It’s not over yet

Equity markets have rebounded sharply to start the year. Inflation is moderating. The U.S. economy continues to add jobs, with record low unemployment. Investors are – once again – piling into the riskiest assets. As of mid-February, the NASDAQ is up ~15%, bitcoin is up ~50%, and Tesla is up ~90%.

Perhaps the U.S. can pull off an “immaculate disinflation.” But the economy and the stock market are not the same. Too many are ignoring valuations (or rationalizing current levels). The “everything bubble” peaked in 2021, with U.S. earnings at all-time highs (as a percentage of GDP*) and close to all-time high valuations (of those earnings). We have a modest pullback of one of the all-time great bubbles (right up there with 1929 and 2000) and many seem to think it is over. It can’t be that easy. I’m not saying equity markets will crash this year. Who knows (hint: no one does, despite the tremendous effort that goes into forecasting short-term market movements).

U.S. large cap equities are still expensive. And U.S. equities tend to dominate portfolios for U.S. investors (even if it comes in a private “wrapper”). So, I think it is a question of whether we are in for “slow pain” or “fast pain” from here. Slow pain would be years of so-so returns, losing ground to inflation. For example, see the U.S. from the late 1960s to early 1980s. The S&P 500 declined 34%** from its peak in 1968 to its lows in 1982, with a stop at -47% in 1974. Fast pain would be a sharp pullback over months or a few years. For example, the bursting of the U.S. TMT bubble in 2000-02. The S&P lost 45% in less than 2.5 years (and the TMT-heavy NASDAQ declined ~80% from its early 2000 peak).

We’ve had bubbles in the U.S. equity markets four times now – 1929, 1972, 2000, 2021. The latest bubble took years to inflate. For the 10 years through 2021, investors in the S&P 500 earned 14% per year after inflation. Even after the decline last year, investors in the S&P 500 earned 10% per year after inflation the last 11 years. The first three bubbles saw declines of 40-50% or more. Could we escape the last one down 20-25%? I doubt it. U.S. equities are cheaper, for sure, but that doesn’t mean they are on sale.

*I know this metric has flaws but the story is the same regardless of the valuation metric.
**Returns for the S&P 500 are total returns after inflation based on data from Bob Shiller.

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