The return of the bull market

published 29 March 2012

Goldman Sachs thinks that the stockmarket is about to take off, and we're at the start of a new age of growth. But are we? Matthew Partridge investigates.

What are they arguing?

"It's time to say a long goodbye to bonds, and embrace the long good buy' for equities," says Peter Oppenheimer, chief global equity strategist at Goldman Sachs. He and his colleague Matthieu Walterspiler give the bull case for shares in a recent 40-page report.

Oppenheimer notes that bonds have outperformed shares in the last decade. "The real returns in the bond market have been really remarkable compared to most periods in history."

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However, he argues that this temporary victory for fixed income is set to end. Indeed, "prospects for future returns in equities relative to bonds are as good as they have been in a generation".

What are the reasons for this?

As Joe Weisenthal at Business Insider points out, the report "makes an equity-risk premium argument that stocks are just impossibly cheap relative to bonds". Up until the mid-1950s, US bonds yielded less than US stocks. Stocks were seen as much more volatile and risky than bonds, and so had to offer a higher yield to compensate.

However, stocks outperformed bonds over the long run and, as the pension funds realised this, the dividend yield fell below the bond yield. Partly due to this mass conversion to the "cult of the equity", between 1956 and 2000, US equities made an annualised real (ie, inflation-adjusted) return of 7.4%. Then the tech bubble burst, and for the last decade, note Oppenheimer and Walterspiler, bonds have come out on top. The gap between equity yields and bond yields is now roughly where it was in the mid-1950s. The Goldman Sachs team believes "the prospects for future returns in equities relative to bonds are as good as they have been in a generation".

Is that their only argument?

You could argue that bonds are expensive, not that stocks are cheap. However, Oppenheimer and Walterspiler feel that "equities are implying unrealistically large declines in growth and returns into the future".

This is important since, "if growth rates are low, but the market has assumed that the outcome will be even worse, then the returns can be high". And growth might be better than anyone expects. The Goldman Sachs team reckons that the decade from 2010 has more growth potential than any decade between 1980 and 2050.

How can that be?

It's all down to emerging markets, which have largely been sheltered from weak growth in the developed world. Even though Brazil, Russia, India and China are slowing down, says Weisenthal, they are so big, and the other promising emerging markets (such as Indonesia and Vietnam) "are growing so fast, the net effect is that this decade could be a monster". Oppenheimer and Walterspiler argue that world economic growth will average "around 4.3% in the 2010-2019 decade, well above the average of the last decade or the previous one".

Are there any other bulls?

Goldman is not alone in claiming that today's market offers good value. Professor Burton Malkiel of Princeton University argues in The Wall Street Journal that shares "are still attractively priced". In The Daily Telegraph, Tom Stevenson, Fidelity's investment director, agrees: "I'd rather be biased at today's valuations than those on offer 12 years ago", he says.

Investment guru Barton Biggs is also bullish, increasing his fund's weighting in shares to 90%, relying on the wall of money' argument that money will flow back into stocks from bonds and other so-called safe havens'. "There is an awful lot of money that is out of stocks and in very low-yielding fixed-income instruments," he argues. "The odds are that money is going to migrate back."

Could this be a bad sign?

Any contrarian worth their salt sees big bold calls as signs of over-confidence, and the Goldman Sachs report is no different. On The Street.com, Doug Kass of Seabreeze Partners notes that: "I can't help but think that Goldman Sachs might have rung the bell that the market has topped in the near term."

Many within Goldman disagree with the report too, he adds. "Head domestic strategist Dave Kostin recently confirmed his view that the S&P 500 will close 2012 at about 1,250." Kass notes that stocks are far from cheap. The market "already trades at 14 times, not far from the historical average of 15 times over the past five decades [at a time when] we face numerous secular headwinds". Concerns include "profit margins topping out [see below], inflation and interest rates rising, a potentially disappointing upcoming [earnings] season and a slowdown in global growth".

Corporate profit margins - should you worry?

American corporate profit margins are currently higher than ever before at just above 10%. That sounds like this should be good news for stocks, but it's not.

Like many numbers in finance and economics, corporate profit margins tend to be mean reverting'. If companies are making extraordinary levels of profits, that shouldn't be sustainable new competitors will be drawn into the market by the potential profits on offer, undercut their rivals to gain market share, and thus drive down overall margins.

James Montier at American fund manager GMO argues that the key thing sustaining high profits right now is government spending. With governments around the world likely to have to cut back to trim deficits, then "corporate profits are likely to struggle". That could be very bad news for stocks.