The past ten years has produced a remarkable turnaround from the 2008 financial crisis. The psychological damage inflicted on investors from the crisis has resulted in this bull market as seemingly the least loved bull market in history. The U.S. domestic equity markets have led the global markets higher. In our opinion, the underpinning of this bull market in the U.S. has two catalyst. The first catalyst was implemented by the U.S. Federal Reserve, as well as by the U.S. Treasury department. During 2009 the Federal Reserve created liquidity through quantitative easing [QE], which is a program where the Federal Reserve lends their balance sheet to the market through purchases of bonds or asset backed securities. QE is an operation only available through the Federal reserve [FED] and consists of open market operations.
This function is intended to create money supply to the economy by purchasing securities such as U.S. treasuries as well as mortgage backed securities from large financial institutions. The institutions now have newly created cash on their balance sheets. That cash can be levered up and delivered in the form of loans to the public. To be clear, this description is an over simplification for the purpose of brevity. For example, the banks can create 5 to 8 dollars in new loans with just 1 dollar in new cash reserves. Early on, much of this QE operation was used to strengthen bank reserves in order to maintain confidence in the banking system. The FED created four trillion in new dollars by purchasing large sums of securities in the open market. Equity markets love monetary easing. Monetary easing through various QE programs from 2009 thru 2012 was historic. Because of the flood of new liquidity in the bond market as well as federal rate cuts, interest rates plummeted, therefore; despite feeble earnings growth as well as anemic growth in gross national product [GDP], U.S. equity markets soared. However, valuation expansion was not organic in nature due to the lack of economic earnings growth, but rather through net present valuation calculations resulting from plummeting interest rates.
Simply put, the market has been like a balloon expanding from a motor-based air pump. That is to say, it has been the hot air of monetary policy, and not increased economic conditions or increased operational sales, that has been the motor to the stock market. By way of example, on March 9, 2009 (i.e.: what many believed to be the “market bottom” of the financial crisis), investors buying the S&P 500 would have paid $0.61 in capitalization for every $1 in total revenues to own the index. Today, as of 11/26/19, an investor purchasing the S&P 500 is paying $2.35 in capitalization for every $1 in revenues.
The second catalyst fueling this bull market occurred with the 2016 presidential election. The 2016 election resulted in a complete change in behavior concerning government regulations in both the financial and energy industries. There is no doubt that excessive governmental regulation was unleashed on the U.S. economy from 2009 through 2016. Most regulation was enacted through presidential order. The new president and his administration reversed much of the oppressive and arbitrary regulation enacted by the previous President. As part of this deregulation package was broad-based tax cuts for lower- and middle-income earners as well as a corporate tax rate reduction. Higher income earners living within high income tax states experienced a substantial reduction in income tax deductions. Nevertheless, deregulation and lower taxes are now delivering the missing economic activity.
The economic expansion is showing up in consumer spending. The consumer has not been this strong since prior to the financial crisis. We expect capital expenditures to increase in 2020, which we believe will boost economic activity. We believe earnings expansion is now driving equity prices higher and is no longer being driven primarily by monetary policy. One important point should be made however, and that is that the first catalyst mentioned above reversed itself in December 2018 when the FED began monetary tightening, which nearly ended the bull market. Monetary tightening included the FED increasing bank borrowing rates as well as the unwinding of the four trillion-dollar balance sheet. Both the equity market and the bond market viewed the FEDs tightening as ill-conceived and awkwardly executed. The result was a nearly 15% correction in U.S. equity prices, as measured by the S&P 500 Index performance from 12/1/18 through 12/24/18. Meanwhile, interest rates across the yield curve plummeted as the bond market perceived a global slowdown. This inexplicable position by the FED caused concern in capital markets. The messaging from the FED was that it wanted to return to a “normalized yield” curve. This open market activity by the FED would have the reverse effect of QE. Selling bonds on the FED balance sheet reduces credit in the banking system. The result nearly sent a recovering economy into recession.
Going forward, the FED has stated that it is going to be neutral and data dependent. The messaging of a return to a normalized yield curve has not appeared in FED speak since the 2018 debacle. We believe the FED is focused on global deflation pressure more than in 2018. We need to monitor the FED going into 2020 and 2021. The Feds activities could be a reason for equity investors to trim their exposure to equities if monetary tightening resumes. We believe most of 2020 will be a quiet period from the FED. We believe the Fed was seeking a normalized yield curve, based on the period from 1971 through 1999. We believe that this period was an anomaly, and that the current yield curve is modestly below the yield curve that existed from 1900 through 1971. We believe investors would be wise to plan on an entire generation of a low yield curve, and that deflationary pressures created by technology is profound and here to stay.
The most important issue for investors is: Where do we go from here? In terms of the U.S. equity markets, extended equity valuations have now moved prominently onto the decision-making landscape. Global Beta Advisors believes the underpinnings for the U.S. equity markets remain strong. During the past ten years, U.S. large cap growth stocks have dominated all asset classes, both domestically and internationally. Most capitalization weighted equity index strategies have been the primary beneficiaries of the growth market as growth companies have gained the most momentum, and therefore, their market capitalization has grown to be a large part of the index. Most of the large cap growth stocks are technology companies with a global reach. These companies have been able to grow their earnings and revenues at a much faster rate than GDP. Investors invested heavily in these growth stocks because they were the only game in town. Index funds over the past ten years are now substantially overweight to very high price to sales companies. The below chart is a prosaic example of high price to sales portfolios. Currently, the S&P 500 has a price to sales of 2.35.
Source: Data used to compose the above chart was referenced from Factset Research.
Global Beta advisors indexing methodology – in coordination with our relationship with Standard and Poor’s – build index portfolios to gain exposure to the equity markets, and at the same time, avoid the risks posed by high price to sales strategies. Periodically, the equity markets offer glaring opportunities through a statistical life reality of a reversion to the mean. A reversion to the mean shows up in nearly every discipline, from biology to physics to sports, but no other discipline experiences mean reversion more than capital market investment returns.
Notice the return dispersion between value and growth over 1, 5, and 10 years, however, the 20-year return spreads among each asset class are much narrower. In fact, value edges out growth over 20 years despite the substantial outperformance during the past ten years. Moreover, many studies indicate value has a premium over very long periods. One of the most enduring theories is the Fama-French three factor model published in the early 1990s. The Fama-French factors models have expanded to as many as five factors within recent years.
The bottom line is, we believe as a reversion to the mean occurs and swamps market participants, it will be relentless. We believe the trigger for this will be a global economic expansion. Investors will broaden out into equities that have lagged during the past ten years.
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