The risk of a replay of the lost decade in US stocks

The writer is chief executive and chief investment officer of Richard Bernstein Advisors

No economic model would have predicted stocks would be at all-time highs and credit spreads would be very narrow after the Federal Reserve raised its benchmark interest rate by 5.25 percentage points since early 2022. Yet, that is exactly what has happened. 

The Fed seems ready to declare victory in its fight against inflation, but the outperformance of highly speculative investments suggests that even such a sharp increase in interest rates hasn’t been a big enough mop to soak up the excess liquidity sloshing around the financial markets.

Central banks still don’t seem to understand that financial bubbles are sources of future real asset inflation. Bubbles misallocate capital within an economy to unneeded assets (cryptocurrencies and meme stocks, perhaps?). And capital doesn’t flow to productivity-enhancing investment. Indeed, the US consumer price index finally peaked at 5.6 per cent subsequent to the technology bubble in 2008.

There is evidence that speculation could again be curtailing the Fed’s inflation-fighting power, but the central bank seems blind to this. Investors shouldn’t be.

Historically, the performance of higher and lower quality has been consistent across asset classes. Smaller capitalisation stocks’ relative performance versus larger stocks tends to mimic credit spreads — the interest rate corporates pay over benchmark levels. That is because smaller, lower-quality companies have greater operating and financial leverage and are more influenced by the economic and profit cycles. 

In other words, small cap stocks tend to outperform large caps and credit spreads tighten when corporate profits improve, but large caps tend to outperform and credit spreads widen when profits deteriorate.

Speculation over the past two years has significantly distorted this long-standing inter-market quality relationship. Large cap stocks have outperformed small cap stocks despite profits accelerating and credit spreads tightening. This has been primarily driven by the so-called Magnificent Seven tech stocks — Apple, Microsoft, Meta, Amazon, Alphabet, Nvidia and Tesla. The result has been a narrow market leadership and an emphasis on higher-quality stocks. Fixed-income performance, however, has been broader, and more cyclical with lower-quality credit benefiting.

This extreme divergence suggests three possible outcomes. First, the Magnificent Seven’s outperformance might be ignoring the broad improvement in corporate cash flows, whereas narrow credit spreads are correctly accounting for the cyclical upturn. This seems reasonable because the US profits cycle is accelerating and roughly 160 S&P 500 companies now have earnings growth of 25 per cent or more.

A second scenario could be that the equity market’s extremely narrow leadership is justified because an apocalyptic credit event is lurking. Goldman Sachs has pointed out the 1930s was the last time equity market leadership was as narrow as it is today. 

Narrow leadership makes economic sense during a depression because companies are struggling to survive let alone grow. Today’s narrow leadership, however, is accompanied by accelerating corporate earnings and a healthy banking system. Thus, a significant credit event of the magnitude that would justify such narrow equity market leadership seems unlikely. 

A third scenario could be that excess liquidity is fuelling speculation in both the equity and the fixed-income markets, and that neither the Magnificent Seven’s outperformance nor the tight credit spreads are appropriate. There’s certainly evidence of speculation in both markets. If this scenario is the appropriate interpretation, then equity market segments not typically defensive, such as emerging markets and smaller caps, might prove to be havens should the volatility of the current stock market leaders increase.

Although odd, there is a precedent for this. When the technology bubble began to deflate in March 2000, the overall stock market began the “lost decade” during which the S&P 500 had a modest negative annualised return for 10 years, but energy stocks, commodities, emerging markets, and smaller caps performed extremely well.

From March 2000 to March 2010, the S&P 500’s annualised total return was negative 0.7 per cent a year and the S&P 500 Technology sector was down 8.0 per cent a year. However, the S&P 500 Energy sector was up 9.4 per cent a year, the S&P Small Cap Index was up 6.6 per cent a year, and MSCI Emerging Market Index was up 10.0 per cent a year.

Those segments benefited from the reallocation of capital away from technology stocks, but also from post-bubble inflation spurring their profits. The Fed’s past could be the prologue. Capital is again being misallocated within the economy, yet the Fed still doesn’t seem to appreciate that misallocated capital kindles future inflation.