Commentary | 4Q 2019 and Full Year Results
In the fourth quarter, the stock market, as represented by the S&P 500 Index, produced a remarkable return of 9.1%. The fourth quarter result brought the return for the full year to 31.5%. This annual return is one of the highest since this bull market started in the early 1980’s. More on this topic in a moment.
Equity prices benefited from a variety of factors during the quarter. The interest rate environment remains positive, with an accommodative Federal Reserve and still very low intermediate and long-term rates. That said, the yield curve steepened during the quarter with the 10-Year Treasury yield rising to 1.92% by year end, helping to allay some fears of a coming recession. On the economic front many metrics remain positive, with the US unemployment rate at multi-decade lows. Despite the strong business backdrop, earnings comparisons were quite challenging during most of 2019 due to very strong results in 2018. Earnings comparisons for US companies should improve in 2020, and coupled with improving trade negotiations, perhaps investors began to price into the market the confluence of these positive forces.
Our earlier assertion that this bull market began in the 1980’s requires some substantiation. The examination of its origins should provide insight into the behavior of the market in the coming year.
In the period from 1966 through 1982, the stock market generated -1.0% per year return after inflation. The average investor’s assets lost purchasing power every year. This extended period of low returns invites explanations, but few that are consistent with the facts are to be found. This period covers the administrations of four Presidents; Johnson, Nixon, Ford, and Carter. Two of these men were Democrats and two were Republicans. They espoused and implemented different policies, but the outcomes were similar: real GDP growth slowed down and inflation increased on average over the period. When faced with low frequency events such as a 16-year bear market it is almost fruitless to employ sophisticated mathematical tools to look for consistent patterns. This is the only observation in the post-war period.
There are some events that seemed to drive both the direction of the market and the economy. For most of the period, economic real growth drifted lower while inflation rose to double digits and the market sank. President Johnson pursued large increases in government spending as he financed the War in Vietnam and large social welfare programs in the US. The war eventually drove the budget into a deficit condition. Johnson tried to cover the deficit with what came to be known as the unified budget.
Johnson combined both the operating budget and the social security surplus into one budget statement that was intended to hide the deficit. When Johnson declined to run in 1968, Humphrey inherited both the war in Vietnam and the budget deficit. He lost to Nixon. The policy differences between Nixon and Humphrey were minimal by today’s standards.
Nixon tried to end the war, and reign in the budget deficit. While these efforts were taking place, the Fed was engaged in quantitative easing, so inflation crept upward. In 1971, as inflation topped 3%, Nixon put in place wage and price controls and closed the gold window. This was just about the final nail in the coffin for the stock market. Johnson had all but eliminated fiscal constraints and now Nixon ended any need for monetary discipline. In August of 1971 when Nixon put in wage and price controls gold was selling for $35 per ounce. With no need to maintain the price of gold it rose quickly. Soon after Nixon made this blunder, we experienced the first oil “shortage”. There was no shortage, but Nixon managed to create one by placing price controls on oil. The oil flowed to the highest bidder, which was not the US. Nixon tried all manner of market interventions and they all failed. Eventually Nixon was forced from office and poor Gerald Ford was left to clean up the mess. Ford lost to Carter in 1976. Carter appointed Bill Miller as the head of the Fed. Miller was head of Textron with absolutely no experience running a central bank, and it showed. Miller was removed from the Fed Chairmanship and made Secretary of the Treasury. By the time Miller had been removed, the US had experienced almost 14 years of singularly inept economic policy. Our luck was about to change.
By the end of the 1970’s the conventional wisdom on wall street was the Dow could never sustain a move through 1,000. In 1980 Paul Volker was Chairman of the Fed and Ronald Reagan was elected President. Volker’s monetary policy was directed at reigning in inflation, and Reagan’s economic policy was geared to restoring real growth. The great minds on Wall street said the policies were in conflict; if real growth increased inflation would increase, interest rates would go up, unemployment would increase, and the bond market and the stock market would decline.
Volker reduced the rate of growth of the money supply, while Reagan lowered tax rates. To the surprise of the great seers on Wall Street real growth accelerated, inflation declined, unemployment declined, interest declined, and the stock market rose through 1,000 on its way to 29,000.
The bottom line is economic policies matter. From 1982 through 2019 stocks produced a nominal return of 10.4 % per year, and a return of 7.6% per year after inflation. This outcome may be just fortuitous, but we prefer to believe that economic policies that control inflation and promote real growth will produce healthy stock market returns.
While looking forward to the election of 2020, we should expect those who advocate higher tax rates and more government intervention into the marketplace to be more likely to produce conditions more similar to the 1970’s, than they are to the last 40 years.