Murder Mystery: Who Kills the Equity Bull run?
Investors are wondering what can kill off this equity bull run. It might not be the usual suspects.
Equity bull runs do not die of old age; they are murdered in their sleep. But who has historically committed such a heinous crime, and who might kill off the current equity bull run? Whenever equity markets are murdered, the two usual suspects hauled in for questioning are the economy and the Fed.
It’s somewhat understandable that these two suspects get arrested. If the economy enters recession, the decline in earnings should be significant enough to trigger a meaningful correction in equity markets, killing off the bull run. Meanwhile, central banks can instigate a significant round of monetary policy tightening, restricting financial conditions and again causing a decline in the stock market.
As the below chart shows, from the 1950s to the early '80s, the Fed was usually guilty of murdering the equity bull runs, often when they were in their infancy. From 1949 to 1980, the Fed was primarily responsible for killing off four of the six bull runs. Usually, these killings were justified in the name of tempering inflation that was ravaging the economy.
If it wasn’t the Fed, then an economic recession was usually found responsible. The U.S. economy was still reeling from the Great Depression when it fell back into a recession in 1937. In a similar manner, the equity bull run in 1961 coincided with the onset of a US recession.
The Fed and the economy are not always guilty; occasionally, equity bull runs are killed off by bad luck. In 1973, the onset of an oil crisis halted the equity market rally that began three years earlier. Meanwhile, the post-WW2 economic transition in 1946 took down the bull run.
Financial markets in the 'post-capitalist' system
However, since the late '80s, the potential suspect list has changed. More recent bull runs have not been brought down by the Fed or economic recessions. Instead, equity bull runs have brought themselves down, often ending in a flurry of speculative mania (e.g., Black Monday in 1987, the dot.com bubble in 2000, or the housing bubble of 2008). Why have equity bull runs suddenly started expressing suicidal tendencies?
During the '80s, the financial markets started to become increasingly disconnected from the real economy. The below chart shows that the cumulative size of both public and private equity markets exceeded 100% of GDP in the early '90s as financial markets became larger relative to the underlying economy. Since then, the disconnect has only grown. U.S. equities amount to nearly 280% of GDP as of October 2023.
In what I would describe as a 'post-capitalist' financial system, as equity markets have become larger relative to the economy, they have become increasingly insensitive to changes in the macro backdrop. This has effectively decoupled financial markets from the industrial economy. The sheer levels of financial engineering, balance sheet management, and sizable multiples mean that equities no longer draw their strength from the economy; rather, it is investor speculation more than industrial output that influences changes in overall share prices in today's markets.
With equity markets now divorced from economic conditions, equity bull runs can no longer be easily killed off by classic protagonists like recessions or the Fed, as these characters are simply not big enough to bring down an equity bull run. Tightening interest rates or a mild economic downturn are unlikely to bring the financial behemoth to its knees, potentially explaining why
Instead, the only probable way that equity bull runs can end is if they are driven to suicide in a fit of speculative hysteria. If asset bubbles pop and the financial juggernaut falters, only then do equity bull runs come to an end. The notable exception to this theory is the onset of a speculative shock such as the pandemic, which forced the global economy into lockdown. Outside of these (hopefully) rare exogenous shocks, equity bull runs in a post-capitalist system will only come to an end if asset bubbles pop.
What will kill the current bull run?
If you are still not convinced by this thesis, consider the current equity expansion. It has already withstood a vicious assault from the Fed after they hiked interest rates by 525 bps. While there was a brief interlude where the S&P 500 corrected by 25%, it swiftly adjusted to the higher interest rate environment and resumed its bull run.
In short, in a post-capitalist system, it is unlikely that Fed rate hikes or a mild recession are enough to kill off equity runs. Even extreme 'acts of God' or exogenous events, such as the onset of the pandemic or the breakout of a major global conflict, might struggle to take down modern-day equity bull runs. So instead of watching industrial data or the pathway for interest rates, investors should keep an eye open for potential destabilizing asset bubbles that might force the equity bull run to jump off a cliff!
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