US STOCK prices have jumped some 10 per cent since the end of May, even though the economic data has been almost universally shy of Wall Street expectations of late. It is clear that investors’ high hopes continue to trump deteriorating fundamentals.
The unseasonal upturn in the major market averages has prompted the diehard bulls to declare confidently that the latest move is just the beginning of a multi-year upswing in equity values. The never-say-die optimists argue that the conservative investor can reasonably expect a near-doubling in stock prices over the coming decade.
However, the bullish thesis conveniently ignores the fact that the advance off the crisis-depressed lows during the spring of 2009 has been accompanied throughout by unimpressive trading volumes – a development that reflects market actors’ unwillingness to sell equities in the face of the Federal Reserve’s ultra-accommodative monetary policies, rather than the robust demand that underpins secular upturns in stock prices.
The bulls remain undeterred and believe trading volumes will accelerate as the impressive returns since the spring of 2009, entice investors back into the market after more than four years of net selling.
Unfortunately, the belief is nothing more than wishful thinking, undermined in its entirety by the historical evidence. It took more than a decade for individual investors’ appetite for risk assets to return following the conclusion of the secular bear markets that extended from the autumn of 1929 to the summer of 1949, and from the winter of 1968 to the autumn of 1982.
More importantly, the argument also demonstrates a dearth of knowledge, at least when it comes to the supply/demand dynamics that underpin secular bull markets. Once the initial stage of a new secular bull market is complete, the major buyer of equities is neither individual nor professional investors, but the publicly quoted corporate sector itself.
An examination of the historical record shows that sustained, multi-year upturns in stock prices are always accompanied by merger waves that grow in intensity as the secular bull market progresses. Indeed, the phenomenon was more than apparent through the 1980s and 1990s.
This is not simply a modern development, however, and can be observed in the 1890s bull market, which saw the formation of DuPont, General Electric, Standard Oil, and US Steel; the 1920s upturn with its emergence of Bethlehem Steel, Deere, and General Motors; the “golden age” from the late 1950s through the 1960s and the growth of the “empire-builders”, including International Telephone Telegraph, Litton Industries, and Textron.
For those who question the relevance of long-term cycles that occurred several decades ago, the emergence of a new secular bull market in August 1982, and the developments in the years that immediately followed, should serve as a useful yardstick.
The high inflation that accompanied the stagnation in stock prices over the preceding 14 years meant the corporate sector traded at a substantial discount to the replacement cost of real assets, as this episode began.
The discrepancy between what investors were willing to pay for a company’s shares and the underlying value of its assets ushered in a large wave of takeover and restructuring activity.
As early as the late 1970s, shrewd corporate raiders recognised that leverage could be employed extensively to acquire a company’s net assets at a sizable discount to their “true” worth, and the purchased assets could be disposed of one by one to realise substantial profits.
Corporations appreciated that acquisition-led growth was a far cheaper alternative than the purchase of the property, plant and equipment required to enlarge operations.
By the third year of what would eventually transpire to be the greatest bull market in US stock market history, the debt-fuelled merger wave was in full swing. The number of private-to-public leveraged buyouts accelerated, as market actors recognised that equity prices continued to trade at a sizable discount of as much as 50 per cent to the replacement cost of assets – despite the sharp advance in stock prices in the intervening period – while rapid growth in the size of the original-issue junk bond market meant ample credit was available to finance prospective deals.
The corporate sector responded to the merger frenzy with debt-financed acquisitions of its own, and instigated share repurchase programmes as a defence against takeovers. All told, net share retirements through leveraged buyouts, mergers and acquisitions (MA), and stock buybacks amounted to $640 billion from 1984 to 1990, and reached a peak of 7.5 per cent of the total equity outstanding during the fourth quarter of 1988.
Fast forward to today, and more than three years after the major stock market averages reached their crisis-induced lows, net share retirements through MA and stock buyback activity remain roughly half the level in dollar amounts that prevailed five years ago, and just a fraction of the total equity outstanding as compared with the 1980s.
It seems that today’s equity valuations are not sufficiently attractive to compensate for the heightened level of macroeconomic uncertainty, and prompt the business sector back into the market for corporate control. The historical evidence confirms that this is not the stuff of which secular bull markets are made.
