What next for Wall Street?

Opinions vary as to whether US equities are currently in a long bull market, a bear market or an extended correction. What is clear, however, is that everything will change when credit expansion comes to an end.

Let's re-examine the long-term history of the stock market. Printed below is Robert Power's table showing the performance of the American stock market from 1802 until 1999 which explains how the long-term total return of 7% per annum, adjusted for inflation, happens not on a year-by-year basis but instead as a result of long periods of above average returns and alternate long periods of very poor returns. The median annual return of the strong cycles averaging 17 years each, has been 14% and the median annual return for the weak cycles averaging 16 years each, has been zero percent.

Years Per Annum Duration

1802-1815 +2.7% 13 years

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1815-1835 +10.0% 20 years

1835-1843 -0.6% 8 years

1843-1853 +13.7% 10 years

1853-1861 -3.0% 8 years

1861-1881 +12.0% 20 years

1881-1897 +3.9% 16 years

1897-1902 +15.2% 5 years

1902-1921 +0.0% 19 years

1921-1929 +21.2% 8 years

1929-1949 +0.8% 20 years

1949-1966 +14.0% 17 years

1966-1982 -1.4% 16 years

1982-1999 +14.9% 17 years

The period from 1929-1949, 20-years averaging 0.8% per annum was followed by 1949-1966 17-years at 14% per annum; 1966-1982 16-years at minus 1.4% per annum and culminating in 1982-1999 17-years at 14.9% per annum.

So, what we might expect for the period from 1999 is a long, approximately 16 year period of zero returns. So far, what we have received as far as most major stock markets are concerned, is seven years of zero returns; in other words, many of the major stock markets such as the FTSE 100 and S&P 500 are roughly back to where they were. Over the full period of this study, there have been two negative periods of only eight years and one positive period of only five years. So it is quite feasible that the period of poor returns since 1999 could end here after only seven years and now be followed by a long positive period of about 14% per annum.

US equities: Where to from here?

From here, there are three possibilities. Firstly, the one to which we subscribe, the move back to the 1999 high is part of a longer-term primary bear market that started in 2000 and it is not likely that markets will be meaningfully above current levels for many years; in fact, they might plumb new depths below the lows set in 2002 and 2003. One of the reasons for that view is that the boom' that ended in 1999 never went to a bust'. If the low set in 2002/03 was the final low of the bear market that started in 2000, valuations should have been outstanding. However, yields then were still too poor and P/E ratios were too high values were not outstanding. The bear market never properly ended.

It always remains possible, that "this time it's different". If that is the case, then valuations, as measured by P/E ratios are nowhere near the level we would expect at the end of a primary bull market. If this, the second possibility, is a new bull market, it has a lot further to go. Does that really make sense, can the credit expansion continue significantly longer?

The third possibility and the one that is the basis of the recently revised thinking of Richard Russell, who writes the Dow Theory Letter is that the bull market that started in 1983 is still ongoing; it never finished and what happened between 1999 and 2002/3 was a very considerable correction in an ongoing bull market. If that is correct, the same issues would apply as if it were a new bull market. To continue further, the bull market would require current economic conditions of credit expansion to continue, probably for several years more.

Barron's recently reported on some illuminating work by Doug Cliggott, Chief Investment Officer for Dover Management. Cliggott pointed out that US bond yields are rising even as the economy is slowing and that situation is exacerbated because foreign Central Banks are becoming increasingly reluctant to add to their piles of dollar reserves. Higher bond yields are not good news for US equities more so because it appears that earnings per share (EPS) growth have stalled and profit margins are beginning to decline. For the past four quarters he quotes, the EPS for the market has been relatively unchanged at $22.36; $22.73, $22.07 and in the latest quarter $22.78; clearly proving that the rise in US stock prices since last year has not been driven by earnings.

The important evidence he provides, and this is critical to working out the current situation, is that corporate profit share of GDP in the past five years has been in tandem with the growth in credit. As borrowing has boomed, so the US financial sector has grown dramatically; profit margins that have risen very sharply have become highly correlated with debt growth.

Debt growth, he said, peaked at 9.4% in the fourth quarter 2006 and has since slowed sharply and the increase in bond yields, he says, puts even further downward pressure on profit margins.

A crucial part of his work concerns his study of profit phases over the past fifty years which he divides into "up phase" of profit share of GDP which have lasted about four years each and during which period the S&P 500 has returned an average of 14.07% annually and "down phase" of profit share of GDP which has lasted on average about 3.5 years, during which the S&P 500 returned on average just 2% a year. Based upon that calculation, the period from 2002/03 which was an "up phase" should now be exhausted and now be followed by a "down phase".

His key point is the link between credit expansion and profits. For the "up phase" to continue, credit expansion must also continue and if the credit expansion does not continue, then the "up phase" has ended and the "down phase" is about to start.

Credit expansions come around regularly, this one is different in detail but the basic principles remain unchanged. In a credit expansion, asset prices rise and lenders become less concerned with risk and lend ever more imprudently. Lenders become madly optimistic about who is a good credit, sub-prime mortgages in America was the latest example of this. P. Henry Mueller, nearly 30-years ago when he was Chairman, Credit Policy Committee, at Citibank, in his famous article entitled "What Every Lending Officer Should Know About Economics", described the banks' practices, at this stage of the credit cycle, as follows:

Susceptibility to euphoria and loss of perspective of what constitutes good credit. Mania for growth, going down market to get it.

Usually, loans to poor credit risks initially appear to be sound because of the relaxed nature of the arrangements and the availability of more credit. It was recently reported in the Financial Times that the US company Bally which was apparently deeply in debt and a total candidate for bankruptcy, was able to borrow another $284m. The Financial Director was heard to say "How on earth was this so easy?" - the officer from JP Morgan who had organised it, said "There is a lot of money out there".

For the bull market to continue meaningfully higher, credit expansion will have to continue which means that the lending terms become more ludicrous it can't happen or if it does, surely not for much longer! Potential credit problems are serious enough for the Governor of the Bank of England, this week, to issue a remarkable "toxic" debt warning.

Dr Prieur Du Plessis recently wrote about US equity returns and what to expect by measuring different entry points based on P/E ratios. Depending at what level the entry is made, the probability of good or poor returns going forwards is forecastable. His work was an update and extension of an earlier study by Jeremy Grantham of the Investment firm GMO. We wish to look at one aspect of his report. Based on a collection of calculations, the critical P/E level of twelve is key. An entry point below twelve times, has always delivered, over the following ten years, good real returns. However, an entry point when P/E ratios are twelve or higher, has always delivered negative real returns at some stage. Relating that to the lows of 2002/03 P/Es, then the P/E was above twelve; so we should expect, at some future date, for investment returns since then to turn negative.

To summarise, there is compelling evidence that we are at a significant moment in time. As reported in the Wall Street Journal on 19th June, we are on the edge of the "Coming Credit Meltdown".

By John Robson & Andrew Selsby at RH Asset Management Limited, as published in the Onassis Newsletter, a fortnightly newsletter that gives insight into the investment markets.

For more from RHAM, visit https://www.rhasset.co.uk/