We see that this index of corporate profits was below the level of the stock market from the 1970s up until the mid-1990s. At that point, the dot-com bubble was upon us and despite generally flat corporate profits the stock market surged higher, as the Fed-engineered bubble ultimately led stock market valuations to more than three or four times their historical relationship with corporate profits.
That bubble burst, of course, as all bubbles eventually do, replaced by the financial and real estate bubble of the mid 2000s. With it followed higher corporate profits, as real estate and financial firms raked in bubble-economy profits far in excess of normal profit margins. When that bubble burst, corporate earnings, and the market, sharply retreated, before the Fed’s zero percent interest rate scheme (see chart below) inflated the newest bubble, in stocks, bonds, real estate, and nearly everything in between.
The graph below compares the U.S. stock market and corporate profits again, but looking at just the last five years, (the current year’s stock market activity is shown although first quarter corporate profit data is not yet available).
The past five years have shown what can be done with a properly engineered financial bubble. What is different from the mid-2000s bubble is that the current bubble has been less reliant upon corporate profits to “justify” the lofty stock market valuations. Corporate profits have been flat over the past five years, but the total U.S. stock market has risen by more than 107%. That’s a compounded average of more than 14% per year, more than 10% per year higher than the level of nominal economic growth.
While overall corporate profits have been flat, corporations have been able to increase earnings-per-share by issuing bonds and buying up their stock. Share buybacks are at record levels, and levels more than five times that of the early 2000s. Up until as recently as the mid-2000s, yearly dividends exceeded the level of stock repurchases. But with the “emergency” low interest rates over the last decade, corporations have been given a green light to leverage themselves with record bond issuance, buying back stock, and at record levels. Goldman Sachs predicts nearly $800 billion in U.S. stock buybacks in 2017, more than doubling levels from five years ago. All with the purpose of boosting stock prices, and large payouts for insiders.
There are dangers of relying on stock prices to support the economy, as appears to be the current plan by the Federal Reserve. I have shown before that consumer confidence has become increasingly conjoined with the level of the stock market. The stock market in turn, has become increasingly dependent upon near-zero interest rates to be sustained and elevated at near-record high valuations (see John Hussman at Hussman Funds for more on historical and present valuations).
Current interest rate and economic policy is a stark departure from history and fundamental economics. Even when the Federal Reserve began managing some of the interest rates early in the 20th century that the markets had previously managed, the Fed was historically more attuned to the rate of employment and inflation and less so to the level of stock prices. Below I’ve reprinted a graph showing the last 60-year history of the Fed Funds rate, the key interest rate managed by the Federal Reserve. When we compare the Fed’s set interest rate to economic conditions, we see a basic pattern. In nearly every economic cycle over those years, interest rates generally rise during periods of economic expansion (shaded green), then peak as economic conditions get overheated, before falling during the recessionary period (white vertical bars).
The rates set by the Fed during most of those six decades closely aligned to what would be expected from market forces. When interest rates are set by the market, as the economy heats up, interest rates will generally rise as the increased demand for money, along with higher inflation, drives up interest rates. The opposite occurs during recessionary periods as lower economic activity reduces demand for money and interest rates naturally decline. As interest rates decline businesses become increasingly willing to invest and expand and the market and finds increasing interest rates. This has been the basic system since the beginning of money and borrowing. In past decades, the Federal Reserve was willing to generally “cooperate” with market conditions.
Clearly, we have seen a marked change in this latest economic cycle. There has been almost no increase in interest rates for close to a decade despite much higher economic activity, a substantially lower unemployment rate (near record lows) rising inflation (sharply higher in many areas, including services, utilities, healthcare and education), and of course, increased speculation in real estate and the financial markets. Despite these factors, the Fed has allowed only miniscule increases in interest rates.
If economic conditions are robust yet interest rates are not allowed to rise to natural levels, the consequences will be an increasingly leveraged and risky economic system. We saw this in the last economic cycle ending 2008. Leverage then was high as very low interest rates over several years had encouraged overinvestment and speculation, similar to current conditions. During that economic cycle, the market also relied on higher corporate profits to justify high and increasing valuations in the stock market. But much of the economic activity was reliant then, as now, upon the rising stock market. The success of much of the economic activity in the mid-2000s, including banking, investment companies, real estate and mortgages, as well as the industries dependent upon those, was dependent upon a rising stock market. Very low interest rates also contributed, and the higher level of speculation worked in tandem with a rapidly rising stock market to boost economic activity.
The risk for every environment with elevated levels of speculation is when, for whatever reason, speculation declines and risk aversion rises. Financial markets, at least historically, have substantial volatility embedded within. Higher market volatility leads to greater risk aversion. The markets can and have gone down substantially even when economic conditions were good, interest rates were low, or for no real reason at all.
We have already seen the economic sensitivity to market conditions in recent years where even the smallest stock market pullback is met with warnings of economic doom. Similarly, with the potential for trivial interest rate increases (with related potential for causing a stock market selloff), dire warnings are issued to the consequences for economic activity. The Fed of course sees this too, which is why it goes to such great lengths to prevent any decline in the stock market. In recent years, it has been all too easy for the Federal Reserve to control the stock market, with just a few words indicating forthcoming stable, lower or higher interest rates.
But in a world where stock prices are never allowed to correct in any significant way, there will be consequences, seemingly positive in the short-term, less so in the long-run. As more and more time goes by without a significant stock market correction, the stock market will be perceived as less and less risky. As it does so, it will draw more and more money into the stock market as more previously risk-averse investors accept the (apparently) declining risk of stocks. Lower perceived risk increases demand for stocks, further inflating the bubble. The speculation further widens the gap between it and economic fundamentals, such as today, where stock market returns are now more than five times the rate of nominal (before-inflation) economic growth over the last five-year period.
In the past, an antidote to excessive speculation was a natural increase in market interest rates, reflecting expanding monetary and economic activity. The higher cost of money would then limit increasing economic and speculative activity, which tended to prevent financial bubbles from getting out of hand.
A fundamental law of investing is that higher risk investments deliver higher returns than those of lower risk. If inherently risky assets are deemed as low-risk, and their prices bid higher to compensate, the result will be lower average returns, over the long-term. In the short-term they can still gain, but all this does is further reduce the long-returns. In other words, let’s say a particular asset class - large-company U.S. stocks - has historically returned after-inflation (real) average long-term returns of 6% per year. Well, if those same stocks are subsequently deemed to have less risk/volatility than before, then those stocks will be bid up, perhaps to a point in which long-term expected returns might fall to 2%, 3% or lower. This will satisfy the intrinsic risk-reward investment relationship.
In the meantime, with market interest rates mostly a thing of the past, and without natural limits to speculation, an increasing number of small investors have been lured into the stock market. Because of negligible returns from traditionally safe investments like banks savings or CDs, and with stock market volatility apparently being tamed by the expectation that the Fed has their back, going into the stock market now appears the most reasonable place for savings, long-term or not.
But if sharply lower long-term (5, 10 or 15 year returns) returns are the result of current high valuations, then it will be a rude wake-up call to millions of small investors who believe that investing in the stock market always delivers high long-term returns. But on multiple occasions, high returns past returns led to low future returns. For example, investors in the late 1990s who would see negative returns for a decade. In fact, throughout the last hundred years, investors looking at high past returns would have been better served by looking at low future ones, and investing accordingly.
It’s also important to remember that the stock market is not the whole picture. Nearly every investor invests to at least some extent, in cash and bonds, traditionally safer investments. Even with high stock returns over the past several years, the low returns from cash and bonds are making it difficult to earn a “satisfactory” total return. This is the downside to the Fed’s strategy: it wants to boost stocks, but low returns from cash and bonds are offsetting that. And if recently high stock gains lead to lower ones in the future, this will make it even more difficult for investors, small or large, to earn an adequate return.
In addition to small investors, we are seeing this in the world of pensions and endowments. A recent study (Commonfund Study of Endowments (NCSE)) highlighted the difficulty even professional investors are having earning a sufficient return in a low interest rate world. For the full year 2016, the endowments of 805 U.S. colleges and universities returned an average of -1.9% for the 2016 fiscal year (July 2015 – June 2016). That return, on the heels of an average 2.4% return the prior year, has produced 10-year average returns averaging just 5.0%. This is far below the 7.4% average return that institutions say they need to earn to keep up with spending, inflation and investment management costs.
Despite the meager returns, endowments are still spending, 8.1% in the latest year, far in excess of their investment returns. Perhaps they are hoping for higher long-term returns. While they may get them from stocks (and perhaps not), they are unlikely to get them anytime soon from cash and bonds, which make up a substantial part of their assets. The endowments’ average cash return was just 0.2% for the latest fiscal year, and bonds, 3.6%.
Financial assets of all stripes - bonds, stocks, real estate, “alternative” investments – have now been bid up so high that their current perception as low risk has only guaranteed low long-term returns, met with an increased risk that their inherent volatility and risk will again be revealed. If that happens, the consequences of relying on risky financial assets as the foundation of an economy will also be revealed.