Sixty years of endless summer are winding down. Investors have happily surfed atop a long, beautiful but increasingly dangerous wave of credit. The past two years have been like the last days of August. We realized it was ending, but we were intent on enjoying every last drop of its pleasures because we knew we wouldn't see it again.
But the endless summer is finally over. Our wonderful credit wave is crashing on reality beach and it's time to go back to school.
When it comes to the credit crisis that kicked the Fed and Treasury into high bailout gear, John Mauldin maintains that the time for prudence was ten years ago. There are now no good choices. He argues that leverage in the developed countries has reached a climax from which we must retreat, either slowly or quickly, the latter being the most painful option. Last month, Ben Bernanke seemed to concur when he said the recovery is still shaky and the Fed will probably keep interest rates low for an extended period of time.
This article has two simple purposes: 1) to observe that our personal and governmental responses to an unmanageable debt burden will produce a future very unlike our easy-credit endless summer; and 2) to propose an investment strategy appropriate to the unfolding reality.
The World As It Was: The Great Moderation Of 1979-1999
Harvard economist James Stock coined the term "The Great Moderation" to describe the marvelous final two decades of the 20th century, when it appeared that modern central bank policies had succeeded in domesticating the business cycle. Energized by the consistency and predictability of economic growth during these 20 years, both stocks and bonds were very well bid. Investor optimism kept gaining altitude as each year of delightful returns begat expectations of the next.
As seen in Figure 1, returns to equity investors during this "Goldilocks" era were truly unprecedented in magnitude, duration and consistency. In 21 years, there were 19 "up" years for large-cap stocks and only two small annual declines (of -5% and -3%). The average return for the entire period was a positive 18% per year.
It is easy to identify the unique set of salutary economic characteristics that supported the Goldilocks investment experience:
Steady consumer spending growth (increased borrowing and decreased savings);
Short, shallow inventory recessions artfully managed by the Fed;
Declining inflation (from productivity gains and rising imports from low-wage areas);
Declining interest rates (a result of falling inflation and an optimistic view of credit risk because of steady growth); and
Soaring business profits (a result of strong consumer demand, high capacity utilization, the low costs of debt and oil and productivity gains).
Price/earnings ratios are the emotional barometer of the stock market. The steady decline of interest rates during the Great Moderation, plus the deepening confidence in America's perpetual growth machine, drove the market's P/E from devoid-of-hope single digits to the giddy 30s. This P/E escalation accounted for more than half of the storied return on stocks.
And that was the world as we knew it for a whole generation. All in all, it was a beautiful thing; beautiful, but far from permanent.
The Great Fluctuation: 2000-2009
From 2000 until the present, our stock market experience has been anything but smooth; in the following chart, you'll see why I call it the Great Fluctuation (Figure 2).
As every reader knows, U.S. stock valuations soared on the wings of Internet euphoria toward the end of the Great Moderation period, but collapsed rather abruptly amid a shallow recession and the terrorist attacks of September 2001. Most of the cash-burning dot-com IPOs evaporated during that two-year "correction," and even large-cap stocks lost almost half their value. But any expectation that the investor class had suddenly embraced sobriety was soon discredited by a credit expansion, one like the world has never seen and one that (here is the point of the memo) the world may not see again for a long, long time.