Assume Bull Secular — How Do You Justify It?

The analytical struggle I’ve been having with the market lately is this: the housing market is now in a full-fledged recovery, with building permits growing roughly 30% year-over-year:


And at ~900k, they still have a long time to go before they get back to a normal range of 1.5-1.7M. If they continue to grow at a quick pace of 25% a year, we wouldn’t hit normalized levels until the second half of 2015. Which means that the earliest possible time I’d be worried about a sustained economic-driven recession and bear market would be 2016. We can always imagine exogenous shocks like China hard landings and Middle East oil flareups, but these aren’t realistic. It’s unlikely that we’ll have a recession until we’re talking about the 2016 Democratic and Republican conventions.

At the same time, we’re in the late stages of a balance sheet recession. Fiscal policy remains a headwind to growth. Demographics, with tens of millions of Boomers set to retire over the next 5 years, are a headwind to growth. It’s unlikely that we’ll see a surge in household borrowing any time soon. Profit margins have likely peaked, or just about, so it’s hard to see where robust profit growth will come from.

And valuation-wise, it doesn’t look like 1982 or 2009 out there. If we could go back in time to 1982 we’d know that interest rates and inflation were set to collapse, and demographics were so favorable, that we’d get the combination of falling interest rates and inflation with robust GDP growth. And in 2009 we’d know that the collapse had been arrested, risk premia would collapse, and profits would come roaring back. Today, the VIX is below 13, profit margins are near a peak, interest rates and inflation are already low, and the US equity market trades at around 15x trailing earnings — not historically expensive, but not generationally cheap either, and with no obvious profit drivers on the horizon.

But for argument’s sake, let’s say that someone traveled back through time, from the year 2023, and told us that we really were living through the start of a new secular bull market. How, then, would that be possible?

I’d point to two things — the market’s price/book value and the equity risk premium (ERP).

In 1995 the price/book of the SPX was 2.8. In 2005 it was 2.8. Today it’s a little under 2.3. So on that measure we’re about 20% cheap to fairly typical years in the past. Equity risk premium, defined as the earnings yield of the S&P 500 minus the 10-year treasury yield, however, remains historically elevated at 4.7%. The median ERP from 1962-2012 was essentially zero.

Now, obviously we’re unlikely to see the S&P 500 trade at 50x earnings to get ERP down to 0%. I’d argue that the demographic profile of the US, with more aging Americans around who need money in safer assets, could point to a decade or more of an ERP in the 1-2% range. But it’s not going to stay at 4.7%. Through some combination of higher risk-free rates and lower earnings yields, it will compress.

But how could risk-free rates rise if households are unlikely to borrow like they did in the past, and if fiscal policy remains a headwind to growth? The only possible answer, and the only way I’d feel comfortable betting on a new secular bull, is an explosion in corporate borrowing, M&A, and LBO activity.

We know that public+private fixed investment as a share of GDP could rise another 3% before it’d be a concern — that’s $500bn/year on our current GDP base:


And on a real basis, household+business credit growth remains slightly negative:


I don’t know how the corporate sector could start borrowing and spending an extra $500bn/year, and how that would flow through the financial system and economy. But all I know is this: we are not going to remain in a world of low interest rates, low implied volatility, low credit spreads, with recession risk years away, without private sector leverage increasing somehow.

Risk finds a way.

  1. csen posted this