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Rekenthaler Report

Should We Have Foreseen This Bull Market?

The future that almost nobody predicted.

The Judgment of Time
History may not regard us kindly.

It does not speak highly of the perspicacity of post-World War II investors. In 1949, the S&P 500 traded at 6 times earnings, entering an economic boom. Labor was cheap, new technologies would spark productivity gains, and the United States had the capital. The stock market was poised to surge. Few saw the opportunity. The S&P 500 rose 353% for the decade of the 1950s, but only 5% of Americans owned equities.

Such is how the decade is remembered. Those investing at the time, however, would tell a different story. Inflation had averaged an annualized 10.3% for the three years prior to 1949, gross domestic product shrank for the year, and unemployment pushed 8%. Stagflation! Perhaps a price/earnings ratio of 6 was too conservative, but there were good reasons, besides the memory of the past 20 years of stock-market woes, for being wary in 1950.

We post-2009 investors may be similarly judged. To be sure, equity ownership is much higher than during the '50s. But that is not because investors perceived a bargain after 2008's plunge. On the contrary. The percentage of Americans who own common stock, both direct and indirectly (that is, through funds), is gradually declining. Retail investors have been unconvinced. Professional managers haven't exactly pounded the table with enthusiasm, either.

What Matters
As is customary, stocks climbed the wall of worry. As is also customary, most of the public discussion was nonsense--unnecessary worries about political issues. Investment experts will talk at length about such subjects as election results, tax proposals, and budget negotiations. To the first approximation of truth, those things never matter. Nobody who listened to fears about tax-policy "uncertainty" profited from that decision, nor has anybody in 2018 benefited from the trade-war chatter.

(Your author is not immune to the disease. Earlier this year, I warned that the 2018 tax bill might trash home prices, because the mortgage-deduction benefits had been sharply reduced. That problem, shall we say, has not occurred.)

What drives stock prices are corporate profits, which lie mostly outside government control, and inflation, which is perceived to be under government supervision, but which in reality is an unherded cat. Forecasting the long-term fortunes of U.S. stocks means leaving not only the Washington Beltway but often the country entirely. The results are largely determined by global business trends.

And, in 2009, we misread what those trends would be.

Right--And Wrong
The consensus was that the U.S. economy would enter "the New Normal" (a phrase popularized by PIMCO's Bill Gross, although he was not its inventor)--an era marked by sluggish growth and, for a while, dormant inflation. After a few years, though, the government's efforts to stimulate the economy by "quantitative easing" and "fiscal stimulation" would likely spark inflation. The Federal Reserve would then need to tighten money supply, thereby reducing the already feeble growth.

In many respects, that outlook was correct. GDP growth has been subdued; inflation has been dormant (although for longer than was generally anticipated); and the ancillary predictions that global interest rates would remain low and China would increase its presence, economically and politically, came true. Today's investment world is much as the economists envisioned almost a decade ago.

But they missed one very big effect: capital's victory over labor. Historically, economic booms have been quickly followed by economic busts, because workers rapidly progressed from being delighted to have a job, to thinking that they could do better, to demanding that they be paid more, lest they leave the company. Then would come the aforementioned inflationary pressures, the Federal Reserve would raise interest rates, and the cycle would turn.

Not this time. Corporate executives managed their labor costs splendidly (or wickedly, from the workers' perspective), thereby boosting their companies' margins beyond all expectations. In 2014, the S&P 500's profit margin exceeded the peak that it recorded during the previous economic cycle. It hasn't stopped rising. This year, despite repeated predictions that margins would revert to the mean, the S&P 500's net margin is its highest yet.

Small Top, Big Bottom
Fat margins mean fat profits. In 2011, S&P 500 calendar-year earnings outdid those of every previous year, save for 2006. The S&P 500 then repeated that feat for each of the next six years, meaning that it posted seven-straight record (on three occasions the index also surpassed its 2006 totals) or near-record results. This year, to replay the theme, will be the S&P 500's best yet.

The top line, as predicted by the economists, has been unimpressive. Superficially, the S&P 500's revenue growth looks acceptable, as the index eclipsed its precrash high in 2011 and, aside from a brief 2015 blip, has been rising since then. But those figures are nominal, not real. (In contrast, the earnings statistics presented above are adjusted for inflation.) On an after-inflation basis, the index's revenues required nine years, from 2008 until 2017, to reach a new high.

Credit to the prognosticators for getting that point right. Foreseeing that corporations would not grow their revenues as rapidly--indeed, barely at all for several years, after adjusting for inflation--as during previous recoveries was no mean feat. Doing so required a deep understanding of global economic forces, as well as the willingness to break from experience. Saying "this time is different" is a perilous task. Most market forecasters did so in 2009, and they were correct.

But they missed what would happen with the bottom line, badly.

Revisiting this topic has convinced me that our investment generation was not collectively foolish. Setting aside the needless attention paid to political squabbles--a problem that will afflict future generations, just as it has afflicted us--the economic discussions have been sensible and mostly on target. The only major factor that was missed was the improvement in corporate profitability. Unfortunately for the accuracy of forecasters, although very fortunately for equity shareholders, that one item was so important that it overwhelmed the results.

Whether the investment history is written that way remains to be seen.


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.