Earningless bull markets are bull markets in which stock prices rise substantially despite falling earnings. Consider two examples from U.S. market history (price and EPS are for the S&P 500):
Both of these earningless bull markets started from low valuations. We can therefore attribute a significant portion of their moves to mean reversion. For whatever reasons, sentiment towards equities improved, and better valuations followed, despite falling earnings and rising interest rates.
But why did the moves go as far as they did? The P/E ratio in August 1961 was 22. The P/E ratio in June 1987 was 21. The 1987 advance was particularly puzzling, given how high interest rates were. Investors were holding equity at an earnings yield (inverse P/E) of 4.75% when the 10 year treasury offered almost twice that yield, risk-free. What were they thinking?
It’s often assumed that June 1987 equity buyers were wrong to be buying, that they were victims of irrational exuberance. But if we neglect the unlucky crash they walked into, a crash that no one could have foreseen or predicted, they turned out to have been right. The 10 yr total return they ended up earning in equities was a whopping 14.7% annualized, whereas those who bought and held the 10 year treasury (zero coupon) only earned 8.4%. The equity risk premium (difference in return between stocks and bonds) ended up being 6.3%, significantly higher than the historical average of 4%.
Now, some might say that 1987 buyers got lucky–that they road the coattails of the multiple expansion of the 1990s. But actually, on a 10 year time horizon, they received no multiple expansion at all. The multiple in June 1997 was 21, the same as in June 1987. The S&P’s stellar total return was driven entirely by the growth of earnings, which tripled during the period. The success of June 1987 equity buyers shows the danger of equating earnings yield (which is not actually a yield, just an internal ratio) with total return, in neglect of other important variables such as profit margins and the trajectory of earnings (profit margins are inversely correlated to earnings growth, and were at a historical low in 1987).
But even if we try to explain the earningless bull market of the 1980s by pointing to low profit margins and high anticipated earnings growth, we still aren’t telling the whole story. We’re ignoring the role of asset supply.
In the previous post, we laid out the mechanics of asset supply in rigorous detail. Looking at the three types of financial assets–money (cash), credit (bonds), and equity (stocks)–we found two rules to be fundamental:
(1) For every financial asset that exists, someone must willingly hold it at its current market price. If no one can be found that wants to hold it at that price, the price will fall until someone is found.
(2) The “supply” of a financial asset is its total market value–the total dollar amount of it in existence at market prices, which is the amount that investors can allocate their wealth into. Equity assets have a flexible supply, meaning that if demand to allocate wealth to them exceeds supply, the price per share will rise, therefore the total market value will rise, therefore the supply will rise, fixing the problem.
Ultimately, the only sector of the economy that genuinely owns any financial assets are households. There are different ways that households own financial assets–directly on their own, or with the help of a manager, or through mutual funds, or through hedge funds, or through pension funds, etc. But the final ownership always comes back to them. They are the people that make up the economy.
When we use the Flow of Funds report (Z.1) to draw a picture of the universe of financial assets–how much cash, how much credit, and how much equity there is in the overall economy—what we are actually looking at is the aggregate household investment portfolio: how households, in aggregate, are allocating their wealth. From rule (1) above, someone must hold every financial asset in existence, so if there is a large supply of cash and credit floating around, and a small supply of equity, then households (or whoever represents them financially) have to want their portfolios to be allocated in that way–with big positions in cash and credit, and a small position in equity. If that’s not what they want, if they want a bigger portion of their wealth invested in equity, then the per-share price of equity–and therefore the market value, and therefore the supply–is going to get pushed up under the pressure, until aggregate allocation preferences are achieved.
Every investor has a preferred asset allocation, informed by both structural (age, risk tolerance) and cyclical (outlook, sentiment) factors. Allocation is the most important decision that investors make when they build and manage portfolios. Where should I put the money: in stocks, in bonds, in cash? How much to each? Which sectors of the stock market should I invest in? Which sectors of the bond market?
Consider the classic allocation that efficient market gurus recommend: 60% to stocks, 40% to bonds. What rule says that there has to be enough equity, at “fair” valuations, for everyone to be able to allocate their portfolios in that way? There is no rule. If everyone wants a 60/40 allocation, but equities are not 60% of total financial assets, they will quickly become 60%, as they get lifted to higher prices by all the bidding. There is nothing to guarantee that the prices they end up at are going to be “fair.”
Now, valuation concerns can certainly push back, and motivate investors to accept a lower allocation to equities (lest they have to buy really expensive stocks, expensive because of the short supply). But, outside of extremes, “valuation” doesn’t tend to be a very strong counter force, especially given that (1) it’s hard to reliably determine–it involves making tenuous predictions about the future, (2) it’s ambiguous–there’s a wide range of what can be considered a “reasonable” valuation, and investors tend to be quite willing to rearticulate that range as needed to rationalize their deeper market biases, (3) it’s self-fulfilling–investors base their assessments of valuation on future estimates that are as much a reflection of a given sentiment towards equities as they are a cause of it, and (4) equity investors invest for price appreciation, rather than yield (which is what valuation actually hits, concretely). Because price is the bottom line, the ultimate source of return, investors tend to get very uncomfortable sitting out of rising markets on the grounds that the valuation is too high (a call they can’t even be that confident in). They miss out on real, tangible profit.
These insights can help us explain one of the reasons why earningless bull markets happen. Whenever an economy is growing, money and credit are being created through the lending process. The rising supply of money and credit end up in investor portfolios–they have nowhere else to go. To the extent that investors’ desired allocation to equities remains stable in the presence of the rising money and credit supply, the supply of equity has to rise at a similar pace. Otherwise, its share of the total–which literally is the aggregate household investment allocation to equities–will shrink.
As an aside, it’s worth noting that if you look at the available historical data, which goes back to the early 1950s, you will see that money and credit have both grown at about 8% per year over the period. The market value of all equities in existence has also grown at about 8% per year. These numbers are not the same by coincidence. If the market value of all equities in existence had grown at some smaller clip, say 4%, while money and credit were growing at 8%, the equity share of overall investment portfolios would have collapsed to near nothing. Investors would have had to have wanted that. Very unlikely.
Now, there are two ways that equity supply can rise. The number of shares outstanding can rise (corporations can issue new shares), or the price per share can rise. Historically, corporations have been very hesitant to increase their number of shares outstanding. With the exception of the 2008 crisis, annual share issuance over the last 60 years has never exceeded 2%. For most of the last 35 years, corporations have been operating in share consumption mode–reducing their shares outstanding through buybacks and M&A. The situation now is not as extreme now as it was in prior decades, but net consumption continues to take place. The chart below shows total equity issuance as a percentage of total outstanding. Note the extreme level of share count reduction that took place in the 1980s. This phenomenon is not unrelated to the earningless bull market that the 1980s produced:
As stated earlier, money and credit grow at a rate much faster than 2% per year–over the last 60 years, at an average of 8% per year. Unlike share count, money and credit rarely, if ever, contract. The following chart gives an approximation of the growth of money (red) and credit (blue) since 1959:
For these reasons, if investors maintain a constant desired allocation to equity, that is, if the percentage of their portfolios that they want to have invested in stocks remains stable, then stock prices have to rise. There is no other way. Rising stock prices are the only mechanism through which the supply of equity can keep up with the supply of everything else, so that equity allocations can stay at the level that investors want them to be at.
If, as happened in the 1970s, the stock market doesn’t rise commensurately with the rising supply of credit and money, then equities will steadily become a smaller and smaller percentage of the aggregate pool of total financial assets. To the extent that the demand for allocation to equities remains stable, a shortage will develop. This shortage will put upward pressure on prices–regardless of what is happening on the valuation front.
Normally, there isn’t a problem. Equity prices need to rise to keep equity supply growing at a pace consistent with money and credit growth, but they are already rising for fundamental reasons–specifically, because earnings are growing. And if corporations choose to buy back shares or conduct M&A, no problem is created, because the buyback leads to a de facto earnings per share increase–therefore prices can rise to keep overall supply constant without affecting valuations.
But what happens when you have a long period of time during which money and credit grow normally, but earnings fail to grow, or fall? Unless the aggregate investment community’s preferred allocation to equities as a percentage of the overall portfolio falls, prices are going to have to go up–regardless of what “valuation” says they should be doing.
To better understand what I’m saying here, let’s do an experiment. Let’s calculate how the U.S. investor allocation to equities would have had to have changed if the economy had gone through ten year “lost decade” periods where credit and money grew at their historical rates, but where stock prices stayed constant. The purple line shows what the portfolio allocation to equity would have ended up being from each point forward (into the lost equity decade), in comparison with what it actually was (the orange line).
As we see from the falling purple lines, for market prices to stand still over ten year periods in which credit and money grow normally, investor equity preferences have to fall precipitously. There is little reason to expect this to happen inside a healthy economic expansion, where investors are optimistic, and want to be invested for the future.
Notice from the chart that the aggregate allocation to equities rose during every healthy economic expansion (late 1970s inflationary mess excluded), and fell during every recession. This trend is consistent with what a behavioral view would predict. The key assessment that determines the eagerness of investors to invest in equities as opposed to other asset classes is the assessment of risk, specifically tail risk–how much might I lose? Will there be a selloff, a crash? Large losses really hurt; they are the feature of equities that keep investors away. As investors become more confident that a selloff or crash is not coming, they become more comfortable with equities, and more eager to allocate wealth to them. Thus, as the economy moves farther into periods of healthy expansion, where social mood is high, and where memories of the traumas and tail events of the last bear market have faded, investors display a rising preference to be invested in equities. However, for market prices to remain constant over long periods, so as to catch up with earnings and valuation, we need the opposite–we need investor equity preference to fall. In healthy economic expansions, this just isn’t likely to happen, and therefore earningless bull markets are sometimes unavoidable.
Let’s do a similar experiment with the two earningless bull market examples that we studied earlier. Let’s assume that investors respected “valuation”, and kept the P/E ratio constant from 1956 to 1961, and from 1979 to 1987. The market would not have risen, because earnings didn’t rise. In fact, the market would have have fallen, because earnings fell. Therefore, the supply of equity would have fallen, even as the supply of money and credit expanded rapidly. The aggregate allocation to equity would have shrunk–and investors would have had to have accepted this result in their portfolios, accepted a situation where less and less of their wealth is allocated to the stock market. In a vibrant expansion, where sentiment towards equities is improving, why would that happen? The point is that it wouldn’t happen–and it didn’t.
The orange line below shows what the actual investor allocation to equities was from 1951 to 2013. The dark blue line shows what the allocation would have had to have been reduced to if “valuation” had been respected, and if the market were to have fallen (or stood still) consistent with the falling (or stagnating) earnings.
Alarmingly, from 1979 to 1987, investors would have had to have willingly allowed their allocation to equities to fall from an already generationally low, post-1970s-bear-mkt-allocation of 25%, to an even lower 13% of assets–this, in the middle of a vibrant economic renaissance where consumer and business sentiment, plagued by the inflation, regulatory, and tax nightmares of the 1970s, were finally improving (or at least that was the narrative), where investors were gaining confidence that policymakers were on their side, and where the economy was reaching a demographic sweet spot in which a large number of baby boomers were entering the 30-something age range where equity allocation is naturally favored. It just wasn’t going to happen. That’s part of the reason why the market was pushed up to such a high P/E multiple, despite a sky-high interest rate. The market was not wrong in making that move–it was following the forces that were driving it.
Now, you might ask, shouldn’t rational investors have been content with such a low equity allocation, given that bonds and cash were offering such an attractive yield relative to equity? But that isn’t how markets work. We’ve seen time and again, in the U.S. and abroad, that though valuation unquestionably drives long-term returns, it is easily overshadowed by sentiment and demographics in determining how investors choose to allocate in the here and now.
Much of the time, as in 1987, investors don’t even know what the market’s proper valuation is, because they don’t know how future earnings are going to evolve. To determine value, they have to rely on forward estimates, which means they have to rely on their own mood-influenced visions of the future, rather than concrete, simple-to-measure facts. The 1987 market looked really expensive from the vantage point of earnings and interest rates, but in hindsight it turned out to have been very attractively priced. Investors that irrationally chased it before the crash were doing exactly the right thing. Much of their being right probably had to do with luck, but they were right nonetheless, and were compensated handsomely for it in the final analysis.