Several weeks ago, we shifted from a rather neutral near-term stock market view, to a hard-negative outlook, based on fresh deterioration in various trend-sensitive components within our broad measures of market action. From a cyclical perspective, the stock market has effectively gone nowhere since mid-2014 (with zero total return on the broad NYSE Composite since then). The past two years can be characterized less as an ongoing bull market than as the extended top-formation of the third speculative episode since 2000, the third most extreme equity market bubble in history (next to 1929 and 2000), and the most extreme point of overvaluation in history across the broad cross-section of individual stocks and asset classes.
I’ve discussed nearly every detail of our present concerns with charts, data, and analysis in dozens of recent weekly comments. The chart below is a reminder that our estimates for the prospective 10-12 year return on a conventional portfolio mix of stocks, bonds, and money market instruments have never been lower. This poor long-term outlook is also joined by immediate near-term concerns. We currently estimate flat or negative prospective return/risk profiles across virtually every major asset class, including domestic equities, international equities (which despite better relative valuations, still tend to have a beta of roughly 1.0 when U.S. markets decline), Treasury bonds, corporate bonds, junk bonds, utilities, and even precious metals shares (which despite reasonable long-term valuations are facing sufficient near-term headwinds to keep us roughly neutral).
We don’t expect the current situation to end well for investors who insist on taking larger investment exposures than they’re actually willing to hold, with discipline, through a period of severe market losses. From present valuation extremes, a 40-55% market loss would represent a fairly run-of-the-mill resolution to the current market cycle; a decline that would take valuations only to the high-end of the range they’ve visited or breached over the completion of every market cycle in history. By the completion of the current cycle, I expect over $10 trillion of what investors count as paper “wealth” in U.S. equities to disappear without a trace.
Keep in mind that what investors count as “wealth” in financial assets doesn’t “go” somewhere else during a market decline. It simply vanishes. Market capitalization equals price times the number of shares outstanding. If even one share changes hands at a lower price, market capitalization falls by the change in price times the number of shares outstanding. If a dentist in Poughkeepsie sells a single share of Apple stock, at a price that’s just a dime lower than the previous price, over $500 million of paper “wealth” is instantly wiped out of U.S. stock market capitalization. Every security that’s issued has to be held by someone until that security is retired. It’s just that the owners change. The actual cumulative economic wealth embodied in a security is the stream of future cash flows it will deliver to its holders over time, and even that stream of cash flows counts as a liability of the issuer.
Both investors and policy makers would do well to understand that when one nets out all of the assets and liabilities in the economy, the only true wealth of a society consists of its stock of real private investment (e.g. housing, capital goods, factories), real public investment (e.g. infrastructure), intangible intellectual capital (e.g. education, inventions, organizational knowledge and systems), and its endowment of basic resources (e.g. land, energy, water). In an open economy, one would include net claims on foreigners (negative in the U.S. case).
So contrary to the idea that Fed-induced yield-seeking speculation has created “wealth,” the fact is that monetary policy has done little but to distort the financial markets and encourage repeated cycles of malinvestment and collapse. It’s misguided to imagine that the gap between the future consumption needs of an aging population and the future output of a productivity-challenged economy can be addressed by central banks through greater purchases of riskier assets or “helicopter drops" of spending power, as if speculation generates economic productivity, or as if fiscal policy is run by central banks rather than Congress. No. The only way to close the gap is through policies that encourage productive real investment at every level of the economy, rather than fostering pointless financial speculation. Every day that central banks hold out the false hope of a paper solution is a day that chips away at the productive foundations of our economy.