A Secular Bear Is Not Out Of The Question

The divergence between the stock market and the rest of the economy is purely psychological. During the last decade, this has been especially true, as successive rounds of monetary intervention persuaded investors to “buy the dip.”

While the association between economic activity and the rise and fall of stock prices has become less precise in recent years, there is still a correlation between the two. Because of the slowdown in economic growth, corporate earnings fell by 54 percent in 2000 and 88 percent in 2008, respectively. This was despite previous predictions of earnings growth that would last indefinitely.

As results fell short of expectations, stock values plummeted by about 50%, reflecting lower-than-expected current earnings and slower future earnings growth than had been anticipated.

In addition, because of their reliance on economic growth, earnings and profits have a long-term relationship with the stock market. Earnings cannot exist in a vacuum, separate from the economy.

Consider the potential that markets can, and frequently do, diverge from long-term earnings. It would be good not to dismiss this possibility out of hand.

According to historical precedent, such variances have not benefited overly “bullish” investors. It becomes more apparent when the market is compared to the ratio of corporate earnings to gross domestic product (GDP).

With correlation coefficients of 90 percent, it should be evident that economic growth, earnings, and business profits are all linked together in one way or another. As a result, neither the final reversion in either series should be considered.

Reversions occur on a regular basis.

Because of the stock market’s dissociation from underlying profitability, investors can expect to receive disappointing returns in the future. Markets, on the other hand, may appear to “remain irrational for a longer period of time than logic would suggest,” as has been the case throughout history.

Such detachments, on the other hand, are never permanent.

Whatever the circumstances, there is one general truth about stocks and the economy that cannot be ignored.

Stock prices are NOT a reliable indicator of the state of the economy. The economy, on the other hand, is a reflection of the very thing that is driving asset prices higher in the first place: corporate earnings.

Expectations for three decades of Fed-fueled financial asset inflation have been surpassed.

Profits and income will take years to catch up with already inflated asset prices.

As interest rates increase and normalize, valuation multiples will continue to decline.

According to the Wilshire 5000, the US GDP was $4.8 trillion in Q2 1987. Wall Street equities accounted for 62% of GDP back then.

With the advent of “the wealth effect” theory followed by financialization the last 34 years market value increased by 1,440% to $46.3 trillion. Over 375% nominal GDP growth.

The Wilshire 5000 should be worth $14 trillion, not $46 trillion, based on the 1987 stock market capitalization rate. So the $32 trillion excess stock market value looms large over the banking sector.

With Lehman Brothers gone, the gap between GDP and market size has grown and become riskier. For example, since October 2007, the Wilshire 5000’s market capitalization has expanded by approximately $32 trillion, yet the US GDP has grown by only $8 trillion during the same period.

The future holds THAT market capitalization should be declining, not rising. After all, the US economy has been hamstrung since the financial crisis and Great Recession.

Since Q4 2007, pre-crisis real GDP growth has averaged just 1.5% per year, half its historical trend rate.

Within these 14 years, the stock market’s value has climbed from 106% to 204% of GDP.

So, while the US economy’s growth rate has halved, the stock market has ballooned in value.

To restore a healthy link between financial asset values and national income, the stock market must stagnate or fall.

However, It would take till the US economy reached $75 trillion for the Wilshire 5000’s market capitalization to revert to 62% of GDP.

After the stock market boom years, investors should expect a long period of very low returns on stocks, a secular bear.

As the chart above illustrates the swings during secular bear markets can be much more dramatic than most investors realize. Although secular bull markets have similar swings, they are upward-sloping and are often ignored.

The last full secular bear market period (chart) delivered 16 years of annual changes and 343% cumulative peak-to-trough movements thus over 21% per year.