We Haven't Seen a Bull Market, Yet
After a dozen years of very poor economic policies under Republicans and Democrats that have resulted in anemic U.S. equity returns, we may have been down so long that we don't remember what up looks like. But don't despair, as bad policy isn't a forever thing. A future shift in economic policy could unleash a bull market not seen since the 15x stock-market return, and 40 million new jobs of the 1980s and 90s.
What can't be stressed enough is that government policy matters. We believe that a government's economic policies don't merely influence asset prices; they determine asset prices. Think of policies as the rules of the investment game. Shifts in policy alter the supply and demand for products, labor and capital, thus altering the supply and demand for all asset classes. Capital and labor are allocated across sectors, countries and asset classes based on the set of economic policies put in place. While every policy impacts supply and demand in some way, we identify three major policy domains that dominate asset class returns: monetary, fiscal and regulatory.
The best lens we know to view the consequences of changes in policy is supply-side economics, specifically the "wedge" model. Supply-side economics is incentive based and examines the changes in incentives for supplying both labor and capital. Since a worker can only demand because they supply labor, supply and demand should be seen as the same thing: an identity. The goal of policymakers should be to maximize the incentives for supplying labor and capital.
Sadly, policies often have the opposite effect, and sometimes even good policies at first glance end up having negative unintended consequences on supply. Jude Wanniski, a political economist credited for coining the term supply-side economics, called these policy barriers to supply "the wedge." The wedge gets in between work effort and reward. When the wedge decreases you get more income, output, employment - in short, growth. In the three major policy domains (monetary, fiscal and regulatory) a wedge reducing pro-growth prescription would include a monetary policy resulting in a stable to strong U.S. dollar, a fiscal policy resulting in lower marginal tax rates, and a regulatory policy resulting in a reduced burden on business activity.
The overall direction of the policy wedge is powerful because policy changes tend to be durable. We can live under a certain tax code or a certain monetary policy regime for a very long time. This causes asset classes responding to incentive shifts to be in or out of favor for long periods. Policy is the reason there are no average stock market years. In fact, there aren't even average decades. Instead, returns cluster around policy. Good policy regimes produce growth in incomes, output, employment and equity markets. Bad policy regimes produce the opposite.
Importantly, these policy periods are outside the scope of political party. Politics doesn't matter. Only policy does. Ronald Reagan and Bill Clinton both implemented policies that reduced the "wedge," and prosperity followed for two decades in the 1980s and 1990s. The S&P500 increased roughly 15x in nominal terms over those twenty years.
Conversely, George W. Bush and Barack Obama implemented growth-killing policies that have starved the past thirteen years of any real progress. Since 2000 the S&P 500 is up only 20% in nominal terms. But the story is far worse. Progress in equity markets must be measured in real terms in order to strip out nominal gains caused by a weak U.S. dollar instead of real economic growth. In terms of gold, the S&P rose 1,500% from 1980 to 2000, and collapsed 75% from 2000 to 2013. Remember, this return from 2000-2013 includes the excellent 32% return last year. Prior to 2013, U.S. stocks had lost nearly 90% of their value in gold terms since 2000.
The flawed monetary policy of the early 2000s has expanded into flawed fiscal and regulatory policies under the Obama administration. Through six years of the Obama administration the incentives to supply both labor and capital have dropped substantially due to higher tax rates on dividends, capital gains and work effort. Bad fiscal policy has combined with a poor monetary policy that transfers wealth from savers to borrowers (namely the government), and poor regulatory policy that is making it more difficult for economic actors to transact.
Given this uninspiring policy landscape and the dismal results it has produced over the past 13 years, why are we guarding against under-optimism?
To put it simply, the "wedge" is decreasing. The 32% advance in U.S. equity markets in 2013 sounded the alarm that policy is indeed shifting. The market's advance was not caused by the Federal Reserve printing money. Instead, it is explained by a stronger U.S. dollar. The dollar's value, most efficiently measured by the price of gold, acts as a scorecard for the set of political/economic policies being implemented. In late 2012, the dollar and equity markets celebrated a shift in the fiscal policy wedge caused by the tax cliff. In 2013, they further celebrated improvement in monetary policy as the Federal Reserve announced and then began exiting from its flawed and dangerous "Quantitative Easing" program. Along the way the will of the country shifted against the larger government regulatory agenda of Washington, D.C. as evidenced by dwindling support for Obamacare, not to mention the politicians who foisted the policy on us.
The stage is being set for a transition from the failed policies of the past thirteen years to a new set of pro-growth policies. The mid-term elections this fall will give us a strong signal about the reality and strength of this shift.
Future policies cannot get much worse than they have been. Reductions in the "wedge" across monetary, fiscal and regulatory policy have the power to unleash a U.S. bull market not seen since Reagan and Clinton.
Many pundits have celebrated the recent equity bull market since 2009. As we pointed out, this advance barely got us back above the nominal all-time highs in the S&P 500, and in real terms we lag far behind. There has been no bull market, yet. If we get the right set of incentive-based polices going forward, then maybe 2013 will be seen as the first pitch of the first inning of a new bull market. Follow the policy, and guard against under optimism.
James Juliano and Russell Redenbaugh are partners at Kairos Capital Advisors.