Market Super Cycles
Are we still in a Bull Market or is the future Fat & Flat?
When Peter Oppenheimer began his career in the mid-1980s, governments were stepping back from interfering in markets, extolling the inflation-fighting virtues of independent central banks and promoting globalization.
Forty years later the cycle is reversing.
We’re now in a world of competing government industrial policies that is switching from globalization to regionalization. Government debt is rising and it’s hard to escape the conclusion that inflation will stay elevated as central banks are pressured to buy government bonds.
How Do Those Fundamentals Make You Feel?
These economic and policy trends are intimately connected to equity market cycles. Oppenheimer tells their story and explains how investors can prepare for the future in his new book, Any Happy Returns: Structural Changes and Super Cycles in Markets.
He describes the phases of each market cycle - Despair, Hope, Growth and Optimism - in psychological terms. This makes sense because although market cycles are grounded in fundamentals, they are driven by sentiment.
The graph below compares the total returns investors have realized in each phase to actual corporate earnings growth. The Despair phase has awful returns even though earnings growth is positive, while the Hope phase has phenomenal results despite negative growth.
Why the disconnect?
The Despair phase is often short and kicked off by a shock (think February-March 2020). Investors are shaken. They refuse to buy equities until prospective returns are sufficient to compensate for the perceived higher risk. This despair isn’t necessarily irrational. Instead of watching current earnings, investors are looking forward to the next phase where actual EPS growth is negative.
Eventually two things happen. First, valuations become so cheap that future expected returns look attractive. Second, expectations for future earnings growth improve. Thus begins the Hope phase, so-called because although returns are spectacular, actual EPS growth is negative. But the disconnect doesn’t matter because investors have turned optimistic about the future.
Speaking of optimism, Oppenheimer currently places us in this final phase. Returns in this phase can still be positive, but the ground is shakier because valuations are expensive and future growth prospects not as strong.
Market Super Cycles
It typically takes around seven years to complete all four phases, although the times vary. For example central bank support for markets made the most recent Despair and Hope phases very compressed.
Stepping back further, Oppenheimer claims that markets also rotate through longer-term ‘super cycles’ that are either very rewarding for investors (Secular Bull) or not so good (Fat & Flat).
The table below shows each of his post-WW2 super cycles. The tricky thing - which Oppenheimer readily admits - is figuring out where we are in real-time. Market peaks and troughs only become clear with hindsight. For instance, it’s possible we could still be in a Secular Bull market, with the Covid crash a short-term blip.
Alternatively, if we are indeed in a new Fat & Flat period, then market prospects for the next 5-10 years are not good. The last two Fat & Flat super cycles produced negative returns for investors while this one has produced strong results so far.
The next table shows how valuations move across cycles. Fat & Flat cycles start with elevated valuations and end with depressed ones. By that criteria, we are either still in a Secular Bull market, or valuations need to fall a lot across the remainder of the current Fat & Flat super cycle. An important caveat is that the data refers to the S&P 500. Valuations in other markets are cheaper.
Post-Modern Cycle
Whether we are at the end of a Bull market or in the middle of a Fat & Flat phase, the message appears to be the same - merely riding the S&P 500 from this point isn’t likely to be rewarding1. In the book’s final chapters Oppenheimer aims to help with this problem by outlining opportunities arising from structural changes he expects in the upcoming ‘post-modern cycle’.
They fall into two broad categories.
The first is growth driven by the dual government priorities of security and decarbonization. The emphasis on security means increased defense spending and encouraging a reorganization of critical economic links along regional, politically-friendly lines. Decarbonization will involve massive capital spending, as low-carbon energy investment is about twice as capital intensive as fossil fuels.
Although Oppenheimer expects market-level valuations to fall, partly due to a higher risk premium stemming from global political conflict, he also sees room for multiple expansion at companies that can exploit these trends. He notes we’ve already seen an example of this in the lofty valuation of tech companies. Yes, they’re expensive, but tech has sustained return-on-equity levels 20-30% above other sectors for the last fifteen years.
I’d call the second category problem-solving. Companies will face profit squeezes on multiple fronts. Wages will rise as globalization and favorable demographic trends reverse. The growing capital expenditures noted above will be a source of higher commodity costs. And rising government spending will keep interest rates higher and make corporate debt service more expensive.
Eesh.
But that also means that technologies and services that help companies offset these pressures will be hugely valuable. More broadly, governments beset by rising debt will be desperate for anything that increases productivity. In the US, the biggest drag on productivity growth has been the health care sector. Any technology that can help here is likely to be richly rewarded.
This is a surface-scratching summary of his work. To learn more, listen to Peter and me discuss the book on the most recent Ideas Lab Podcast:
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For an alternative view on why the current bull market may have much further to run read the excellent Paulsen Perspectives Substack.