Market History: Secular Cycles - Part 4

The start of the new millennium coincided with the beginning of the next secular market cycle. Ever since the end of World War 2, credit has expanded faster than GNP. Government debt expansion, an easy monetary environment and increased use of leverage by consumers and corporations further contributed to inflationary asset growth and a record economic boom since the early-80s.

# 2000 - 2020 : Secular Bear Market

The super bubble that formed, dating to its inception to 1980, inevitably led to a cycle of bust as prices must revert towards the equilibrium level at some point in time. Since year 2000 (a span of just 12 years), the equity markets already witnessed 2 severe crashes, one correction and another flash crash - a definitive characteristic of a secular bear market we are currently in.

The severe plunge of Nasdaq (and along with it, the Dow and S&P) in year 2000
saw a total of $8 trillion in wealth lost in the market decline. The internet euphoria led to the unfounded belief that in the new age economy of the new millennium, company valuations were less important or relevant in view of the limitless growth potential arising from this internet revolution and how the world could be transformed. By year 2000, stocks were trading in the hundreds and some in the thousands on a P/E basis. The IPO market even had new companies  losing tons of money with no hope of profit until many years down the road but trading at over 1 billion dollar market cap.

Stocks were certainly over-valued. At the same time, there were problems brewing in the market. Corporate fraud saw many companies like Worldcom and Enron inflated their profits by means of shady accounting practices to hide debts and inflate revenue and assets to mislead banks, investors and regulators. Corporate officers awarded themselves with outrageous stock options that diluted sharholders' value. Conflict of interests also arose as analysts and investment bankers worked closely together such that whenever a company was trying to raise capital, the investment bankers made sure their research  firms would put favourable ratings on stocks, misleading the investing public. In some cases, analysts had favorable ratings on stocks less than a month before the companies filed for chapter 11 (bankruptcy). The advent of the internet and online trading at around that time also gave many individuals a quick and cheap way to trade the markets. This led to millions of new traders hitting the markets with little or no experience, further driving up prices by these retail investors before reality returned and the market caved in.

In 2008, the stock market cratered as another financial crisis struck, one that would trigger what would be known as the Great Recession. Had it not been for the sustained and concerted government intervention to support the financial markets, the collapse would have much more disastrous consequences on a global scale that could surpass the Great Depression of 1929. While inflationary pressure such as from rising oil and commodity prices threatened global economic growth, it was the US housing meltdown that triggered the Great Crash of 2008.

The crisis could be traced back to the Government's desire and drive to promote home ownership amongst Americans as it became an important political agenda to win electoral votes. A robust construction sector also bode well for the economy. Unfortunately, the Federal Reserve supported this political objective by keeping interest rates artificially low for too long a period while encouraging banks to expand mortgage credit. Demand for mortgages rose rapidly as Americans not only borrowed to finance the house they lived in but also overleveraged to purchase more houses to flip in anticipation of a quick profit. As the mortgage market became very competitive, mortgage brokers proliferated and banks started to drastically drop underwriting standards in order to keep or grow their market shares. They dropped income requirement criteria and sold ARM (Adjustable Rate Mortgages) to make the new mortgages affordable in anticipation that home prices would continue to rise and that would allow borrowers to re-finance when higher rates kicked in later. Basic credit principles were cast away. Banks instead resorted to loan securitisation which effectively removed mortgage assets from their books, believing their credit risks were eliminated while freeing up capital to underwrite even more mortgages. All these while, regulators subscribed to the ideal of a free market economy from the Reagan years and scorned at over-regulation. Federal Reserve and the Congress continued to prefer a laissez-faire attitude towards supervising banks and the derivatives markets. The Federal Reserve also mistakenly believed that loan securitisation would indeed help remove risks from the US banking system as these securitised assets were sold to investors elsewhere and globally and the resultant risks would be effectively diversified. To make these mortgage-backed securities or Collateralised Debt Obligations (CDOs) more attractive to investors, insurance companies like AIG provided default insurance while rating agencies like S&P and Moodys accorded top credit ratings to these derivatives. To manage these risks, there were also many financial swap transactions involving various financial and non-financial institutions, that effectively created huge and highly complex counter-party risks when the crisis eventually unfolded.

The housing market collapse soon led to a collapse in the CDO and CDS markets as these derivatives were basically written on unsound sub-prime mortgages. Many banks, insurance companies and even pension funds were severely implicated as holders of these supposedly safe derivatives. The collapse of Lehman Brothers sparked off a panic and rapid loss of confidence in the entire banking system as the extent and magnitude of losses from counter-party obligations became too complex to determine. Banks became fearful of lending to each other which effectively froze the money markets. This led to the Federal Reserve stepping up its lending in the money markets and structuring TARP bailout of the major financial institutions whose capital base was decimated but deemed "too big to fail" like AIG, Citigroup, Bank of America and JP Morgan. Their collapse was thought to pose severe systemic risks to the global financial system. FDIC took steps to assure depositors to avert potential bank runs. Freddie Mac and Fannie Mae were re-consituted and so were companies like General Motors as the housing market collapse caused a widespread decline in economic activity in the US and across the world. The housing collapse was further exercabated by the glut of homes the developers built during the boom years creating a supply overhang currently. The volume of foreclosure added to the supply glut that would continue to keep US home prices depressed for a number more years to come (see my earlier post in this blog captioned "Future of the US" on how and when the economy and housing market would turn around).

The Federal Reserve expanded its balance sheet as part of its quantitative easing program to keep rates low to fight deflation and unemployment. It actively bought Treasuries and Mortgage-Backed securities to keep rates low so the housing market could stabilise and banks hopefully would be incentivised to lend more given the wide lending margin which in turn would enhance their earnings and help re-capitalise them.

Consequently, the US government ran into record budget deficits of around $1.4 trillion annually since 2009 or around 10% of GDP each year. Simply stated, $1.4 trillion is approximately the amount of debt the US accumulated from its founding until 1984. In a single year, the US government would outspend its income by as much as it did during two entire centuries of cross-continental expansion, civil war, depression, world wars and the implemenation of the modern social welfare state. Going forward, it is likely to add more than $900 billion a year to its national debt. The largely monetary policies so far have helped avert a deep-seated recession and yet inadequate to stimulate employment growth. The massive US budget deficit offered little hope for fiscal stimulus unless tax policy changes are made as well as government spending on social security and the military reformed.

The two major crashes in this secular bear market were violent and would take a longer time to recover.

(a) Dot-Com Crash of 2000

        - Nasdaq declined 79% (from peak of 5132) over 30 months
        - Nasdaq has not reclaimed its prior peak till today
        - SP500 declined 49% over 30 months
        - SP500's full recovery took 60 months

 
(b) Financial Crisis of 2008

        - Market declined 58% over 18 months
        - Market has not reclaimed its prior peak till today


Outlook

US economic growth is likely to muddle along over next few years till end of this decade unless external shocks like Eurozone became severe enough to derail its growth. Strong growth in foreign economies, especially those in Asia and China, pent-up consumer and business demand and an accomodative monetary policy are likely to support growth in the US in the near-term. Yet, there remains challenges such as a huge deficit, unemployment, tepid housing market, risk of inflation in future and policy uncertainties from the next administration(s).

Meanwhile, corporate earnings growth remain strong and resilient with record cash per share. Reinvestment will return when market clarity improves and that should further boost earnings growth justifying higher share prices.

By 2020 (end of this secular bear market), Dow should be trading between 15,000 and 18,000, S&P500 between 1,500 and 2,000 while Nasdaq should exceed 4,000 points.

Sluggish growth and volatilities are likely characteristics defining the equity market till 2020.