I like to compare equity markets to a swinging pendulum. When a force is exerted upon a pendulum, it begins to swing back and forth. Each continued swing
becomes less and less significant until the pendulum finally comes to a resting point in the center. We have cycles in equity markets much like the swings
of the pendulum. In late 2008-early 2009, the pendulum moved very far to the bearish side of things as the S&P fell precipitously. This, of course, had
been followed by an equally impressive swing to the bullish side of things through present day. If we think of that center resting point as “fair value” in
the markets, the real question is just how far from the center we are in our current values. Some argue that we are at the resting point of fair value, and
there is room to swing this pendulum further to the bullish side before this run is over. Others contend that we have moved significantly from fair value
and are overvalued at this time looking for the pendulum to swing back to the midpoint through a price correction of some size. Underneath this swinging
market pendulum is true economic growth that should correlate strongly with the degree of momentum and swings. History may give us a clue as to just where
this pendulum is at present time.
Today’s bull market is the fourth largest in history since the Great Depression and crash in 1929. Markets as a whole have nearly tripled since the bottom
in April 2009. What is most interesting – and potentially concerning – about this bull run is the fact that is appears to be quite “out of sync” with the
underlying economic growth – more so than at any prior point in history. This market run has largely been fueled by the Federal Reserve’s prolonged policy
of incredibly low interest rates which make investments other than equities less attractive. With the 10 year U.S. Treasury yielding 2.68% and inflation
near 2%, such an investment does not “pencil out” if you are in need of a higher return on your investment. Corporate bonds, certificates of deposit and
other fixed income products are largely losing propositions in this environment driving investors to the one spot they can earn a feasible return – equity
markets. In short, stocks have become more attractive not because of a surging economy or strengthening corporate profits, but because they are the only
choice in this low rate environment. That is significantly different from bull markets of the past.
For instance, the bull run between 1935 and 1937 occurred as U.S. gross domestic product rose 10.8% in 1934 and 8.9% in 1935. Initially, stock performance
lagged the recovery, taking off in that last year eventually logging a 132% increase until 1937.
The next long-term bull market occurred from 1942 to 1946 when stocks jumped more than 150%. This is a more challenging comparison, given the nation’s
involvement in World War II at that time. There were some robust years economically. Once again, the market moved along with the economy: a 17.7% growth
rate in 1941, followed by 18.9% in 1942, 17% in 1943 and 8% in 1944. Much of the growth was offset by inflation (9% in 1942), but at least investors had a
compelling reason to buy in the strong underlying economy.
The first post-war bull market began in 1949 and lasted nearly seven years. Stocks rose more than two-fold as U.S. GDP grew at least 4.1% in each of those
years, including an 8.7% growth rate in 1950. The Dow Jones Industrial Average finally passed its 1920s record high in 1954. Levels of inflation fluctuated
dramatically with prices rising 8.7% in 1951, but increasing at about 1% or lower between 1953 and 1956.
The mid-1980s bull market saw stocks double during a five-year period beginning in 1982. There was economic growth that exceeded historical levels —
between 3.5% and 7.3% during the rally — and inflation and unemployment fell during that time.
The period from 1987 to 2002 was a strong bull market as markets rose more than 500% during that span. The strongest part of this run occurred between the
start of 1995 until early 2000. Stocks in the S&P 500 rose 237% as GDP increased between 3.8% and 4.8% annually. Inflation was low, between 1.6% and
3%. Unemployment fell each year, starting at 5.6% and ending at 4%. We know that much of this gain was fueled by unrealistic expectations about dot-com
companies, but there was also real economic growth underlying the bullishness.
In all of those periods, the market reflected strong economic trends: solid growth, high or strengthening employment and stable inflation. Only the latter
is present today. The unemployment rate is improving, but it is still a relatively high 6.1%. The recently strong GDP rate followed the first quarter of
negative GDP since the true start of the recovery. Questions still remain as to the ability for GDP to continue to grow.
Perhaps, as some suggest, this is a new normal. At best, it represents a disconnect between economic reality and market valuation. At worst, it is a
manufactured market distorted by the extraordinary measures used to create an economic lift. I use this information to help me create hedged trades for
profits in a continuation of the bullish environment while providing some degree of downside protection against what may be an overdue pullback in the
markets. Only time will tell.
Karen Smith
OptionsANIMAL Instructor
