Annual Real Rate of Return (S&P 500)*
Authored by Mike Petrino, Sr. Portfolio Manager
1/1914 – 1/2021
The data shown above are consistent with the view there has been one bear market and one bull market in the period since 1966. The bear market, summarized in Period 1 data, was one in which the stock market, as represented by the S& P Index, produced a return net of inflation of -1.4% per year. The bull market, summarized in Period 3 data, produce an annual return of 9.1% over the rate of inflation. The 10.5% return differential reflects the substantial difference in economic conditions during the two episodes.
During Period 1 the economic policies of 4 Presidents (Johnson, Nixon, Ford, Carter) from both parties produced a prolonged episode during which the annualized real return for the market was negative. The rate of inflation was higher than the rate of growth for real GDP on average during the period. The favored economic policies consisted of raising tax rates and increasing regulations. While tax rates were increased the Fed raised the rate of growth of the money supply rapidly. Using the DJIA as standard, the conventional wisdom of the smartest people on Wall Street was the market would never rise above 1000. In 1981 the Reagan Administration brought with it a new set of economic policies.
Yesterday it closed at around 34,000.
The economic environment of Period 1 was preceded by a period of strong economic growth and low inflation. In 1964 the Johnson Administration was able to put in place the reduction in tax rates proposed by President Kennedy. The highest tax rate on personal income was reduced from 91% in 1963 to 77% in 1964 and then further reduced to 70% in 1965. In 1964 real GDP growth was 5.2 % and in 1965 real growth was 8.5%. Inflation ran at a 1.8% rate in 1964 and 1.8% in 1965. Real growth was well above average, and inflation was below average.
Not long after the JFK/LBJ tax rate cut became law, the Johnson Administration proposed a temporary surcharge on income taxes to help fund the costs of the Vietnam War. A 10% surcharge on income taxes was levied in 1968. The spending for the War rose rapidly and led, in part, to President Johnson’s Unified Budget presentation. The new budget format folded the Social Security surplus into the budget and thereby eliminated the appearance of a deficit. The papering over of the operating deficit reduced the constraints on spending for the War or social programs. Federal net outlays as a percentage of GDP rose from 16% in 1965 to approximately 22 % in 1982.
In 1971 the burden of financing the rapid rise in government spending fell on the Fed and capital markets. One-year Treasury bill rates rose from about 4% in July of 1967 to 6% in July of 1971. The Fed increased the rate of growth of the money supply somewhat, but its actions were constrained by requirements established in the Bretton Woods Agreement. The Agreement, put in place in the 1940’s, established a fixed exchange rate for currencies, using gold as a benchmark. In August of 1971 the Nixon Administration closed the Gold Window, ending the facility by which foreign governments could exchange dollars for gold at a fixed rate, $35 per ounce at the time President Nixon shut the window. This action ended the Bretton Woods Agreement. In the same announcement that ended the last remnants of the gold standard, the Nixon Administration put in place wage and price controls and levied increased tariffs on imports. These actions increased both regulations and taxes. Regulations in every instance impose the same sort of burden on economic activities as do taxes; they raise the cost of output and lower the level of output, all other things being equal.
By 1971, with the establishment of the Unified Budget, and the closing of the Gold Window, the hardest constraints on government spending and Fed policies had been removed. One consequence of the removal of constraints was a rise in the price of gold from $36 per ounce in 1971 to $460 per ounce in 1981. As the Fed printed money, inflation rose from an average of 4.4% in 1971 to 13.5% in 1979. More changes were soon to come.
In 1973 OPEC imposed an embargo on oil shipments to the US. In response to the embargo, the Nixon Administration put in place a system for rationing oil and gas consumption, and price controls on oil. Rationing, price controls, and a rapid decrease in the rate of growth of the money supply were policy changes that tipped the US into a recession. The recession began in the fourth quarter of 1973 and ended in the first quarter of 1975. During the period from January 1974 through December of 1981, the price of oil rose from about $7 per barrel to $31 per barrel.
As a result of the Iranian Revolution there was another disruption in our oil supply in 1979. Having learned nothing from the policy errors which followed the 1973 disruption, regulations were imposed in lieu of market driven solutions. The result was predictable, a recession began in February of 1979 and ended in June of 1980.
Throughout Period 1 the rate of growth on the money supply was volatile. On a year-over-year basis the monthly money supply growth rate ranged from 38% to -3.0%. Each time there was a substantial decline in the rate of growth of the money supply, a recession followed. During the period there were four Fed Chairmen and each failed to maintain a consistent rate of growth of the money supply. Eventually President Carter appointed Paul Volker as fed Chairman to replace William Miller who held the position for about 18 months.
At the time Volker took the reins at the Fed, the growth rate for real GDP was negative, and inflation was running in a range of 10% to 13 %. The conventional wisdom of the time was embodied in the Phillips Curve paradigm. The model posited that there was a positive correlation between prices and economic activity. Thus, declining real growth and rising inflation was a source of puzzlement for the average economist of the time. Volker seemed aware of the role money played in driving inflation and he sought to reduce the rate of growth of the money supply. As the Fed reduced liquidity, the Fed Funds rate peaked at about 22 % in December of 1980. A recession began in early 1980 and ended in late 1982. By the end of the recession, there was a new economic regime in place. Ronald Reagan was President, and Paul Volker, who tamed inflation, was Fed Chairman.
President Reagan cut marginal tax rates, much as did President Johnson. The initial cut in rates lowered the highest marginal rate from 70% to 50%. Over the eight years of Ronald Reagan’s two terms, the highest marginal rates were lowered to 28% eventually. In 1983 real GDP growth was 7.9%, in 1984 it was 5.6%., For the remainder of Reagan’s two terms real GDP growth was above the post-war average of 3.1%. Federal Tax receipts increased during President Reagans’ two terms, but spending grew at a faster rate. During Reagan’s terms the real return on stocks was 10%, a level well about the 6.9% average for the period from January 1914 through January of 2021, a period that begins shortly after the Federal Reserve was established.
During terms of Presidents who followed President Reagan, with one exception, the stock market generated positive real returns. The one exception was the two terms, January 2001 to January 2009, served by President Bush. His terms ended as the capital market chaos produced by the collapse of the sub-prime mortgage market in 2008 and 2009 was underway.
After President Reagan’s terms a sustained effort to raise tax rates and increase regulations was difficult to achieve. Both President Clinton and President Obama served six of their eight years in office when government was divided. In the 1994 off-year election the Republicans took control of the House for the first time in forty years, and they took control of the Senate. In 2010 the Republicans won control of the House when they took 63 seats from the Democrats, the biggest loss for an incumbent party since 1948. The Republicans won 7 Senate seats from the Democrats in that election but did not gain control of the Senate.
In 1993 President Clinton raised tax rates and the Democrats lost the 1994 election. Prior to their 2010 election losses, President Obama and the Democrats passed the Affordable Care Act, which was both an increase in tax rates and an increase in regulations. After the 1994 election President Clinton signed NAFTA and lowered the tax rate on capital gains, and enacted minor tax reductions in other areas. Both Presidents lost the ability to raise tax rates and increase regulations without compromises. The Federal budget experienced a surplus during President Clinton’s second term. However, without President Johnson’s creation of a Unified Budget, there would have been no surplus. The Social Security surplus covered the deficit. The net impact of the two Democrat Administration on the fiscal policies of Presidents Johnson and Reagan were not sufficient to reverse the positive economic trends they established.
The highest marginal tax rate has risen to 37%, but this level is far below the 91% highest marginal rate in 1963, or the 70% highest marginal rate in 1965. The biggest threats to the positive trends established in the Reagan Administration flow from monetary policies and increases in regulations.
In the period from 1983 through 2020 there were only five years in which inflation averaged more than 4 %. In 2021 inflation average 4.7%, in 2022 it average 8.0 %. Through the first four months of 2023 inflation has averaged 6.5%. The causes of these higher rates of inflation are to be found in both changes in regulatory policies and monetary policy.
In 2020 in response to the COVID-19 pandemic actions were taken to “shut down “economic activity and minimize social interactions. Unemployment rose to 14% as a result. A recession followed shortly after the enactment of the COVID related regulations. The Fed increased the rate of growth of the money supply to prevent a deeper and longer recession. An increase in the money supply at the same time the supply of goods and services was contracting led to an increase in the rate of inflation. The pattern of destabilizing regulations followed by a rapid increase in liquidity and ultimately an increase in inflation can be discerned over the last fifty years beginning with the OPEC oil embargo in 1973, a disruption of the oil market in 1979, the collapse of the sub-prime mortgage market in 2008, and most recently the COVID pandemic in 2020.
The Fed is attempting to lower the rate of inflation by raising interest rates. The choice of policies is unfortunate because the increase in the Fed Funds rates will lower the rate of growth of GDP when the Fed should be trying to increase growth. As the Fed is attempting to reduce liquidity the Treasury has proposed a budget which, according to the Congressional Budget Office, will produce a deficit of approximately $2 trillion in fiscal year 2023. If the Fed continues to raise the fed Funds rate and reduce liquidity, how will the treasury finance the budget deficit? Some are speculating that foreign investors who have large dollar holdings will step up and finance the deficit. If foreign investors buy US debt, their purchases will increase the money supply at the same time the Fed is trying to reduce liquidity.
Yet another impediment on the path to a coherent set of economic policies is the Biden Administration’s propensity to advance regulations, particularly those believed to help reduce global warming. These regulations raise the cost of output and lower the amount and make it difficult for the Fed to craft the appropriate monetary policy; one that promotes stable real growth and stable and low inflation.
Real GDP grew at an estimated rate of 0.9% in 2022, and the preliminary estimate for growth in the first quarter of 2023 is about 1.0%. We may have entered a prolonged period in which real growth is well below average amd inflation is above average, much like the economic environment of the 1970’s. There are no pro-growth policies like those of Presidents Kennedy and Reagan, on the table.
As the data for Period 5 show, since the beginning of the Biden Administration in 2021, the stock market has produced, on annual basis, a -3.7% real return. We may have begun a new regime in which inflation is above the rate of growth of output and stocks are a wasting asset.
*The S&P 500 Index is used as a benchmark for the market, however in the earlier period the Index was constructed using different criteria than those used currently.