“That 70’s Show” – Lessons of the 1970’s and the Course Ahead
Like everyone else, we have been thinking a lot about the history of investing over the past year and specifically the relationship between the stock market, interest rates, inflation, and earnings. The chart below is a good visualization of the levels of inflation we are experiencing today in the context of the last 60 years, including two different measures, overall CPI (yellow solid line in lower panel) and core CPI (red dashed line, excludes volatile food and energy price changes). As result we see the Fed’s interest rate reactions (green dashed line) as well as the market’s overall expectations captured in the rate path of the 10-year Treasury yield (white line).
Source: ECM and Bloomberg
As we discussed in a previous post, there were reasons why inflation took off in the 1970s, and there are also well discussed reasons as to why it took off this time around. Both involve the growth of money supply driven by the Fed, policy actions by Government, aggregate demand running in excess of aggregate supply, and unanticipated macro and geopolitical events that happened to hit when the economy was vulnerable to inflation.
This next chart illustrates the long-term relationship between corporate earnings, the value of the stock market and its price to earnings ratio.
Source: ECM and Bloomberg
What’s most interesting about the long-term perspective is that over time earnings have grown (dashed blue line) which has underpinned market appreciation (white line). The relationship between the market level and underlying earnings is the Price to Earnings multiple (or P/E ratio) captured by the cyclical orange line.
The calculated P/E ratio captures the expected value of future cash earnings available to shareholders discounted back to current value. Since companies are expected to operate for decades into the future with various prospects for growth and reinvestment needed to support the growth, it is these future discounted cashflows that comprise the value of a stock. Please refer to our previous post about valuing these cashflows for a more in-depth study.
However, the market’s discount rate — the rate of return that investors require as compensation for taking on investment risk– and its expectations for the level and duration of future earnings growth fluctuates over time. This impacts the multiple on earnings it ends up attributing to stocks.
When current events look bad or interest rates are higher, investors require a higher rate of return for the uncertainty of future earnings, translating to a lower P/E multiple. When things are looking bright, investors generally look to the future prospects of companies with greater optimism and certainty, they require a lower rate of return, resulting in a higher P/E multiple.
Similarly, when they can earn a high-risk free rate of return by holding treasuries, the rate of return net of an equity risk premium will require a higher rate of return to bear the uncertainty of equity risk (lower P/E multiple, higher earnings yield E/P) and vice versa. Earlier this year, we offered an in-depth examination of the relationship between long term risk, perceived risk, and the equity risk premium.
As inflation rates took off in 2021 and 2022, the prospects of materially higher interest rates and the negative impact on economic growth increased, causing the market to sell off. It drove higher risk-free returns in treasuries while also creating greater uncertainty for the economy in the future as the Fed raised rates and drew down liquidity (Quantitative Tightening) to slow inflation. This will eventually result in a “soft” landing in the economy, with low to moderately negative growth and employment scenario, or a “hard” landing, with a steeper negative growth and employment scenario.
Nearly all of the decline in the S&P 500 in 2022 was due to the P/E multiple declining from about 25x to 18x as future confidence declined and required rates of return increased. In the 1970s, P/E multiples declined from 20x to 7x as short-term Fed Funds rate went from 3.5% to 13% and ultimately as high as 20% under Fed Chair Paul Volcker in the 1980s. That was quite a rough economic period!
The chart below shows the same metrics that were presented above, but zoomed in on the 1970-1989 period.
Source: ECM and Bloomberg
But while the PE multiple compressed sharply in the 1970s, S&P 500 earnings increased from about $5 in 1970 to $8 in 1974 and then further to over $15 by 1980. The market, while experiencing a lot of volatility in the 1970s including a 50% drawdown from the 1973 peak of 120 to 1974 trough of 63, roughly held flat from 1970 to 1980 in the 90-110 level. Of course, that outcome was no consolation for equity holders during that period, but fundamental earnings tripled! (Note: Real earnings adjusted for the high levels of inflation in the period grew a cumulative 27%, while S&P 500 total return inclusive of reinvested dividends was actually about 5.5% per year).
We know that in the period after inflation was finally brought under control after some false dawns, the P/E multiple increased like a coiled spring from 7x to 15x from 1980 to 1990 (including a brief flirtation with 25x before the 1987 crash) while earnings continued to increase (at a subpar annual rate of ~5%) from $15 to $24 resulting in the S&P 500 increasing from about 110 to 360. So, the decade of pain was rewarded with a decade of good returns of about 12.6% per year.
And we all know there was a lot more reward in the next decade culminating in the 2000 Dotcom bubble peak over 1500 on the S&P 500 (~15.5% CAGR), PE of 30x, and earnings of $55. But then that peak was followed by 13 years of painful volatility with essentially no progress in the market as P/Es trended lower even as earnings doubled, inclusive of the Great Financial Crisis that rattled the global financial system. Finally, the past decade was a good one, with market return averaging ~10%, inclusive of the drawdown from the S&P 500’s 4800 peak to today’s roughly 4100 level.
Source: ECM and Bloomberg
Of course, an extraordinary macro investment manager could have done really well trading among asset classes based on changing economic trends. This is the kind of environment when some such strategies have posted extraordinary results, though very few have consistently performed well. Since the economy has emergent complex system characteristics, it is much harder to forecast than company fundamental data (relatively speaking a simpler more deterministic system, especially with a longer-term outlook).
Given the uncertainty inherent in emergent complex systems like an economy, its exceedingly difficult to predict inflation rates, interest rates, and GDP growth rates. This is why market expectations are often wrong, despite embedding the collective “crowd-wisdom” of millions of smart individuals.
Source: Apollo Global Management
Neither interest rate predictions nor inflation forecasts play out as expected even in the short term as a result. In part this is because economists often use historical averages as their base case and assume some kind of mean reversion.
But in reality, the interplay of factors play a big role in determining the emergent characteristics that actually transpire. Society prefers predictability, and so we have systems in place that try to control the extremes of emergent behaviors with policies, such as the Fed’s control of interest rates and liquidity and the Government’s control of stimulus policies and financial regulation. Given the complexity and size of the system, however, these policies nearly always end up with countervailing consequences both intended and unintended, with the latter often unpredicted by the consensus view.
There are instances when short to medium term economic activity can be predictable, as we explained after the passage of the hugely stimulatory $2.2 trillion CARES Act in 2020 and the $1.9 trillion American Rescue Plan in 2021, which resulted in strong consumer spending and higher corporate profits. Of course the ensuing “high pressure economy” led to the inflation rise that was triggered by the tsunami of demand ill-matched with supply constraints and aggravated by geopolitical implications of the Russia-Ukraine War.
As a result over the course of 2022, we saw a tremendous change in interest rate expectations, even as rising inflation rates were clear for everyone to observe in 2021, and the Fed shifted its view on the persistence and nature of US inflation in November 2021 when they dropped the “transitory” modifier.
Interest rate expectations moved from a peak of only 2% in November 2021 (dashed green curve) to 3% in the early tumultous months of 2022 (dotted yellow-green curve) to about 4% today (solid green curve) but not before it is expected to peak over 5%.
Source: ECM and Bloomberg
Exactly how high the Fed will drive rates up before pausing or cutting is still up for debate as mixed economic and inflation data eludes a clear picture, now complicated by tightening credit conditions in the banking system. These are big changes in expectations and clearly those expectations were wrong a year ago, and are likely to be wrong today!
Despite all that uncertainty from inherently unknowable macroeconomic factors, we can see from the previous charts that earnings have grown tremendously over long periods of time, especially during the high inflation years because companies were able to leverage the inflation mindset in the economy to raise prices. But a proxy for all the uncertainty in economic data is reflected in the changes in the P/E multiple which is by extension hard to predict for any particular time frame.
It is much easier to forecast fundamentals than it is the valuation multiple (within some bounds), captured by a phrase coined by Ben Graham that’s often been repeated by Warren Buffett that “in the short run, the market is a voting machine but in the long run, it is a weighing machine.” In other words, in the short run the market guesses about what could happen within a static short-term context as conditions shift, i.e., it reflects quick opinions in the face of uncertainty, while in the long run the market reflects how people and companies and economies dynamically adapt to changing conditions in effectuating what actually does happen.
In that way, it is a better risk-reward to focus on company fundamentals within a set of companies that have better than average control over their businesses. In Ensemble’s jargon that means competitive moats with relevant products to prevent competitive degradation in the fundamentals, matched with capable, adaptable management teams to guide the organizations through challenging periods that likely require some level of change given the stresses to their markets and customers.
Regardless of what happens in the macroeconomy, these kinds of companies are able to have the resources, talent, and cushion to navigate challenges, and adapt their offering and tactics to make it through turmoil and come out stronger on the other side. If one recognizes that the macroeconomic and geopolitical events are inherently hard to predict, then the next best thing to certainty is to side with the kinds of teams that can adapt and compete in whatever those conditions are that they find themselves in.
Unfortunately, while cash is a “safe haven” during turbulent uncertain times, it is only a temporary one that investors flock to in order to reassess their situation when they are in the business of betting on the right horse as the macroeconomic racecourse changes. However, over time, “the system” is rigged against cash as a store of value, with real rates of return on cash generally being negative. This is nicely illustrated by this chart from the Visual Capitalist.
Wealth must be invested to be preserved if not grow in real terms, and so the investor’s job is to figure out the best way to deploy the cash as the world changes. Either the investor can redeploy the cash through the uncertain macroeconomic changes themselves in shifting asset classes geared to benefit from changing economic trends, or investors can find companies that can be adaptable at the microlevel and figure out how to deploy their resources and talent to earn an attractive real rate of return, even as the economic context changes around them. That is essentially the viewpoint that we advocate and make it our jobs to identify within the equity asset class and partner with the appropriate businesses.
To conclude, while it is uncertain what sort of multiple on earnings the market will assign stocks through this period of economic uncertainty, holding a portfolio of competitively advantaged, well managed companies can be one of the better ways to navigate macroeconomic uncertainty and sustain long term value of capital via fundamental earnings growth.
Of course, we generally must be right on what those fundamentals will look like, and we have a process and investment strategy that we believe will help us do that over the course of time. Like the countless number of charts that we’ve all seen showing the stresses the market has navigated and surmounted over the decades (requisite chart below), it’s a truism to say that the market will do well in the long term as a result of groups of people coming together to work on productive, value creating missions, under the right strategic frameworks that improve the lives of their customers who collectively comprise humanity.
We’ve seen thousands of years of progress on this front and, while Buffett would say he would “Never bet against America,” we would broaden the statement to say we would “Never bet against Humanity” (is there really a philosophical choice in this?). The market is simply a reflection and capitalization of humanity’s ability to generate progress, albeit how enthusiastic it is about those prospects can fluctuate over time and has seen its share of stumbles along the way. But the long term trend has indisputably been up and to the right.
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