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Tuesday, October 24, 2017

Financial Focus - 30 Years After the Crash: Is This Time Different?



"This time is different" – a phrase that often can prompt investors to ignore risks (a sign of market tops) or fixate solely on them (a signal of market bottoms).  Last week brought the 30-year anniversary of "Black Monday," when the stock market crashed 23% in a single day. Perhaps ironically, the market set a new record high on last week's anniversary date, extending what has been an extraordinary bull run for equities over the past eight and a half years. 

We don't think another crash is imminent – certainly not of Black Monday proportions – but this anniversary does provide the opportunity for reflection, comparison and evaluation. Doing so provides the perspective that, at a broad level, this time isn't different. Market cycles will continue, and this bull market will also eventually run out of steam. But today's conditions do bear significant differences to prior peaks, suggesting that – despite its steady ascent to record levels – the bull market is not facing an imminent demise. Consider the following perspectives on prior market peaks in '87, '00 and '07:

Bull Market Statistics
1987:  5.0 years in length, with a total return of 266%. While Black Monday (Oct. 19) brought about the end of the bull market, stocks had peaked two months prior, having fallen 14% before the one-day crash.  The end of the bull market is attributed more to a function of market mechanics (program/electronic trading, illiquidity, market panic) than deteriorating fundamentals.
2000: 9.5 years in length, with a total return of 536%, before the peak in March 2000. The bull market ended with the bursting of the tech bubble.
2007: 5.1 years in length, with a total return of 111%, peaking in October of 2007. The collapse of the U.S. housing bubble and the ensuing financial crisis brought about the end of the bull market.  
2017: 8.6 years in length and counting, with a total return-to-date of 350%. While the current rally's gains have been strong, the rise of the market over the past three years (+35%) trails the surge seen ahead of prior peaks ('87: +101%, '00: +93%, '07: +39%)

Valuation
1987: The price-to-earnings ratio (P/E -based on trailing 12-month earnings) was 20.9 near the market's peak, with the P/E measure rising 111% during the previous three years. Stock valuations were helped by falling interest rates.
2000: Stocks had a P/E of 27.3 near the peak, well above average.  Valuations had risen by 34% over the prior three years, driven by excessively high valuations in the technology sector.
2007: Valuations were more moderate (17.2) at the '07 peak, with overvaluations residing more in the housing market than the stock market.
2017: Stocks are by no means cheap today, as the S&P 500 currently trades at 21.5 times trailing earnings and roughly 18 times the next year's expected earnings, moderately above the longer-term average and reflective of solid earnings growth forecasts. This isn't bubble territory, and, in and of itself, we don't think current valuation signals an impending bear market. We do, however, believe that current valuations remove some of the margin for error for stocks, which we think will lead to higher volatility and more average-looking equity returns. 

Economic growth
1987: GDP growth averaged a solid 3.6% in the two years prior to the peak amid rising household spending, dramatically lower inflation from the '70s-era levels.  The end of this bull market did not coincide with an economic decline (per the previous reference to more market-related forces) because GDP growth averaged 4.2% for the following two years. Thus, the market downturn was relatively short-lived, with stocks recovering all of the 34% drop within the next year and a half. 
2000: GDP had risen at a strong 4.8% clip in the preceding two years as the economy was boosted by the rise of the Internet, increasing household wealth/commerce, and gains in U.S. labor force productivity.  The economy endured a mild contraction in 2001 amid a drop in business investment, but the end of the bull market was prompted more so by the popping of the dot.com bubble than economic decline. 
2007: GDP growth averaged 2.3% over the preceding two years, slowing a bit from the above-average pace of expansion in '03-'05 driven by the surging housing market. The bull market came to an end at the hands of a bursting housing bubble that led to a financial crisis and the worst economic downturn since the Great Depression.
2017: GDP growth has been notably weaker than prior periods when the market peaked, averaging just 1.7% over the past two years.  The silver lining of this current modest expansion is that it has not created imbalances or bubbles that necessarily threaten its persistence. We think a pickup in U.S. GDP growth is likely, with the combination of improving economic growth and rising corporate earnings providing a foundation for the bull market to continue, though we'd note that the magnitude of gains and the low levels of volatility are unlikely to repeat as we advance. 

Interest Rates/Monetary Policy
1987: Monetary policy was being tightened, with the fed funds rate rising by nearly 1.5% in the year preceding the peak, reaching 7.25% in late-'87. The Fed lowered rates briefly following the market crash, but the broader policy tightening cycle continued into 1989, reflecting sustained economic expansion.  10-year rates were at 9.6%, having risen from near 7% a year earlier.
2000: Modest monetary policy tightening had begun in 1999, with the fed funds rate rising 1.8% leading up to the peak. Ten-year rates had also risen by roughly the same level, reaching 6.4% near the market peak, but it was the popping of the tech bubble, not overly restrictive monetary policy, that led to the decline.
2007: Monetary policy was neutral in the preceding year, with the fed funds rate remaining flat at 5.3%. However, this followed an extended period of tightening, as the Fed hiked rates more than 4% from 2004 to 2006. Ten-year rates were near 4.6% when the equity market peaked. 
2017: Monetary stimulus is in the very early stages of withdrawal. The fed funds rate is up less than 1% over the past year, coming off a historically low base near zero.  We expect the Fed to continue its approach of slowly hiking rates and reducing its balance sheet, but we think we are still a ways from conditions where interest rates begin to restrict economic growth, with 10-year rates still below 2.5%.

This article was written by Edward Jones for use by your local Edward Jones Financial Advisor, which in Prescott is Jeremy Raverty. The local Edward Jones office in Prescott is located at 1400 N. Acres, Suite 55.

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