Morningstar Magazine - August/September 2018 - 12

Dispatches

The Big Surprise
The great bull market
that everybody missed.

IVORY TOWERS

John Rekenthaler

This may not be the best stock bull market
in modern U.S. investment history. The 1950s and
1990s are formidable rivals. By any standards,
though, tripling one's money in real terms, in less
than a decade, rates as a great success. That
this gain occurred during a period of low volatility,
with few large reversals and subdued inflation,
heightens the achievement.
Yet nobody called it. Of course, that statement
is not strictly true. Somebody, somewhere advised
near the market's bottom that investors load
up on stocks. Not many, though. The best example
that I can recall was GMO's Jeremy Grantham,
who stated in January 2009 that while stocks were
not "dramatically cheap," they were worth
buying, as he expected them to generate a 65%
real return over the next seven years. Half correct;
stocks rose 130% for that period.

abetted by consumer borrowing. That bill had
come due. To pay it, the nation would be
forced to tighten its belts by cutting spending and
strengthening its balance sheet. Those
actions would depress GDP growth for years
to come, thereby impairing stock prices.
That forecast was broadly accurate. Although
belts were not long tightened (neither U.S. citizens
nor the government being in the habit of
scrimping), GDP expansion was indeed punk. Not
once during the recovery did annual real
GDP growth, as measured from one calendar year
to the next, reach 3%. Such a figure was
once commonplace. For example, during the
seven-year stretch from 1983-89 and the
five-year period of 1996-2000, GDP growth always
exceeded that mark.
What the forecasters overlooked was that GDP
growth doesn't much matter. They all knew
that to be so. Seven years before, Triumph of the
Optimists, written by three London Business
School professors,1 had shown, to much
acclaim, that there is little correlation between
a country's overall economic growth and
the performance of its stock market. They noted,
nodded-and continued along their
customary paths.

The New Normal

The reason that GDP growth tends to be
immaterial is that, although it signals increased
activity, there's no telling who gains from
that activity. It might be oligarchs, who scoop
the nation's output into their offshore
bank accounts. It might be labor, which devours
all those benefits in the form of wage
increases. It might be empire-building CEOs,
who plow their companies' cash into
unprofitable new ventures. There are many ways
to spend GDP growth besides increasing
corporate profits.

The consensus economic belief emerging from
2009's rubble was the arrival of the "New Normal."
For decades, the United States had goosed
its economy through deficit spending, aided and

In the case of the U.S., however, every penny
of GDP growth went into boosting corporate profits.
And more. Benefiting from a historic advantage

In hindsight, 2009's economists had the
right starting point. They believed that a single,
overwhelming economic trend would drive
the next decade's stock market results.
Unfortunately, they were unable to identify that
trend, emphasizing instead two predictions
that did not materialize.

over labor, which kept their costs low, and
refraining from making large capital investments,
which kept their margins high (at least for
the time being), U.S. companies have made money
like never before. Before 2010, the S&P 500's
real earnings per share had only exceeded
$80 on two occasions: in 2005 and 2006. Since
2010, they have been above that mark every year,
notching a record $111 in 2017.
Ultimately, stock prices are determined by two
factors: corporate profits and inflation.
The New Normal greatly underestimated the
benefit of the first of those items.
Quantitative Easing

At the same time, fears about quantitative
easing overestimated the hazard of the second.
Exiting the 2008 financial crisis, global
governments wished to stimulate their economies
but had difficulty doing so because their
short-term interest rates were near zero. They
turned then to an unconventional approach:
so-called quantitative easing, whereby
their central banks would purchase government
bonds in the open market. This would have
the twin advantages of supporting bond prices and
increasing the money supply.
To critics, of which there were many, the cure
was worse than the disease. Flooding the
money supply to an even greater extent than was
already being done through short-term
rates would inevitably bring inflation-if not
sooner, then surely later. In the words of
one detractor, "The danger is that higher inflation
pricks the bubble in the bond market,
leading to a collapse in the dollar. Financial
markets then tumble, the banks are
plunged into fresh crisis, confidence collapses,
and activity nosedives."2
That, obviously, has not occurred. Bond prices,
far from being in a temporary "bubble,"
remain firm; the dollar is stronger against the euro,
British pound, and yen than it was when

1 Dimson E., Marsh P., & Staunton M. 2002. Triumph of the Optimists: 101 Years of Global Investment Returns. Princeton, N.J.: Princeton University Press.
2 Elliott, L. 2010. "The Federal Reserve's Latest Quantitative Easing May Lead to Disaster." The Guardian. Nov. 8. https://www.theguardian.com/business/2010/nov/08/fed-quantitativeeasing-may-lead-to-disaster

Morningstar August/September 2018

https://www.theguardian.com/business/2010/nov/08/fed-quantitative-easing-may-lead-to-disaster https://www.theguardian.com/business/2010/nov/08/fed-quantitative-easing-may-lead-to-disaster

Table of Contents for the Digital Edition of Morningstar Magazine - August/September 2018