Here is the opening, which quotes Warren Buffett extensively:
“It is no longer a secret that stocks, like bonds, do poorly in an inflationary environment.”
- Warren Buffett, ‘How inflation swindles the equity investor’, May 1977.
On December 31st, 1964, the Dow Jones Industrial Average stood at 874. On December 31st, 1981, it stood at 875. In Buffett’s words,
“I’m known as a long term investor and a patient guy, but that is not my idea of a big move.”
To see in stark black and white how the US stock market could spend 17 years going nowhere – even when the GDP of the US rose by 370% and Fortune 500 company sales went up by a factor of six times during the same period – the price chart for the Dow is shown below. [Ed: subscriber’s can see this in Tim Price’s letter and also recreate it in the Chart Library, should they ever wish to.]
So the US stock market suffered a Japan-style lost decade, and then some. Back to Buffett, again.
“To understand why that happened, we need first to look at one of the two important variables that affect investment results: interest rates. These act on financial valuations the way gravity acts on matter: The higher the rate, the greater the downward pull. That's because the rates of return that investors need from any kind of investment are directly tied to the risk-free rate that they can earn from government securities. So if the government rate rises, the prices of all other investments must adjust downward, to a level that brings their expected rates of return into line..
“In the 1964-81 period, there was a tremendous increase in the rates on long-term government bonds, which moved from just over 4% at year-end 1964 to more than 15% by late 1981. That rise in rates had a huge depressing effect on the value of all investments, but the one we noticed, of course, was the price of equities. So there--in that tripling of the gravitational pull of interest rates- -lies the major explanation of why tremendous growth in the economy was accompanied by a stock market going nowhere.”
Here is Tim Price’s latest letter for FT Money subscribers.
That seventeen year period from end December 1964 to end December 1981, marked the valuation contraction cycle which occurred between two secular bull markets. The first of these lengthy bull trends commenced with the end of the US Depression and also WW2.
By coincidence, it was in the mid-1960s that I decided to change careers and head for Wall Street. Why? Because although I heard about the difficulties of the Depression from my parents, all I subsequently heard about the stock market during my adolescent years and early 20s was that it mostly went up, thanks to a booming economy.
The mid-1960s through 1981 provided a steep learning curve, as veteran subscribers will have heard me say on occasion during my financial career to date. Thereafter, the next secular bull market commenced from valuation contraction lows in 1Q 1982, before ending with the 20th century.
So what do we make of the S&P 500 Index’s historic chart pattern which dates back to the 1960s, not least in the context of Tim Price’s further assessment?
The long trading range in this century to date is similar to what occurred on Wall Street from the mid-1960s through 1981, although the fundamental background is inevitably quite different. However we did see another valuation contraction cycle, at least until last year’s QE driven upside surge of nearly 30% for the S&P 500 Index shown above.
Currently, Wall Street’s valuations are on the higher side of average and longer-term interest rates have seen their biggest percentage gain since the multi-year downtrend began in 1981, as you can see from this historic semi-log chart of US 10-year Treasury Yields. That is a clear signal that the secular 32-year decline in yields is over. Looking at this arithmetic scale chart of US 10-year Treasury Yields, the rise looks far from exceptional, so far, but it has been testing the last September’s high near 3% as you can see more clearly on this weekly chart.
Please note: there is a temporary glitch with our server which is not processing all of Bloomberg’s data, so this chart is only updated through 3rd January. We expect to have this resolved shortly. Meanwhile, the US 10-year yield is a little lower this evening at 2.938%.
Returning to Tim Price’s letter, see this paragraph below by David Collum:
“The 32-year-old bond bull is long in the tooth, fully priced for an inflation-free world. We have central bankers on a bond buying spree that has the surreal effect of keeping interest rates low by printing money. Of course, these shenanigans will end, and price discovery in bonds will be accompanied by investors’ self-discovery. Optimists bray that rising rates are bullish, a sign that the world economy is recovering. In 1999, however, Buffett wrote a compelling article in Fortune attributing secular equity moves to one and only one parameter—the direction of long-term interest rates. Secular equity bull markets occur when long-term rates are dropping—not low but dropping—and secular bears occur when rates are rising. He didn’t equivocate..”
I have been cautioning in recent weeks that a clear break above 3% by US 10-year Treasuries will introduce a gradual headwind for equities, although it is likely to be partially offset by an additional transfer of funds from the US fixed interest sector to equities. Also, the Federal Reserve’s policies will remain hugely influential. We know that they are currently committed to tapering QE, starting with a 10% reduction this month. However, the Fed will try to delay a significant rise in T-Bond yields, at least until the US economy is considerably stronger, especially if inflationary pressures remain low.
I think the paragraph by David Collum above overstates the risk for stock markets, although I would not be surprised to a somewhat choppy market environment over the next few years. Obviously a lot depends on how quickly or slowly the US and also the global economy recover. I think it may take a few more years for this to occur. If so, and if deflation appears to be as much of a risk as inflation, then government bond yields in the USA and most other developed economies should only rise slowly.
Additionally, stock markets can still perform respectably in the early stages of a rise in long-dated government bonds. For instance, last year’s 10-year T-Bond lows were very similar to the 1945 trough, as you can see on this historic chart from Business Insider but Wall Street’s post WII secular bull market did not peak until the mid-1960s.
Incidentally, if you read the small amount of copy above Business Insider’s chart, I do think 5% 10-year yields would be a stretch anytime soon. Jim O’Neill mentioned 5% as a possibility in June 2013. If I am wrong, 5% anytime soon would most likely trigger a cyclical bear market of over 20% for the US stock market.
Lastly, you may be interested in Tim Price’s concluding comments on gold.Back to top