A rare combination of circumstances created the perfect breeding ground for exceptional equity performance over the past 35 years. Not one pro-equity dynamic did unusually well – they all did, and they did so more or less simultaneously, which explains the extraordinary performance – a perfect storm so to speak.
Those circumstances were:
- The level – and direction – of interest rates
- The level – and growth rate – of aggregate earnings as a share of GDP
- The growth rate of earnings per share
- Demographics
During the early stages of the great bull market – from 1981 to 2000 – all four factors behaved impeccably well and, as a result, we experienced near perfect conditions for equities in many countries around the world. Of the bigger markets, only Japan experienced some problems.
Such circumstances are not likely to be repeated in our lifetime.
Take demographics. Given the large number of boomers knocking on the 70+ door, you will ignore demographic factors at your own peril. We know that total U.S. household wealth is approx. $84 trillion. We also know that U.S. baby boomers own 60% of the nation’s wealth, so their impact on equity markets shouldn’t really come as a surprise. What has been a tailwind for many years is likely to turn into a sizeable headwind in the foreseeable future.
The biggest equity buyers (the 40-49 year olds) are being outnumbered by the biggest bond buyers (the 60-69 year olds), pushing bond valuations up and equity valuations down. Importantly, that trend is likely to continue until at least the mid-2020s, which raises another question and one that I won’t attempt to answer in this paper. How much of the recent strength in various bond markets should actually be attributed to QE and how much is due to demographic factors? Nobody really knows the answer to that question, but I suspect that the significance of central bank policy has been overestimated.
The other three factors could also quite conceivably turn into significant headwinds. Bond yields cannot fall much further, so that party is largely behind us. Aggregate earnings as a share of GDP are not likely to continue to expand indefinitely, as capital’s share of national income has a ‘nasty’ habit of mean reverting to its long term average.
To complete the picture, EPS growth is not likely to continue to do better than aggregate earnings growth. I expect ageing investors to increasingly demand dividend hikes over equity buy-backs, as bonds continue to fall short of their income requirements. The trend has already begun.
It is therefore a much more ‘sober’ 10-20 years (and quite possible even longer) we have ahead of us compared to the party we just came from. It is totally unrealistic to expect a continuation of the near perfect alignment of those important factors that we have enjoyed since 1981.
All of this has (at least) three major capital market implications:
- Equities are not likely to bail out all those investors who are in the process of moving significant parts of their portfolio from bonds to equities in search of higher returns than bonds can offer at present.
- The significant flow of equity capital from active to passive mandates that is ongoing, could quite possibly happen at exactly the wrong time.
- Many of those investors piling into alternative investments at present go into strategies with an equity ‘edge’ (such as the biggest of them all – equity long/short) and, as a result, are likely to suffer from the same low return environment as long-only equities. This will be further aggravated by the higher fee structure amongst alternative investment managers.
Finally, in the future, equity markets are likely to have a much bigger impact on the economy than has been the case in the past. This is a simple conclusion derived from the fact that total equity market value today is 1.2x GDP. 35 years ago, when we entered the great bull market, total equity market value was only 0.4x GDP (the numbers are U.S.). No wonder the financial collapse in 2008 had such a dramatic effect on the economy.
Niels Jensen is CIO at Absolute Return Partners
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