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Rekenthaler Report

The Great Bull Market That Everybody Missed

How the economists got it wrong.

The Big Surprise
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.

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.

The New Normal
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 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, 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 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.

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 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."

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 that passage was written; banks have suffered no fresh crisis; consumer confidence has been fine; and business activity has steadily risen. None of the quantitative-easing warnings have come true.

Much of the argument against quantitative easing was politically motivated, which meant that portion of dissent was useless. The day that a member of Congress makes a thoughtful macroeconomic prediction is the day that the sun refuses to ascend. The informed critics cannot be fully absolved, however. Once again, they had not upgraded their software. By the end of last decade, it had become clear that the traditional link between money supply and inflation had become tenuous. Those who warned against quantitative easing should have beaten their drums less loudly.

Wrapping Up
Four lessons seem apparent:

1) Economics matter, greatly. The combination of persistently high corporate profits and quiescent inflation fully explains today's Great Bull Market. The market's gains owe to numbers, not to sentiment.

2) Getting the economics right is a very difficult task. Doing so requires being correct about many things. Somebody who foresees three major events but misses a fourth will not necessarily have a more accurate prediction than somebody who is consistently wrong.

3) Too often, economic forecasts become groupthink. Following the 2008 financial crisis, too much attention was paid to the New Normal and quantitative-easing critiques, while too little attention was paid to alternative views.

4) New evidence requires new thoughts! Old habits may die hard, but die they must if the best results are to be obtained.


John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.