“I’ve never been certain whether the moral of the Icarus story should only be, as is generally accepted, ‘don’t try to fly too high,’ or whether it might also be thought of as ‘forget the wax and feathers, and do a better job on the wings.” – Stanley Kubrick
Stock markets around the world continued to tip toe higher this week, with many making repeated all time highs. As usual, such high flying comes hand in hand with forecasts of imminent doom from various corners. This week, the Cassandra’s were leant a little perceived meat by the 30 year anniversary of the greatest one day stock market crash ever. We’re also just over 10 years on from the worst financial crisis in living memory – what lessons can we learn from these financial market’s parables and why are we still arguing for stocks to outperform bonds?
October 19th, 1987, a day now known as Black Monday – admittedly one of many such Mondays dotted through history/life. However, none of these Mondays can boast a one day fall of over 20% on the DJIA. That wasn’t it of course. Wild panic saw stock markets around the world plunge lower into the end of the month. As you would expect, this capital markets rout exhumed some of the planet’s most dismal scientists, several of whom rapidly proclaimed that the US economy was facing its bleakest patch since the 1930s. As with now, such doom mongering was perhaps given extra clout by the fact that the economic cycle was already long in the tooth. As it turned out, the real economy barely noticed the stock market turmoil, the cycle continued for another couple of years and ended with one of the milder US recessions on record in the early 1990s. The stock market, for its part, regained its pre Black Monday peaks in just over a year, less if you account for dividends.
“It’s different this time” are regularly held up as the four most dangerous words in investing. However, as we have regularly pointed out, it’s not just different this time; it is different every single time. History can provide us with useful context and perspective of course, but the future will remain unknowable, no matter how carefully we mine the past. Nonetheless, there are of course some important lessons to be gleaned.
Many continue to mistakenly see in the Great Financial Crisis the template for how all business cycles end. Remembering that the last recession sits at the more extreme end of the seizures experienced by the world economy in the last 100 years, as well as the fact that such seizures have actually been becoming less frequent and less violent in the post war period, provides important investing context.
Interestingly, as we sit 10 years on from that terrifying private sector seizure, those investors who were unfortunate enough to buy US stocks right at the peak in 2007 have now still managed to double their money (assuming they held on through all the horrors that followed) – a fact that hints at the benefits of simply staying invested.
The passing of this 10 year anniversary will also start to have an important impact on the valuation debate. The Cyclically Adjusted Price to Earnings ratio, apparently one of the most potent weapons in the doomsayer’s armoury, will automatically plunge back towards long term normality in the next few years even if US companies manage to generate no further earnings growth. This normalisation is a simple function of the earnings rout from the great recession falling out of the 10 year rolling average earnings figure. In any case, the valuation debate has not moved on materially this year. Earnings have grown sufficiently so far to leave price to earnings ratios, dividend yields and other metrics more or less where they started the year in the developed world in spite of surging stock prices.
In the short run, the behaviour of stock markets can be capricious and only tenuously linked to the underlying economy, as black Monday testifies to. However, further out the forces of growth and inflation tend to be harder for asset prices to resist. As we look ahead to the next 3 – 6 months, barring something unforeseen/unforeseeable, interest rates should continue to rise in most regions across the curve, even if inflationary pressure remains muted – the world economy looks well beyond the need for emergency monetary care. That process should provide a stiffer headwind to stock market valuations. However, with the most reliable lead indicators for the global economy, and therefore corporate earnings, telling us that there is more decent growth ahead, stocks should continue to do well, both in absolute and relative terms. It’s ok to fly high if you have the right wings.