A 34-Year Tailwind For Stock Market Returns Has Run Out Of Steam

bear-market--My Comments: Many in my profession have been waiting for a market correction of significance for at least the past 18 months. Obviously it hasn’t happened yet, but unless you expect the sun to rise in the west, it will happen, and probably sooner rather than later.

More and more commentary surfaces every day that suggests a reversal will happen soon. Just when, how severe it will be, what will be the trigger, and how long it lasts is a total unknown. But happen it will.

I’m taking steps with my money and I hope you are doing the same.

Chuck Jones, June 13, 2016

One component investors consider when investing in the stock market is what rate of return they can get in alternative investments such as fixed income securities. Historically as interest rates have fallen, stock market valuations have increased. And when rates rise, it negatively impacts stock prices and valuations. When you look at the past 16 years compared to the previous 40 it looks like this relationship has not just run out of steam but has been broken.

Starting in 1960 the S&P 500 was at 58 and over the next 56 plus years to this past Friday it increased to 2,096 for a compounded annual growth rate (CAGR) of 7.3%. While it would be wonderful if the stock market increased by the same amount every year it doesn’t and one factor is interest rates. I have broken down the past 56 years into four timeframes.

1960 to 1970: The first spike in interest rates
At the beginning of 1960 the S&P 500 was at 58 and the US 10 year Treasury was 4.72%. At the beginning of the 70’s the 10 year Treasury increased to 7.79% while the S&P 500 climbed to 90 which is a 4.5% compounded annual growth rate (CAGR) which was significantly below the 56 year average of 7.3%.

During that timeframe the S&P 500’s PE ratio decreased from 17.1x to 15.8x a decline of 8%. While the 65% increase in interest rates may not have been the only reason the PE multiple contracted slightly the PE multiple decline did impact the stock markets return.

1970 to 1982: Interest rates continue to rise

Interest rates dropped some in the early 70’s but continued their rise from 7.79% to a high of 14.76% on June 25, 1982. Over that 12 and a half year period the S&P 500 only rose 1.5% a year to 109 which was significantly below the 56 year average. For the 22 and a half years since 1960 when the 10 year increased from 4.72% to 14.76% the market only increased 2.9% a year.

The PE multiple took a big hit when interest rates increased dramatically. As interest rates almost doubled (they increased 89%) the S&P 500’s PE went from 15.8x to 7.7x, down 51%. While the PE drop doesn’t exactly match the interest rate increase in percentage terms it is awfully close.

1982 to 2000: Interest rates start their 34 year decline

I remember in the early 1980’s you could get double-digit returns for two and three year Guaranteed Investment Contracts (GICs) in 401k plans since inflation was running in the 11% to 14% range. Over the next 18 years when the 10 year Treasury dropped from 14.76% to 6.66% the S&P rose from 109 to 1,426 or 15.8% on a yearly basis, significantly outperforming the 7.3% average.

While interest rates declined 52% the market’s PE multiple exploded from 7.7x to 29.0x towards the peak of the tech bubble. The 275% increase in the PE multiple far outpaced the decline in interest rates and helped to set up low returns going forward.

2000 to 2016: Interest rates continue to decline but returns are miniscule

As can be seen in the logarithmic graph of the S&P 500 below its price hasn’t moved much over the past 16 years (CAGR of 2.4%) even though the market increased almost 50% from 1,426 to 2,096.

While interest rates have continued to decline from 6.66% to 1.73% PE multiples have also dropped going from 29.0x to 24.2x (down 17%) which is not the typical relationship. It appears that PE multiples overshot so much where they should have been in the late 1990’s even lower interest rates can’t make up for the extended PE multiples.