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However you want to look at it, the stock market has been having quite a run. The market returned over 30% in 2019, and for the decade 2010-2019 the S&P 500® Index has a CAGR (Compound Annual Growth Rate) of 13.5%, well above the long term average of slightly less than 10%. Those numbers certainly create a warm spot close to the heart, but what could we expect going forward?

We pay a lot of attention to macro and fundamentals in order to gauge what the market should look like over time. Currently the numbers aren’t encouraging. While economic growth has held up better than I would have expected, it’s still slowing down. That looks quite likely to continue, as economic data continues its slowing trend. That’s only likely to get worse with the problems at Boeing expected to have a negative impact on GDP. As for earnings, they are expected to show negative year-over-year growth comps for all four quarters of 2019, which means we should see something twice as long as what qualifies as an earnings recession. That also looks likely to continue. The combined lack of sustained earnings and economic growth makes further market gains harder, particularly for higher growth companies.

As we saw in 2019, in the short term, economic weakness doesn’t have to mean much. Specifically, a flood of money from the Federal Reserve appears to have trumped all bad news of late. That’s fine, but what about when the liquidity stream dries up? The primary target of the Fed liquidity operation was the repo market, and that has been less stressed over the past several days – the turn from 2019 to 2020. Thus, the main purpose for the operation appears to have been achieved. In addition, the Fed said the operations were variable in nature, so wouldn’t it make sense for the Fed to get less involved? Near as I can tell, that’s already happening, with repo operations no longer being fully subscribed every day.

What else does the market have to go on besides the flood of free money driving risk appetite? I have a hard time seeing anything else. I guess we have momentum, but a measure like RSI (Relative Strength Indicator) is already unusually high compared to history. At the end of 2019 we also were technically quite extended, about as far above the 200 DMA (Day Moving Average) as we tend to get. I can’t say we can’t go higher, but it’s getting harder to find good short-term reasons.

The long-term also looks awfully rough. When looking at an annual horizon, earnings and macro can give us an idea of what to buy. For longer periods they can give us reasonable insights on what to generally expect for overall market gains.

On the earnings side, Nicholas Colas of DataTrek Research did some nice work on using Shiller’s CAPE (Cyclically Adjusted Price to Earnings) ratio to determine expectations over the next 20 years. The current CAPE ratio is a lofty 31. Outside of today, for which we don’t have 20 years of subsequent returns, the only two data points that are comparable to the current high are at the beginning of 1998, where it was 33, and the beginning of 1929, where it was 27. Obviously, quite a bit happened in the 20 years starting with 1929, so it’s probably no surprise that the 20 years from 1929-1948 only saw a CAGR of 2.4%. 1998 and 1999 saw over 20% returns, but the 20 years from 1998-2017 saw more bad than good, with a CAGR of 7.2%, two major market crashes and current data (CAPE ratio of 31) suggesting more downside danger. (In addition, the 20 year period 1999-2018 saw a CAGR of 5.6%, and the most recent 20 year period 2000-2019 saw a CAGR  of 6.1%, with the result that all three of these most recent 20 year CAGRs are well below the long term average of slightly less than 10%.)

On the macro side, it’s much easier to get good returns when the economy is doing well, as it creates conditions that are conducive to stock earnings gains. For instance, in the early 1980s while we had inflation, high interest rates were heading down fast, along with generally pretty good Real GDP growth. That was a fantastic setup for long term gains. Now, we have a situation where optimists project 3% GDP growth and pessimists project 0% growth. In a highly financialized system with low rates, it’s hard to see much organic growth (growth driven by savings and investment rather than by more debt that just further burdens any future growth).

Despite that, the market is pricing in awfully optimistic growth scenarios. Will low rates and free money continue to support the market? Maybe, but looking at the experience of Japan and Europe, heavy stimulus only generated continued low growth, which was followed by declines from all-time highs in their markets. In a situation of struggling growth, government bonds did well as interest rates declined, but their stock markets struggled. Where will U.S. gains come from? The market gains in 2019 were largely caused by about 20 large names (out of 500 stocks in the S&P 500® Index). Will those 20 names just keep going up?

I find it particularly tough to come up with good scenarios for the next year or two. Expectations are very high and no one, including corporations, seems prepared for a slowdown. FedEx says there’s a global industrial slowdown and no one cares. Could we get a Fed induced further bubble? I suppose. After all, stocks were expensive at the beginning of 1998 and we still had the 20+% returns of 1998 and 1999. But today there’s not much of a lower bound left in rates (the Fed isn’t going to cut 500 bps this time) and back then the economy continued to do well as the stock market became more expensive.

The longer term market upside is also hard to visualize from current stock valuations. I think we could justify these current valuations, but to go much higher we’re going to need to see some source of growth ramp-up shortly. Could something like quantum computing carry the water? Honestly, that seems like an awfully remote possibility, but we can always hope. Even with that, we should probably expect lower than average stock market returns over the next decade or two.

Bottom line, below average returns seems like the optimistic case. What about negative scenarios?

I think you can come up with quite a bit, largely because absolutely no negatives are currently priced in. Probably the clearest problem is the possibility of a further economic slowdown. For all the optimism created by the Fed liquidity injection, there has yet to be a positive effect in the economic data. Thus people are pricing in an economic rebound, but one has yet to show up. There are plenty of companies who have levered up to the point where FCF (Free Cash Flow) could easily be stressed in a slowdown – where cash flow declines but interest payments don’t. I would point out this risk isn’t really the end of the world. The same basic thing happened in 2000 and the market only lost 9% that year. But the thing is, that performance was widely varied. Growth stocks did poorly while value stocks did well. Could we be looking at something similar here – a gentle decline and market rotation?

What about other downside scenarios?  The one that most concerns me is that this market looks an awful lot like the previous tops of 2000 and 2007. In all three cases, the Fed was panicking about the market and eased heavily. This helped spur a surge of debt, followed by a crash. You can also see this in the yield curve, where concerns about the economy invert the yield curve, then easing makes the curve steepen again, and then the market crashes. We just haven’t gotten to the point yet where the market crashes. What could the timing be? That’s beyond hard to know. I would point out that the last two times we saw big spikes in repo market operations were in 2000 and 2008, when the market was in imminent danger. That’s only a sample size of two, but it is worrisome.

In conclusion, the lack of anything negative being priced in is concerning. Could we keep this party going? Possibly, but it’s hard to find good reasons. Fed liquidity certainly seems to be the best reason to think upside could continue, but that’s already been priced in pretty aggressively. Will that belief in the Fed continuing to  ‘feed the beast,’ lead to more gains than are already priced in? Again, that’s possible, but not something that I would invest in heavily, particularly considering that the main Fed concern seemed to be year-end liquidity, much like Y2K liquidity in the 1999-2000 turn. The most recent FOMC (Federal Open Market Committee) minutes said they’d start allowing the Fed repo purchases to unwind beginning in January. We will see.

Given the conditions we have now, I tend to think the idea of the first downside scenario, involving a gentle decline and heavy rotation to safety, is probably the most likely scenario. That said, it’s not all that hard to think up a wide variety of scenarios. In a lot of ways, the basic question seems to be is this early 1998 or early 2000? In both cases the Fed was providing ample liquidity. In 1998, the economy was doing pretty well and that continued for a while, as did Fed liquidity. In early 2000 the economy was doing well, but gently slowing and on the way to getting worse, while the Fed Y2K liquidity was on the way out. In both cases, problems were coming, and it was just a question of when. Do we have a while before we have to face problems or is there only limited time? I’m concerned there’s not much time left. But no one really knows. The Fed’s current program of adding $60 billion a month in Treasury bill purchases is supposed to end in the next few months, and we can monitor what actually happens and the resulting effects.

While it’s hard to get too excited about the broad market, it is worth pointing out that there’s a whole market of stocks out there. Even during most declines there are companies that can do well in the year. When gains slow or reverse, many value funds actually do well, particularly compared to the index. Just a few big stocks dominated the 2019 gain. Microsoft and Apple alone contributed 17% of the total return of the market. The reverse has also happened, where leading stocks fare poorly, and that’s often a great environment to find strong individual stocks. While the broad market may be hard to get excited about here, there should still be opportunities out there.