stresses of your daily life allow precious little time for contemplation. Especially for such dry topics as economics and investment markets. This is a big risk. If you don’t understand where you are in market history, you’ll never see the big risks or opportunities coming.
Yet most people’s financial decisions are based on information gleaned (fleetingly) from mainstream media and/or investment industry marketing.
It’s little wonder news of the record breaking US share market is widely interpreted as a positive. And taken in isolation, the US share market’s recent performance is impressive.
However, when viewed through the wider lens of history, the market high is a climactic ending to a debt super cycle that began 67 years ago. You’re not watching the beginning of the bull market. You’re watching the end of a credit bubble.
The task of this article is to show you that from here, Australian investors should prepare for lower stock prices, not new highs. I’ll show you how we got to this state, and what to expect next. But first, let’s go back to the beginning of our love affair with debt.
Forgetting the Lessons of Depression
The debt crisis we find ourselves in began immediately after the Second World War. The longevity of the debt super cycle has created a conundrum.
The lessons learned from the Great Depression have been taken to the grave with our forefathers.
For seven decades we have been conditioned by an economic model of sustained prosperity. Gratitude and hard work have long been replaced by expectation and entitlement.
After the Second World War the developed world embarked on a prolonged period of prosperity. The combination of a frugal and industrious mindset from the Great Depression generation and government expenditure held in check by the gold standard provided a solid foundation for genuine economic growth.
The gold standard or ‘gold exchange standard’ fixed the price of gold at US$35 per ounce. Gold was used as a means of squaring the ledger between debtor and creditor nations. The ‘checks and balances’ imbedded in the gold standard reined in the spendthrift tendencies of the political class.
This restraint proved to be a bridge too far for the US. On August 15, 1971 President Richard Nixon abolished the gold standard.
History shows this was a defining moment for the economies of the developed world. The value of paper money was no longer anchored to a physical asset (gold).
The change in financial accountability triggered a series of chain reactions in the 1970’s. Gold soared from US$35 to US$850. Share markets stagnated. Interest rates rose from 3% to over 16%. OPEC nations initiated oil crises. It was a decade of turbulence. The world was adjusting to a paper based monetary system backed only by the words ‘In God We Trust’.
The following chart provides a very clear graphic on the gradual build up of debt (public and private) in the world’s largest economy.
The early stage of the debt super cycle saw modest growth in debt levels.
As mentioned previously, the decades immediately following the Second World War were heavily influenced by the frugal mindset of the Great Depression generation and public finances held accountable to the gold standard. But things change. And change they did.
The Boomers Embrace Debt
From the 1980’s onward the key economic drivers were the baby boomers ‘never experiencing tough times’ mindset and a financial system backed by the printing press.
No surprise then that the debt graph resembles ‘the North Face of the Eiger’ from 1980 onwards.
Compared to their parents, the baby boomers grew up in prosperous economic times. Naturally this influenced their more relaxed attitude towards debt. It was to be embraced, not feared.
Consumption driven baby boomers + governments freed from the shackles of the gold standard = unprecedented debt explosion.
The power, influence and profitability of the financial sector grew in tandem with the rising debt levels. In 1970, the US financial sector generated approximately 10% of corporate profits. At the peak of the credit bubble in 2007, the financial sector represented 40% of US corporate profits. This imbalance led to the creation of the ‘too big to fail’ institutions.
All good things must end. The subprime implosion rang the bell on the greatest credit bubble in history. Governments and financial institutions learned very quickly just how dependent they were on this massive debt pyramid. Australia is just now finding this out, and it’s not pleasant knowledge.
The Federal Reserve Make a Bad Problem Worse
The GFC exposed the fraudulent economic growth of the previous twenty years. Vast sums of borrowed money pushed the GDP number higher — again very few really questioned this quantitative data. Mainstream media simply rejoiced and politicians basked in the ‘good’ economic news. In reality the debt noose was slowly being tightened around the economy’s neck.
Minus the private sector stimulus, banking sector profits and government tax revenues plummeted.
For government, the timing could not be worse. The pressure on government budgets is immense — interest payments on sovereign debt; welfare payments to a higher number of unemployed, disabled and age pensioners living longer; provision of health care for an ageing population; the cost of funding the ‘war on terror’ etc.
Policy makers stepped into the breach. A plethora of stimulus schemes have been foisted upon the economy. None have achieved any lasting economic success.
However the US Federal Reserve’s $85 billion per month asset purchase programme (plus zero-bound interest rates) has ignited the US share market.
Wall Street’s addiction to the stimulus poses a dilemma for the Fed. The market is hooked on $85 billion per month, but is that enough to give it the ‘buzz’ for its next high? Any responsible physician knows you need to withdraw the stimulant, but how to do this and not destroy the ‘wealth effect’?
The Great Contraction
The enemy the policy makers are fighting on all fronts is ‘The Great Credit Contraction’. The expunging of private debt from the economy is gradually undermining the foundations of what ‘The Great Credit Expansion’ created — entitlement spending, higher property values, business expansion etc.
We are five years into this war and each side has won their share of battles. The policy makers’ only remaining weapon is the printing press. History shows the printing press has never won an economic victory. What it has done is create far more casualties than it otherwise would have, had it never been used.
Understanding the evolution of the debt super cycle enables investors to appreciate the long-term cyclical nature of the share market.
The following chart, courtesy of CrestmontResearch.com, tracks the ebbs and flows of the S&P 500 index since 1900.
The green periods are secular bull markets. These periods commence with a low P/E ratio and finish with a high P/E ratio.
The red periods are secular bear markets. These periods commence with a high P/E ratio and finish with a low P/E ratio.
The undulating blue line at the bottom of the graph is the range of the P/E ratio.
Investopedia.com defines secular markets as, ‘A market driven by forces that could be in place for many years, causing the price of a particular investment or asset class to rise or fall over a long period of time.’
If we focus on the Post-Second World War period, there have been two secular bullmarkets and two secular bear markets.
The 1945 to 1966 period reflected the genuine prosperity created by a world intent on rebuilding itself. The S&P 500 index posted a return of 955%.
The P/E gradually expanded over this period — from around 12x to 25x — as investors became more confident in the market’s ability to outperform other investment classes. An expanding P/E is a manifestation of investor optimism and greed.
The next period, a secular bearmarket lasting 16 years, delivered a paltry 33%. The abolition of the Gold Standard, high inflation, rising interest rates and spiraling oil prices all conspired to sap the enthusiasm of share investors.
The P/E ratio shrank from 25x to around 8x. In pricing terms this equates to a 66% reduction in value. At the end of the secular bear marketin 1982, pessimism and fear reigned supreme.
Then came the greatest secular bullmarket in the history of the share market. The deregulation of financial markets, the end of the Cold War, the tech boom, the Greenspan ‘put’ and an abundant supply of credit combined to drive markets to stratospheric levels.
The P/E expansion from 8x to over 40x was a clear indication of the excessive optimism that prevailed at the height of the tech boom in 2000. The ‘crash’ of 1987 proved to be a mere speed bump in the 1982-2000 secular bull market.
The financial planning industry flourished on the strength of this secular bull market. ‘Time in the market not timing the market,’ became the industry’s mantra. The previous secular bear market had been conveniently airbrushed.
Since 2000, the US share market has been in the claws of a secular bearmarket. The recent record highs are only marginally above the levels first reached in 2000.
Over the past thirteen years, the P/E ratio has fallen from over 40x to around 23x. It is important to note this is the level previous secular bear markets have started at, not finished.
Behold the Secular Bear Market
If history is a guide, the recent surge in the US share market is a bear market rally rather than the start of a new bull market. Every previous secular bearmarket has ended with a P/E ratio below the long-term market average. The current US market P/E ratio is 50% above its long-term average.
US investors have been in this funk for thirteen years. Australian share investors joined the secular bearparty much later. Our market peaked in late 2007 and we are still 25% below this level.
Understanding the dynamics of secular markets is, in my opinion, critically important to investor wealth. It also aids in tuning out the noise from mainstream media and high-profile brokers.
The Great Credit Contraction is destined to have an equal and opposite effect on markets. Caution will replace exuberance. This is yet to be reflected in P/E ratios.
In looking at the two previous major credit crises — the Great Depression and Japan post-1990 — share investors should brace themselves for losses of up to 80%. The secular bull market reached its zenith on the back of extreme greed, the secular bear market will eventually bottom out on a wave of panic.
‘Time poor’ investors who are dependent on headlines to form an opinion are destined to become just ‘poor’ investors.
To successfully navigate and prosper from a secular bear market you need a strategy based on patience, timing and access to well-researched independent advice not aligned to financial institutions.
History suggests this next decade has the potential to make or break retirement plans. In the coming weeks, I’ll show you how to survive a secular bear market with as much of your wealth intact as possible. And then, we’ll look at what I call ‘family wealth’ strategies, which can help you prosper in the decades to come.
for Markets and Money Australia
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