An interesting bit of research from UBS on what has driven equity markets over the last 40 years

2 mins. to read

All or Nothing. Stocks tend to experience very long periods (5-20 years) of either anemic or exceptional returns, which we call Investment Regimes. For instance, the market returned 1.5% a year from 1962-82, before returning over 16% on an annualized basis from 1983-00. Since the end of the TMT bubble, stock returns have been close to flat once again.

It’s About Multiples, Not Earnings. Somewhat surprisingly, returns during these periods are not driven by divergences in economic or earnings growth. In fact, real GDP averaged 3.5% from 1962-82, marginally lower than 3.7% experienced during the boom years from 1983-00. Rather, Investment Regimes are defined by secular multiple expansion or contraction.

Key to Success: Know Your Regime. If secular returns are driven by changes in valuation, then it is critical to understand this dynamic. According to our work, investors tend to focus on one key variable during each Investment Regime. However, it’s important to note that the driver in one period tends to not work — and can even be a contra indicator — in others.

Below we briefly describe how Investment Regimes behaved since the mid-1960s:

The Disco Regime (1965-80). During the 70s, inflation was the key driver of stock multiples, given that prices were not only rising sharply, but also in a volatile manner.

In the 1970s, inflation was the primary driver of stock valuations…

Falling inflation since the late ’70s has made CPI less important to valuations…

The Great Moderation (1981-99). After Chairman Volker broke inflation, the economy entered an 18-year period of solid, less volatile growth, accompanied by falling interest rates. In this environment, investors could focus on a nominal cost of capital (the Fed model) to value stocks.

During the “Great Moderation”, the “Fed Model” explained returns…

Since 2000, the Fed Model has broken down…

The Hangover Regime (2004-09). In the aftermath of the TMT bubble, risk became a much more important driver of multiples, with investors using a full cost of capital to value stocks. During this period, stock multiples were closely tethered to investment grade (Baa) yields.

From 2004-09, P/E’s anchored on investment grade (Baa) bond yields… This relationship has come unglued since ’09…

Hangover Part II (2010-12). Over the past two years, the key metric for valuing stocks has shifted from investment grade to non-investment grade yields. Given the fiscal situation in both the U.S. and Europe, we believe that this regime will likely persist until structural imbalances are meaningfully addressed by policymakers.

Since 2010, valuations have moved with non-investment grade (B) yields

So, the new regime – is equity performance is pegged to extreme high yield credit. Thanks to Bernanke’s repression and yield-seeking unintended consequences… with leverage rising, who knows what the fundamentals will signal when technicals dry up for a split-second…

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