Golden Age for Stocks is Over

Lies, damn lies, and statistics.  For the US stock market, since World War 2, it has been an amazing period of high returns that has shaped the current view on the equity market for institutional, retail, and foreign investors.  The assumptions for forward returns are often based on past history, most of it dating back to a period where the US was a emerging as the world superpower, obtaining reserve currency status, with both high growth rates and big productivity gains.  Those historical assumptions are projected out into the future, with most investors thinking its natural and common for stocks to return 10%/year, or 7-8%/year after inflation.  Those are bold assumptions likely to disappoint current investors.  

How did the stock market go up so much since World War 2?  There are 3 phases which contributed to this great bull run in stocks.  

Phase 1:  Demographic Growth

From 1947 to 1964, the US population grew at a 1.7% annual rate, laying the foundation for a much bigger labor force in the 1980s and 1990s.  The working age population surged higher.  The labor participation rate for women went from under 35% in the 1950s to 60% in the 1990s.  This resulted in a huge increase to the labor pool, especially during the 1960-1990 time period.  More labor = more production = more wealth.  That flowed through to more consumption which boosted revenues and profits.

Phase 2:  Technology Golden Age

Computers and Moore's law, making computers both faster and cheaper continuously from the 1970s to the 2000s.  Add in the network effects and efficiency gains from the internet and you had a golden age in technology.  EVs, AI, cloud computing, etc. don't even come close to what happened in the past.  EVs will have no effect on productivity or efficiency for the overall economy.  Cloud computing is just outsourcing servers.  AI is the hype monster at the moment, and I'm no expert, but its got to get a lot better to even have a marginal effect on the economy.  Improving search results and answers to questions doesn't do anything for productivity.  It could be a niche tool for certain tasks, but its doesn't have the mass game changer potential that computers and the internet have had in the past.  Not even close.  

Phase 3:  Profit Margin Expansion

Anti-trust legislation has been in the books for over 100 years, but the enforcement and interpretation of the law have gone extreme to the right side of the spectrum.  In the past, when companies got too powerful and too big, they were forcefully broken up.  Classic examples being Standard Oil and AT&T.  If the standards of the early 1900s, or even the 1970s or 1980s for anti-trust were enforced, Google wouldn't have been allowed to buy Youtube.  Facebook wouldn't have been allowed to buy Whatsapp or Instagram.  Cisco would be much smaller, and many of its acquisitions would have been blocked.  Microsoft and Amazon would have been forced to breakup their Cloud business.  A lot of modern day oligopolies wouldn't exist.  Mergers and acquisitions are basically rubber stamped, and collusion is the norm, not the exception for many industries.  While I don't expect a return to the past of more strict anti-trust enforcement, you've reached a point where corporate influence in politics is near a maximum, as populism keeps growing.  

The corporate tax rate going from 35% to 21%, and the addition of favorable tax rules and loopholes have gone straight to the bottom line of corporations, at the cost to the government having to issue more debt to fund those tax cuts.  Corporate welfare in the form of lobbying to get favorable treatment, as well as pressuring lawmakers to put in  regulations to prevent competition and build a moat around a business are now normal and expected in corporate America.  

The US budget deficit has been ballooning higher since 2008, and even during boom times in 2022, the deficit hit $1.4T, which is unheard of for such a high GDP growth year. For 2023, the CBO projects a $1.5T budget deficit, but that's already looking way too low, as the April tax receipts came in $250B less than expectations, mainly due to less capital gains collected due to the falling stock and bond markets in 2022.  So 2023 is looking like its going to be closer to $2.0T budget deficit.  That's a deficit of around 8% of GDP, which is a big boost to the economy.  No wonder the recession keeps getting delayed.  

You should have seen a big slowdown in the US economy in the 2010s with the excess credit being taken out of the system but the government came in to fill the hole with big budget deficits which continued even when the economy was fully recovered.  And it hasn't looked back.  Even before the Covid stimulus, you had big budget deficits even during an expansion in 2018 and 2019 because of unfunded tax cuts and the growing baby boomer population collecting Social Security and Medicare.  These public sector deficits become private sector surpluses.  That's kept the growth going even though natural demand from a growing working age population is just not there anymore. 

The 1960s-1980s were about demographic tailwinds, the 1990s-2000s were about technological tailwinds, and the 2010s-2020s were about corporate welfare and government deficit tailwinds.  

With the working age population stagnant and no breakthrough technologies to improve productivity, the stock market can only lean on corporate welfare and big government deficits to fuel future profit growth.  But welfare and deficit fueled growth is pure inflation.  Inflationary growth is growth of the lowest quality.  As it concentrates wealth into those with the most access to government largesse and money spew.  It doesn't add real growth.  Its a redistribution of wealth, not an addition of wealth.  Inflation is not wealth creation.  Even though it often feels like it for those who only look at nominal numbers.  Inflationary environments mask recessionary conditions because we live in a nominal world.  If you reduce volume but increase price, you can increase revenues with negative real growth.  That's what the weak commodity markets in an inflationary environment are telling you.  That's what greedflation is doing to the economy.  Corporate pricing power is very strong, and the CEOs are pushing prices up to maximize profits, not revenues or volume.  

US corporations have done a great job pushing up profit margins over the past 20 years.  They have been rewarded with higher and higher stock prices, so the incentives are there to keep pushing margins higher.  Only when consumers are no longer willing to pay up will corporations change strategies.  But with all the government money floating around and $2T added each year, prices have to go up to match supply and demand.  Wages have to go up as more money is chasing the same number of workers.  More money is chasing the same number of goods.  That's inflation.  

So I expect future stock market gains to be fueled mainly by higher inflation, which boosts nominal numbers.  The golden age of low inflation and high stock market returns are history.  

The irrational exuberance phase of this rally is frustrating bears and the underinvested.  You will need to see even more greed from investors to take this market higher.  Its not going to be fundamentals doing the heavy lifting.  This rally over the past few months has been all valuation expansion and soft landing/delayed landing optimism.  Valuations are quite rich for such a tight monetary policy environment.  Take a look at the SPX/M2 ratio as of April 1 (when SPX was ~4100), around 0.20. With the SPX around 4400, that ratio is above 0.21.  That is higher than almost all periods since the pre-Covid highs in early 2020 and mid 2021 to early 2022.  You had brief periods in 2000 and 2007 when the ratio was higher, but only marginally so.  You are in nosebleed territory here. 

 

We are finally getting that pullback after an extremely sharp up move in the first half of June.  Based on how slow this pullback is developing, and the shallow nature of the losses, its not going to be easy for the market to reach that 4300 level I was originally expecting later this month.  I will lighten up on shorts today into the weakness, with plans to add more shorts if we get a bounce next week.   Bond market is looking heavy so I don't expect a sharp rally from stocks anytime soon.  There are rhythms and patterns to how the stock market reacts to such sharp and fast up moves, and they are usually not immediate collapses (Jan 2018 being an exception).  You get a shallow pullback most of the time and some consolidation and narrow range trading with compressed vol.  That appears to be the case this time as well.  Yesterday, VIX went down even as the NDX sold off over 1%.  Not looking for any big moves right now, just trying to hit singles.