The popular story of the Bear Market is familiar: in 1973 OPEC launched an oil embargo in order to drive up oil prices. The oil shock resulted in long lines, fistfights and economic devastation. In 1974, the pressure of the Watergate scandal forced the resignation of President Richard Nixon. Gerald Ford became the first President of the United States never to be elected. In 1976, the United States elected a “tax and spend” President in Jimmy Carter. The aging industrial base of the United States was failing under heavy competition from abroad, especially Japan. Top marginal tax rates exceeded 70%, discouraging entrepreneurs. President Carter complained of a “malaise” in the country and “stagflation” in the economy. The final cut occurred when Iran, flush with oil profits and fresh from Islamic revolution, took 52 hostages at the U.S. Embassy in Teheran, subjecting Americans to a morale-crushing “America held hostage” vigil of 444 days that seemed to underscore American helplessness. The footage of the smoking hulks of helicopters that couldn’t even get off the ground to attempt a rescue summed up the decade. In 1980, Ronald Reagan was elected and it was “Morning in America”. The hostages were home within days. Shortly thereafter, the United States suffered a sharp, but cleansing recession and then all was pretty much well. Stocks, so often a barometer of American national health, mirrored the country’s ordeal.
That’s the story, anyway.
From an analytical perspective, the story is a bit simpler.
In January 1973, adjusted for inflation, the earnings of the major U.S. Corporations were $34 per share in aggregate. The stock market stood at 118.4. By the cold December of 1974, the stock market stood at 67.1, down 43% from less than two years before. Economic devastation? Hardly. In December 1974, earnings were $38 per share – up more than 10% from 1973. At no point in the period did earnings fall below $31.75 (in September of 1975), less than 10% below 1973. Malaise? A crushing lack of confidence in the future? No, it was interest rates.
The chart below shows the market valuation (expressed in Price-to-Earnings terms where Earnings are the average of the preceding 10 years) and the interest rate on long-term government bonds. Earnings times the number expressed by the pink line yields the market average. With the “multiple” in 1975 at half the 1973 levels even decent increases in Earnings could not produce stock market gains. The market “multiple” did not reach 1973 levels again until 1992, when interest rates were once again below 7%.
The relationship is clear, but requires some imagination. In the next chart the same data is shown, but I have inverted the Price/Earnings ratio into an Earnings/Price ratio (and multiplied it by 100):
In late 1974/early 1975 there may have been a loss of confidence (the pink spike), but otherwise the fate of the stock market was in the hands of Interest Rates.
By May 1977, corporate earnings broke above $38 per share and would not fall below that level for the rest of the decade. The stock market remained below 1973 levels because interest rates held down the valuation of stocks relative to earnings. Indeed, when stocks finally broke above the 1973 highs (in 1980), earnings were about to go into a tailspin that saw them fall as low as $28 by 1983. Yet the stock market average at that point in May 1983 was 164 (up from 118 in 1973). Interest rates tell virtually the entire story.
At first glance, the current crisis appears to be completely unlike the 1970s because Federal Reserve interest rates are very low. On the surface, this is true.
In reality, the scarcity of credit, not so much from banks but from bond investors, has driven borrowing costs for companies up dramatically. In recent weeks interest rates and yields on investment grade corporate bonds have jumped to about 7% and rates and yields on non-investment grade debt are now near 13%. These terribly high interest rates on loans that are actually available to borrowers – even good credits – are a contributing cause to the current market declines. The chart below compares the yield, effectively the interest rate, on a major High Yield bond fund to the market valuation (inverted, an E/P ratio as above) for 2008:
It appears to be happening again, though the trouble is in the private sector. When the Government says we “need to get lending going again”, this is no doubt a big part of what they mean. Based on the experience of the 1970s, when these effective interest rates start to come down, the stock market should start to go up.
[An easy barometer to watch is the yield on the Powershares High Yield ETF, ticker symbol PHB, which has a 12-month yield of 14.51% as of 11/20/2008.]
Thanks to Richard Smith for getting me started on this analysis
Historical raw data from the Shiller Irrational Exuberance database
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