US Stock Market History 101

This morning @KeithMcCullough of Hedgeye Risk Management tweeted:  US Stock market history 101:  as inflation expectations rise, you get multiple compression #P/E

We agree 100% w Keith and think this concept is one of the most misunderstood among investors, analysts and central bankers.  Corporate profits generally grow at the same rate of nominal GDP (NGDP) which has been fairly stable YOY (ex-2009) averaging 5.5% since 1981 v today’s Q42011 YOY reading of 3.8%.  Clearly we are growing below the long term trend but since 2001 the average rate is 3.9%  It’s not the NGDP that fluctuates as much as the inflation deflator that makes up Real GDP.  Just like it’s not corporate profits that fluctuate over time, it’s the the multiple paid for those earnings that generates market performance.

Since WWII there have been 4 basic market cycles, the post-war boom that ended in the mid 60s, the following bear market that ended in the early 80s, the subsequent bull market that ended in 2000 and the current bear market that remains since the tech bust.

During these cycles it wasn’t the economic growth rate that differentiated performance it was how much of that growth was inflated and how much was real.  During the post war boom which was one of the best periods to own equities we had multiple contractions in NGDP yet very low inflation (Eisenhower).  In the years that followed that included various examples of explosive government spending including Nixon’s closing of the gold window and very high inflation relative to growth it was one of the worst periods to own equities as the multiple severely contracted.  While the price low on the $SPX was 1974, the multiple low was in 1982 at 1x book value.

When we were introduced to the “Greenspan put” in 1998 w the collapse of LTCM the market entered what we have deemed the ‘era of easy money’ where the Fed thought they could simply reflate asset prices whenever they wanted to generate increased consumption.  But the market is not stupid and the market doesn’t pay for inflated growth.  It’s easy to point to the contraction in multiple during the most recent bear market but even during the great asset reflation credit bubble from ’02-’07 received no increased multiple for book (equity) even as equity prices rallied.

This brings us to current situation w Bernanke intent on reflating us back to prosperity.  Think about it, every time we have seen assets synthetically reflated the market has crashed and taken it all back.  Do we really want to see more crashes like we experienced last year after QE II ended?  We think the biggest risk to this equity rally thus far is for the Fed to continue pushing on the accelerator targeting higher nominal growth in order to fill the perceived output gap.  If he wants he can generate the NGDP and increase the book value (equity) of US corporations but if its just inflation that will not be good for asset multiples and risk premiums…  1x book?

$SPX book value = $614.72

more on this later….


About exantefactor

capital market veteran of over 15 years covering multiple asset classes. Focused on analyzying markets ex ante (before the event).
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