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Two reasons this Bull Market is set to continue

Roger Montgomery – Founder and Chief Investment Officer of Montgomery Investment Management

Since early 2009, soaring global markets have made shares an extremely rewarding place to invest. With profits likely to keep recovering, and interest rates and inflation likely to stay low, I see no reason why this bull market will not continue.

Since the beginning of 2013 the real S&P500, which is adjusted for inflation, has risen by almost 200 per cent and, apart from two bouts of volatility in 2015/2016 and at the end of 2018, it’s been smooth north easterly sailing especially since 2016.

If you recall, global stocks began a march higher in February 2016. At the time the global economy looked bleak but major economic ‘blocs’ were about to accelerate (relatively speaking of course) thanks to a dovish Federal Reserve and a massive Chinese domestic economic reflation attempt.

That we have been in a bull market for the last six years cannot be contested, and that’s a difficult thing for a value investor to want (or need) to admit. What’s challenging is not that we want lower prices to be able to buy more safely, what is challenging is holding on to what we have even when prices start to exceed the valuation estimates based on our most optimistic assumptions.

When we take a balanced look at global markets, we see conditions similar to those that existed in 2016. A manufacturing slowdown, as measured by the world industrial production excluding the US – is underway. And the US indicator for new manufacturing orders, published by the Federal Bank of Dallas, has fallen 30 per cent from its 2018 highs.

But despite these simple measures, the market is focused ahead. With the US Federal Reserve easing and China again reflating, investors are looking past the gloom and are factoring in an improvement in conditions. At some point in the future, the market might even become fearful of inflation emerging but right now it’s a trade truce between China and the US and a calming of Brexit uncertainties that has captured investors imagination.

Interest rates will be lower for longer

On top of all of that, we have a Federal Reserve confronting a suite of structural factors that should keep rates low. Low rates don’t render asset prices immune to sell-offs but they are of course supportive for all asset including equities.

The structural factors that suggest rates could remain low for a very long time and therefore support already stretched asset prices, include demographics and debt among others.

Over the next eight decades to 2100, Earth is forecast to see its population growth slow almost to a halt. More importantly perhaps, the proportion of the global population over the age of 65 will rise from 10 per cent today, to over 20 per cent by 2100. A doubling of the proportion of people over 65 will have a significant influence on global growth as well as on government budgets.

We have seen in Japan when more people retire, productive capacity and economic output decline. Coincidentally, government healthcare and pension liabilities rise.

Individually, and in combination, lower economic output and greater debt have a depressing effect on interest rates.

If an ageing population and increasing debt are a negative influence on interest rates, then the world may be in for an extended period of low rates. And the US Federal Reserve is in no rush to turn hawkish or tighten policy. Despite a continuing decline in unemployment, real wage gains remain muted.

Over in China, the economy is collecting itself off the mat after its trade war with a Trump-led USA. Understandably, Chinese shares were hit hard and are arguably ‘under-owned’. They now trade at about 11 times current earnings. If Chinese stocks are included, emerging market equities are likewise trading at just 12 times current earnings. The question is whether these earnings are bottom-of-the-cycle. If they are, and earnings rebound, Chinese shares could be a bargain. We note reports that Chinese credit creation has accelerated, and manufacturing is also recovering. If correct, industrial profits could be at the low point of this cycle.

Earnings could keep recovering

If global growth continues, the equity risk premium (ERP) should also decline. A decline in ERP while the risk-free rate remains subdued, will raise equity valuations even if earnings don’t recover. But earnings may indeed recover as well. Under these conditions, stock market performances could exceed those of the year just completed.

It could be argued that, much as we can now see was the case in 2016, global markets could be in a bit of a purple patch – a sweet spot, if you like – where aggregate profit growth is only beginning to recover, while inflation remains low and central banks remain accommodative with no warnings about a change of tack.

If there is no change expected in this stance, and the current combination of factors remains unchanged, then with the exception of a black swan event – that by definition is unpredictable – there is no reason to expect anything but a continuation of the bull market and, with that, higher prices and expanding PE ratios in 2020.

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