Today, we continue our two-part series from Justice Litle, editor of TradeSmith Decoder.

Yesterday, Justice explained why investors are at risk of a lost decade in the stock market.

Today, we build on that. Justice walks us through the last four decades, highlighting each decade’s unique tailwind that supported a rising stock market.

Unfortunately, none of those tailwinds exist today. And in their absence, here’s a preview of what Justice sees coming:

If you think markets are tough now, just wait until we reach a point where the United States, and the world, enters full-blown recession conditions with unemployment climbing, corporate profit margins tanking, and politicians screaming — and inflation pressures yet remaining high.

This is an important essay for all investors to take seriously. If Justice’s forecast plays out as he expects, the broad, bullish stock market conditions we’ve enjoyed for decades is a thing of the past.

I’ll let him take it from here.

Have a good weekend,

Jeff Remsburg

Four Unique Decades

The optimists don’t want to hear this, of course.

The idea of a 1968-1982 period, in which stocks do nothing with a whole lot of volatility — while losing to inflation the whole time — sounds like a waking nightmare for the long-only investor.

And “waking nightmare” might not be far off given that, in 1974, even Warren Buffett had a 50% down year. Ouch!

Instead of facing this possibility, hopeful investors want to believe the stock market will soon be back to “the good old days,” meaning something like the decade of the 1980s… or the 1990s… or the 2000s… or the 2010s.

Any decade of the past four will do, in fact, because all of them — barring the occasional crisis scare here and there — were great for stocks.

Here is the thing though: That which investors believe is the baseline “normal” for stocks, based on 40 years of lived experience, was not actually “normal” at all.

For markets “normal” does not exist. The stock market is not guaranteed to behave a certain way — it merely responds to the prevailing set of general conditions, which can vary widely depending on the decade.

The typical investor today assumes stocks always go up, as a rule of thumb, because they have somewhere between one to four decades’ worth of lived experience that tells them so.

This makes sense, kind of: If you experience the same set of prevailing conditions for 40 years, it is logical to assume, without thinking about it, that “things will always be this way.”

But if we take a closer look at the historical drivers of the past four decades, we can see it just ain’t so.

Each of the past four bullish decades for the stock market — the 1980s, the 1990s, the 2000s, and the 2010s — were bullish for their own unique set of circumstances, and thus bullish in their own way.

And guess what — all those bullish drivers are now gone. Let’s take a quick tour.

The 1980s: Volcker Payoff and Shadow Banking

The great bull market that encompassed both stocks and bonds alike, and which defined the conditions that a majority of investors have known for their entire careers, began in 1982.

That was no accident, because Federal Reserve Chair Paul Volcker, a.k.a. “the man who broke the back of inflation,” took office in 1979.

Volcker put the U.S. economy through back-to-back recessions, taking the federal funds rate to 20% in the process, in order to kill off inflation. The cost was brutal, but the payoff was evident in the decade that followed.

Because of what Volcker did, the 1982 bull market was able to kick off in an environment of falling inflation, falling interest rates, and extremely low levels of leverage and debt in the U.S. economy (because the recessions under Volcker’s watch had cleaned them out).

In addition to that, Wall Street invented shadow banking in the 1980s. This was the rise of high yield debt instruments — think Michael Milken and junk bonds — and leveraged buyouts and other means of credit exploitation.

That ability to exploit new credit instruments, starting from a base of low leverage with inflation and interest rates falling, helped drive the boom of the 1980s, as did Reagan administration Cold War deficit spending (counterbalanced by tight monetary policy) and the birth of Silicon Valley legends like Microsoft and Apple.

The 1990s: Peace Dividend and Technology Boom

In 1989 the Berlin Wall fell, and in 1991 the Soviet Union collapsed.

At the same time, the crude oil price fell sharply in the latter half of the 1990s, approaching $10 a barrel by year-end 1999, and the U.S. economy started to experience technology driven productivity gains via the personal computer revolution.

The end of the Cold War (via the demise of the Soviet Union) made it possible for the U.S. government to rein in deficit spending — there was no more need to spend the Soviets under the table with a nuclear arms race — which in turn allowed the Federal Reserve to keep short-term interest rates low, thus allowing long-term interest rates to continue in a broad downward trend.

At the same time, the microchip and software revolution that kicked off in Silicon Valley in the 1980s was having a real impact on productivity in the 1990s, creating a kind of golden age for stocks in which liquidity was ample, the economy was humming, and the Federal Reserve was complacent about bubbles because inflation was absent.

The 2000s: Cheap China Goods and Surplus Dollars

In the 2000s China came to the fore.

China had been on a growth tear ever since the late 1970s, when Deng Xiaoping took over from the late Chairman Mao — but it was the first decade of the 21st century when China truly made its presence felt.

China fueled the equity bull market of the 2000s in multiple ways:

• Low-cost Chinese-made goods kept inflation subdued by keeping goods and services prices low.
• China demand for natural resources fueled a commodity-related equities boom and talk of a commodity supercycle.
• China’s habit of selling large quantities of goods to the United States, then taking the dollars it received and parking them in U.S. Treasuries rather than spending them, helped keep long-term interest rates low via exaggerated demand for U.S. Treasuries (Middle East oil exporters and Japan were doing the same thing).

At the same time, the 2000s were fueled by wildly accommodative monetary policy from the Federal Reserve as the Greenspan Fed, and then the Bernanke Fed, responded to one crisis after another, and one bubble after another (housing bubble, private equity bubble, etc.) with even more stimulus and even more accommodation — and surplus countries like China further underwrote the Fed’s actions by purchasing huge quantities of U.S. Treasuries.

The 2010s: Doubling Down on Quantitative Easing and ZIRP

The 2010s, in some ways, were the craziest decade of all.

As the global financial crisis of 2008 unfolded, many observed it felt like “the end” — but in many ways it was just the beginning.

In response to 2008, global central banks doubled down on all their monetizing and stimulating ways.

The arrival of mass-scale quantitative easing and emergency liquidity injections — as a specific response to the 2008 crisis, from China to Europe to the United States — ushered in the policies of ZIRP (zero interest rate policy) and volatility suppression that defined the decade.

Over the course of the 2010s, blue chip corporations could borrow money for next to nothing — their cost of capital was practically cheaper than tap water — and use that borrowed money to buy back shares, thus making their earnings-per-share numbers look better.

At the same time, all the major central banks sought to squash volatility and pump-up asset markets with liquidity, to generate a “wealth effect” that, it was hoped, would trickle over to weak labor markets to help revive sickly economies.

Another defining feature of the 2010s was Wall Street feasting at the expense of Main Street because the latter could not be helped.

The Federal Reserve was like a doctor whose actual patient — the labor market — could not be helped, and so the doctor decided to pump morphine and other feel-good drugs into the patient in the next bed over — the stock market — instead.

This was fantastic for asset prices, and if the U.S. labor market looked weak and sick, the medicine, which got hoovered up by Wall Street, continued.

All of That Is Gone — and Stagflation Is Coming

If we had to boil down the unique bullish drivers of the past four decades into a handful of bullet points, they would be:

• 1980s — Volcker dividend plus shadow banking starting from a low leverage base
• 1990s — Post-Cold-War peace dividend and technology productivity boom
• 2000s — China as provider of cheap goods and bottomless U.S. Treasury demand
• 2010s — Doubling down on stimulus via Quantitative Easing and ZIRP

The key point here is that all those drivers are gone. Every single one is history now.

With respect to inflation battles, we have come full circle — the mother of all inflation battles is ahead of us, not behind.

With respect to war, we are entering a wartime period, not leaving one.

With respect to China, we are now deglobalizing as China transitions from trading partner to Cold War II adversary… and breaking supply chains rather than building them… and the world is raiding its piggy bank to sell U.S. Treasuries, rather than accumulating them, because the world is desperately short of dollars and close to broke.

And with respect to quantitative easing and ZIRP, “QE” has now become “QT” for quantitative tightening — and instead of hovering above zero, two-year Treasury yield is above 4%.

Then, too, stagflation is coming — and investors have no idea how painful that is going to be.

Stagflation is not just sticky and high inflation. It is high inflation coupled with high unemployment simultaneously.

If you think markets are tough now, just wait until we reach a point where the United States, and the world, enters full-blown recession conditions with unemployment climbing, corporate profit margins tanking, and politicians screaming — and inflation pressures yet remaining high.

That is where we are likely headed — and 1968-1982 is the template. As noted, we are already getting a taste of 1969.

Regards

Justice Litle
Editor, TradeSmith Decoder