As clients and regular readers know, we believe that the stock market has been in the grips of a long-term secular bear market since 2000. In that context, stock prices have suffered two devastating declines and enjoyed two powerful rallies. Despite the wild gyrations, most major equity indexes rest at 1999 levels. U.S Treasury bills have outperformed the average common stock over more than a dozen years. Feckless monetary policy has reduced the value of the U.S. dollar by about 20% over that extended period of time.
At the end of the 1990s, we warned in conferences and publications of the coming long weak cycle. We pointed to absurdly high equity valuations and forecast that they would inevitably revert to or below their historic means. We argued that analysts failed to appreciate the danger to equity valuations resulting from the markedly improved productivity introduced by the IT revolution. If young companies could rapidly get up to relevant mass and importance, established companies’ competitive advantage could quickly be competed away. In an environment of a less durable competitive advantage, companies should logically sport lower rather than higher price-to-earnings and other valuation multiples. Since 2000 those valuation metrics have been noticeably reduced, but in the aggregate they remain near their historic highs but for the bubble period that began in the second half of the 1990s.
The second great excess leading to the still unfolding long weak cycle was debt. Unlike valuations, which have improved somewhat, debt conditions have worsened. In 2008, debt conditions nearly brought the world financial system to its knees. Only through a flood of money creation were many of the world’s largest financial institutions kept alive. Since then the world’s major central banks have continued to supply unprecedented amounts of monetary stimulus in a so far unsuccessful attempt to reinvigorate economic conditions.
Virtually every news release out of Europe highlights the growing debt crisis that has spread from the financial system to sovereign nations themselves. The very existence of the entire Eurozone financial structure now depends upon the continued willingness of the German electorate to support the debt of the Eurozone’s most beleaguered nations. As Europe’s fundamental conditions deteriorate, that willingness will increasingly be called into question.
Friday’s economic news was bleak in Europe, Asia and the United States, and the world’s stock markets reflected growing concern that repeated government attempts to prevent another recession may be failing in much of the world. Even the hope that poor economic news will prompt another Federal Reserve rescue action in this country failed to stem the worst price decline so far in 2012. We have contended for many months that investors are potentially reaching the point at which they will doubt the effectiveness of any additional rescue efforts. After all, following QE1, QE2 and Operation Twist, our economy is still struggling, and the rest of the world is clearly deteriorating. Should the Fed introduce QE3 and the markets fail to demonstrate the vigor that followed the first three stimulus efforts, market psychology could turn aggressively gloomy very rapidly.
As we have stated since the end of the 1990s, we are not in a “business as usual” environment. The world financial structure is held together by a thin thread of confidence in governments and central banks. If that confidence is lost, risk asset prices could sink precipitously and could remain submerged for a very long time. Each investor must evaluate carefully how much capital should remain at risk in an environment in which governments may or may not succeed in sustaining the current global financial system.