On August 13, 1979, nearly 42 years ago, a BusinessWeek (Figure 1) headline infamously announced “THE DEATH OF EQUITIES” with the subtitle, “How inflation is destroying the stock market.” The cover story captured well the antipathy of investors toward the prospects for future returns from equities.
Looking backward, in Figure 2 below (white line), the S&P 500 seemed forever anchored in the vicinity of 100 in the years leading up to the publication of the cover story (dashed vertical line). Though the magnitude is not particularly dramatic on the arithmetical grid, the bear markets of 1969–70 and, more significantly, 1972–74 had added insult to injury. The latter episode saw declines of 50%. These were agonizing and dispiriting interludes in a market that otherwise went nowhere.
Simultaneously, there was the seemingly unrelenting rise of inflation through the 1970s (Consumer Price Index, red line), in which the sharply higher price of oil was a major contributor. The OPEC oil embargo in 1973–74 was soon followed by the 1979 supply constraints in the wake of the Iranian revolution.
Not surprisingly, the yields on U.S. Treasury securities rose. Treasuries became known as “certificates of confiscation,” as their prices fell in the inflationary environment.
Within three years of the BusinessWeek cover story, an unimagined resurrection in equities began without fanfare. Forty years later, the S&P index is up 44 times, and that does not include dividends. Disdained in the early 1980s when it yielded more than 15%, the U.S. Treasuries are once again popular, though presently the 10-year offers a nominal yield of just 1.25%. The current run rate on the overall CPI is 3.7% compared with over 15% in the early ’80s.
How Could Investors in the Aggregate Have Been So Blind?
Discernment is the capacity to comprehend what is obscure and not easily distinguished. While others often hurry through, discernment digs deeper than mere impression and makes nuanced judgments about the characteristics of the situation at hand. Such was, quite evidently, practiced poorly at BusinessWeek.
While many explanations account for the short-sightedness of equity investors in the 1970s, extrapolation is a likely culprit. For many, the absence of any historical context is an Achilles’ heel. Assuming that existing trends will continue is like driving by looking at the yellow center lines of a two-way road through a driver-side rearview mirror. The proposition is absurd on its face. No sane driver would get behind the wheel on the assumption that the road ahead will replicate the course of that which is behind. And yet, or so it would appear, that’s the way many investors navigate the capital markets.
Not all investors embraced the equity market’s death sentence in 1979. Since stocks must be owned by someone all the time, in the aggregate sellers and buyers were deadlocked at a price averaging around 100 on the S&P 500 during the 13 or so years before 1982. Unbeknownst to most at the time, a massive wealth transfer was underway—from the sellers to the buyers. Extrapolation was the sellers’ undoing.
The best that can be said about those of us who were buyers was our conviction that stocks were simply too cheap not to constitute the bulk of one’s portfolio, despite, or perhaps because of, the prevailing news and widely held belief to the contrary.[1] At those giveaway prices, we didn’t need to know what the future held. That conclusion was anything but heroic, but it still harbored a discernment that cut through the prevailing wisdom of the time. It was empowered by the logical deduction that the economy could not endure 15% interest rates indefinitely. That made the argument for owning bonds also compelling. For the undersigned, the decade of the 1980s provided the greatest prospects for return at the lowest exposure to risk in my career. Of course, the ’90s also were incredibly rewarding, but at a progressively greater level of underlying risk as the dot.com bubble grew.
While it could not be seen, the invisible hand of mean reversion was indeed at work. As it has throughout history, it does its job with a vengeance at the extreme ends of the continuum. Similarly, after the taxing experience for owners of both equity and debt securities during the ’70s, extreme risk aversion had settled in like a cold winter after the 1973–74 bear market. Mean reversion is a tendency of markets because it also is a tendency of investor psychology. Swings in price result from oscillations between risk aversion and speculation.
The Death of Discernment: Nobody’s Cover Story
The situation is markedly different today.
Figure 3, beginning in 1986, continues where Figure 2 left off. The S&P 500, again in arithmetical grid scale, experienced two turbulent bear markets: in 2000–02 and in 2007–09. Although the drawdowns interrupted a rising trend, they will likely be remembered as speed bumps on the way to the post-Great Recession, fivefold meteoric rise of the S&P 500 into the record books.
The spectacular advance was certainly not without cause. Over 15% in 1981, the 10-year U.S. Treasury bond 40 years later traded to yield less than 1%. The CPI has averaged less than the Fed’s 2% target since the Great Recession, not including the current spike, which Fed Chairman Jerome Powell has assured us is “transitory.” Although GDP growth has been well below historical norms since 2008, corporate after-tax profit margins are near 10%. Capital appears to be winning the tug of war with labor.
Much like the mindset in 1979, extrapolating the past into tomorrow is the default perspective of many at the margins where the transaction-based price of securities is set. The result is a wildly overvalued market and a widespread belief that the future of equities is bright. There is a dearth of discernment among investors. Whereas the death predicted for equities in 1979 was ill-timed, we believe that abandoning a discerning approach in 2021 would be similarly disastrous.
Discernment attempts to see beyond superficial conclusions based on extrapolation. Therefore, we wonder if the inverse of what occurred in 1979 might characterize the environment today. Another massive wealth transfer may be underway —but now it is from buyers to sellers. Could extrapolation this time be the buyers’ undoing?
Despite, or perhaps because of, the omniscience widely attributed to the amorphous “stock market,” a handful of us cannot countenance embracing the seeming death sentence of discernment. Hearing echoes from the distant past—as sellers in 2021 who were buyers in the early 1980s—we only need to know that stocks are far too expensive to constitute but a small portion of one’s portfolio. By any historically supported metric, the long-term expected returns for equities from today’s prices is negative. Of course, there will be exceptions to the rule, but the aphorism that the tide lifts all boats applies in both directions. At today’s nosebleed valuations, even a perfect economic and financial future seems fully discounted. Our conclusions don’t rely on forecasts of interest rates, CPI inflation, GDP, or corporate profit margins. All we need to know about the future is that it would be unwise, even dangerous, to define it by extrapolating the past.
In fact, never in my 55 years as a professional investor have I witnessed more significant risks of permanent loss of capital, coupled with almost no prospects for significant, sustainable gains.
The Gravitational Pull of Valuation
We recently referred to the total market-cap-to-GDP ratio as an indication of off-the-charts overvaluation in the market. As a market phenomenon, mean reversions, like those of the early ’80s, are coupled with a correction in price-to-value dynamics. Imagine a pendulum like that of a grandfather clock. It will remain at rest until set in motion by some external force. The acceleration of the pendulum depends on its mass (weight) and the amount of force applied. It will swing along its arc, until gravity exerts an equal and opposite force to change its direction.[2]
Think of the Wilshire 5000 as the pendulum. Its position at rest is the mathematically determined fair value of the index in a theoretical market environment where risk aversion and speculation offset each other. The “market” is set in motion when one of these two forces begin to dominate the collective psyche of investors. The farther the pendulum moves from its resting place, however, the more energy is required to overcome the force of gravity. Increasing acceleration of speculation is difficult to sustain when participants are already in a frenzy, as we saw this spring through the meme stock episodes of GameStop and AMC. Whenever the growth in speculation slows, the pull of gravity remains to draw the index back toward its (fair) value. And when that shift occurs, accelerating risk aversion is present to speed the decline and push it past the bottom of its arc, toward excessive pessimism.
How Far Can the Pendulum Swing?
Sometimes up-or-down cycles continue to heretofore unimaginable extremes. Even in the face of gravity, the manipulations by the Fed have thus far proven effective at keeping speculation airborne. When investors form their expectations for returns based on price behavior, and price behavior is driven by investor expectations in turn, a positive feedback loop contributes to self-reinforcing bubbles. The current “Buy high, sell higher” market has markers that are reminiscent of the great secular bull markets of the past: 1922–29, 1950–65, 1982–99. Today the situation is precarious because investors ignore valuations on hopes of limitless “support” from government policymakers. While a direct link between policy and prices is difficult both to ascertain and sustain, the trust that investors seemingly have is all the more curious given the fact that the only constant in politics is change.
Still, if elevated valuations were enough to drive the market lower, we could never observe the sort of extremes that emerged in 1929, 2000, and today. While extreme valuations make the prospect of holding equities anathema for the discerning investor, in their effect they provide cause for optimism. It is in the reversion from such episodes in the past that the patient among us found the opportunity to buy low.
When risk aversion returns, when valuations normalize and likely more, and when investors pry their eyes away from the rearview mirror to access the present-day course on which they find themselves, history may yet repeat. It’s hard to imagine 1979 ever occurring again—unless you were there the first time.
[1] My career in the investment business began in 1966. Moved to action by Pres. Nixon’s August 1971 devaluation bombshell, I started writing about the security markets and the economy. As for the absolute cheapness of equities, see our 2018 Martin Capital Management Annual Report, page 20. While it wasn’t available at the time, the Shiller CAPE PE would have been 7.9 times, down from 23.7 times in 1966. For the observant and sagacious, the fact that the CAPE is 38.0 today has not escaped their attention.
[2] Isaac Newton’s Laws of Motion:
1. An object at rest remains at rest, and an object in motion remains in motion at constant speed and in a straight line unless acted on by an outside force.
2. The acceleration of an object depends on the mass of the object and the amount of force applied.
3. Whenever one object exerts a force on another object, the second object exerts a force of equal magnitude and opposite in direction upon the first.