Let’s take a cursory look at wars and the markets because many others are doing this. Typically you see a table showing returns following the start of a conflict. Many of those conflicts were regional and WWII. The problem in this analysis are the starting conditions.
While not complete and also I will say upfront that much has changed recently in how our monetary policy is executed, but we can at least look at the basics. Let’s look at a chart instead of a table because a picture is worth 1000 2000 words (inflation).
Instead of straight price, we are using Shiller’s PE (blue) which in effect is Price/Smoothed Earnings. Price moves faster, so we can still think in terms of market price but the earnings component makes this an oscillator instead of an ever-rising plot.
The red line is the 10-year Treasury yield which is gives a strong hint on inflation levels overtime.
So what I see is a price contraction (relative to earnings) for WWI, WWII, and the Korean War. In all of these instances, valuations started near historical averages.
What I see during the long Vietnam war is a secular bull and then bear market.
Why? Because fiscal policy switched to deficit spending (guns & butter) and drove both demand (butter) and supply (guns) and this lead to high economic growth and high inflation which forced high interest rates.
So with valuations high (high price relative to earnings) in 1966, the rising interest rates slowly started to bring valuations down, then pierced the high valuations into a collapse. At what point? At the time the market struggled at 4% on the 10-year and collapsed at 6%. But they started at 2.5% so this was a 1.5% and 3.5% rise from the bottom.
What’s different this time than during the 60s rise in interest rates?
1) stock valuations are near double what they were in the 1960s. In 1929 and 2000, at these levels of valuations the markets collapsed on their own. So it will not take much this time to collapse them, but it would take more than the central banks can muster today to hold them up without setting off hyper-inflation.
I’m willing to say we are starting at 2% this time also if you note that the drop to 1% was due to hyper monetary policy ($6 trillion printed in one year) and this in turn moved valuations from 1929 crazy levels to current bat-shit crazy levels. So simply allowing rates rise to 2.5% should knock 30% off the market rapidly. And from there we can get on with the secular bear market.
Take away: If interest rates today matched inflation the 10-year would already be 8% which in turn would collapse stock market valuations back to 10x earnings… so the stock market would be 65% lower today relative to earnings.
I expect earnings to drop by the end of 2022 as demand dries up from the fiscal cliff in government stimulus. Corporations have pumped up profit margins on supply-constraints relative to last years high demand. But all this will reverse over the next couple of years and profits will drop back to trend.
I drew the red line showing where interest rates should be heading because they would already be there without copious central bank printing to suppress interest rates the last decade during low inflation. Actual inflation forces their hand to allow interest rates to start rising to contain the damage in the long run.
Make no mistake, the central banks have wanted inflation to devalue debt. But debt has grown faster under their interest rate suppression. Investing in assets growing over 6% annually with debt rates at 2% is a no-brainer. How has your home done in terms of price? Your mortgage rate is much lower and this makes it a money machine until everything breaks.
I consider this whole monetary experiment one massive transfer of wealth to the top from the middle. From pensions and savers to speculators. I see it as corrupt. And I see no way back to normal without much pain. The pain needs to be at the top this time and better not squeeze angry middle.
I’ve expected a 1987 market crash on top of a bear market. Will the central banks allow it or intervene over and over again. Their interventions now stoke inflation which hits the middle class. What a mess.
To put this into family terms: In order for the central banks to hold your home prices near current levels they print to suppress interest rates and allow the price of gasoline to rise over $10 then $15 a gallon with corresponding rises in all you buy. Or they let the housing (and financial markets) reset and your home will ultimately (10 years) settle at a price 30% lower than today due to 6%-8% mortgage rates.
Back to the stock market: You can not compare today with previous wars because the conditions are vastly different: Valuations today are double any of the previous starts, interest rates were reasonable at previous starts because there was no suppression of rates during the Vietnam war. Normalization today requires much higher interest rates and in turn a 50% hair cut in the SP500 at the very least.
TSP Smart & Vanguard Smart Investor trying to educate & save small investors & talk about how to invest in this new environment
Categories: Perspectives