What Negative Years Tell Us About the Cycle?
Collectively we channel our inner Ice Cube (or now Michelle Obama, or my daughters) and say, “Bye Felicia” to 2018.  For the first time since the U.S. financial crisis, the broad U.S. equity market posted a negative total return including dividend payments.  I’d call this an unprecedented nine-year run if the markets hadn’t done the same thing from 1991-1999 (preceded by an impressive eight-year run from 1982-1989).  Plus, the best nine-year run will always belong to Boston Celtics legend Bill Russell who led the team from 1959-1967 to eight championships in nine years (and this coming from a NY sports fan). 

Nonetheless, when you preach, as we do in our Compelling Wealth Management Conversations program, about the infrequency of negative calendar years, it hurts to enter one into the record books.  After all, in the 73 calendar years since the end of World War II, markets have only posted negative returns 16 times.  That’s roughly one in five years, or about as many Americans who approve of how our politicians have handled the government shutdown.

Is there anything that we can glean from those other negative calendar years (besides the fact that the Federal Reserve raised interest rates in each year)?  For brevity’s sake (and to be relevant to most of the readers), I’ll focus on eight “recent” years and make comparisons to today.

The Inflation Years (1973, 1974, 1977, 1981)

Then: At the beginning of 1972, U.S. headline inflation had climbed 3.3% from the prior year.  By the end of 1974 U.S. Consumer Price Index (CPI) growth was 12.3% and peaked at 14.8% in 1980.  The Fed raised rates to 20% by the end of the decade. 

Now: Before we put on our polyester leisure suits and hop in our AMC Gremlins, remember that inflation is running at 2.2% in the U.S. today, while inflation expectations 12-months forward are plunging.  Falling inflation expectations and tighter financial conditions are currently the bigger risks to the global economy.  Fortunately, the Fed appears to be backing off its tightening stance.

The Tech Wreck (2000, 2001, 2002)

Then: At the height of the U.S. technology bubble, the S&P 500 Index’s price-to-earnings ratio was 30.6x.  For the top 10 companies in the Nasdaq Composite Index, the weighted average price-to-sales ratio was over 20x. 

Now: Currently, the S&P 500 Index is trading at 17x trailing earnings and 14x 2019 earnings.  The earnings yield is 325 basis points above the 10-year U.S. Treasury rate.  Translation, stocks are as cheap to bonds as they’ve been since early 2016, and before that 2013.  As for the top 10 Nasdaq companies, they are trading at a weighted average price-to-sales of one-fifth of where they were in late 1999.

The Financial Crisis (2008)

Then: Households were over-levered.  Household debt to personal income had peaked at 133% in 2007 with mortgage debt equaling 100% of personal income.  Home prices had climbed by 10% in the prior year alone.  Banks were impaired.  Bank tier 1 capital ratios stood below 10%.

Now: Households have de-levered.  Household debt to personal income stands at 99% with mortgage debt comprising only 66% of personal income and automobile debt holding steady from 2008 at 7% of personal income.  For all the hand wringing over student debt, it represents only 9% of personal income, albeit up from 5% in 2008.  As for the banks, they are better capitalized now than they have been in a long time, Treasury Secretary Steve Mnuchin’s concerns notwithstanding.     

In short, the classic tell-tale signs of the end of the cycle are not evident.  If anything, global valuations are more attractive now than they have been in some time.  Don’t get me wrong.  This cycle, like all others, will end with a policy mistake such as further Fed tightening or an ill-timed “trade war.”  The Fed appears to be moving in the right direction and ultimately, we believe the administration will announce a market-friendly trade negotiation framework with China.

For long-term investors, remember that even if you invested money on the eve of 1973, or at the height of the tech wreck, or just before the 2008 financial crisis, your annual return through the end of 2018 was 10.0%, 4.8%, and 7.1%, respectively. 

As my kids also say, that’s lit (or is it savage?).