March marks the 10th anniversary of the birth of the great bull market in global equities, one of the most remarkable financial events in the last century. Since March 2009, US equity prices have risen by 12.5 per cent per annum, and most global stock markets have joined the party. What caused this phenomenal rise in risk assets and what does this tell us about the future?
Many commentators are extremely suspicious about the foundations that underpin the bull market. They argue that the rise in asset prices has been driven by “artificial” monetary stimulus by the central banks, especially quantitative easing. The implication is that when monetary policy returns to normal, asset prices will implode. According to them, not even the Federal Reserve can inflate an asset price “bubble” forever.
This degree of scepticism about the bull market is not fully warranted by the facts. Equity prices have not risen above their long-term rising trend lines, even at the recent extremes (see graph). At the start in March 2009, US equity prices were 60 per cent below their long-term trend line. A decade later, equities have risen sharply, but are still 9 per cent below trend. In this basic and rather “naive” model, there is no prima facie case for arguing that the stock market is in a “bubble”.
We can analyse the behaviour of asset prices more carefully by using a dynamic version of a standard relationship, known as Gordon’s growth (or dividend discount) model, which asserts that the change in equity prices over any given period can be attributed to changes in:
- Company dividends (or, sometimes, earnings);
- Expected future dividend growth;
- The real risk free interest rate on government debt (one of the main factors driving bond yields); and
- The equity risk premium.
If monetary policy has artificially inflated asset prices since 2019, it should have done so via one or more of these variables.
Model estimates by my Fulcrum colleague Gino Cenedese decompose the rise in US equities since 2009 Q1 into the main contributing factors (see table below).
The main contributor has been the rise in dividend payments, probably the most solid of all fundamentals. Higher dividends account for 8.3 percentage points of the 12.5 per cent annualised increase in equity prices since the trough of the bear market.
The next largest contributor is the decline in the equity risk premium (ERP), which has contributed 3.1 percentage points to the bull market. The ERP is the expected excess return on equities relative to risk free interest rates, and is the compensation that investors require to hold riskier assets.
The drop in the ERP occurred in two phases: immediately after the bottom of the global recession in 2009, and during the great culmination phase for equities in 2016-17. Risk perceptions were extremely pessimistic in the panic of March 2009 and are now slightly more optimistic than historical averages.
The other variables in the decomposition contributed rather little to the bull market. Risk-free real interest rates and expected dividend growth are both at similar levels to those observed 10 years ago, so they have not been a large part of the story.
What does this tell us about the supposedly “artificial” contribution of excessively easy monetary policy to the boom in risk assets? If this had been decisive, declining real rates should have been a major contributor to the rally, but that seems not to have been the case.
For example, estimates of the impact of the entire QE programme on the US bond yield, by the Federal Reserve and others, suggest that it reduced yields by perhaps 100 basis points, compared to what otherwise would have occurred. Even if that is accurate, little of the effect is likely to be reversed, because the Fed has already announced the end of quantitative tightening, implying that its balance sheet holdings of bonds will never return to the much lower levels considered normal prior to the crash.
Perhaps it can be argued that the two major contributors to the equity rally — higher dividends and a restoration of risk appetite — were in part due to easier monetary policy. That is plausible, but it does not indicate that monetary policy was too easy, or even that QE was artificially stimulative.
In fact, the behaviour of the US and global economy suggests that monetary policy from 2009-19 was, for the most part, too tight, not too easy. Since 2009, real and nominal GDP have fallen sharply below previous trend lines, and inflation has been persistently below central bank targets. These conditions are symptomatic of a shortage of demand, especially in the eurozone and Japan, despite stimulative monetary policy.
Looking to the future, it is of course possible that a cyclical rise in interest rates will trigger a “normal” bear market in equities in the short or medium term. But it is reassuring that, following the bull market, equity prices are still underpinned by fundamentals more solid than a mountain of paper money. Instead, the equity market is close to its very long-term trend. More important, equity valuation (measured by the ERP in the Fulcrum model) remains within normal bands, albeit towards the expensive end of the range for equities.
The model predicts that total US equity returns will be about 4-5 per cent per annum in nominal terms in the next three years — much lower than recently, but still positive. The great bull run may be over, but that does not mean that a great bear market will inevitably follow.
US equities and great bull market
The US equity market, measured in index price levels, not total returns, was 60 per cent below its long-term trend line in 2009 Q1. It has recovered to 9 per cent below trend:
The Fulcrum asset price model enables us to decompose the annual change in the S&P price index into its main contributing factors: