Investors are celebrating the longest bull market in US history – one that has lasted more than nine years. In fact, though, we’ve seen two bull markets: we can call them the macro-driven and micro-driven ones.
The macro-driven bull market has come in three phases. Phase one was a relief rally. In early 2009 investors feared a long and deep recession. As the economy recovered – in part thanks to quantitative easing – these fears receded and so share prices bounced back. The recoveries in shares and the economy were mutually reinforcing: one contributed to the other.
Phase two, from around 2011 to around 2016, was a normal cyclical upswing. As the economy grew, so too did corporate earnings and appetite for risk.
Phase three is more recent. Shares have been driven up by signs that low unemployment has not (yet) raised wage and price inflation much. This has fuelled hopes that the expansion can continue because interest rates won’t rise as much as expected: in early 2016 the US Federal Reserve expected the Fed funds rate to be around 3 per cent at the end of 2018, but it looks like being half a point lower than that.
The micro-driven bull market rests on a fact documented by Jan De Loecker and Jan Eeckhout – that US companies have enjoyed increased monopoly power and hence rising profit margins. Because of this the share of national income going to profits has risen at the expense of wages. This, they show, is true not just of tech giants such as Alphabet and Amazon but of companies in most industries too.
This matters hugely for share prices because as Daniel Greenwald, Martin Lettau and Sydney Ludvigson have shown, shifts in the distribution of national income are the main drivers of long-term bull and bear markets. A falling profit share in the 1970s drove shares down, and a rising share in the 1980s and more recently drove them up.
It is from these perspectives that we should judge market valuations. The strongest sign that the market might be overvalued is the cyclically adjusted price/earnings ratio (CAPE) developed by Yale University’s Robert Shiller, which is simply the ratio of prices to the last 10 years of earnings. This is now at levels previously seen only in 1929 and 2000, just before the market slumped.
But this has been true for many months. If a high CAPE ratio was a reason to sell, we’d have done so months ago and missed out on big profits.
So far, high valuations have been sustained by two things. One is the hope that monopoly profits can be sustained: if companies have what Warren Buffett called “economic moats”, which can fend off competitors, then they should earn higher profits in future, which should mean higher valuations now. The second is low interest rates. These mean that future profits are discounted only very slightly, which naturally means high prices today.
Which brings us to the question of how this bull market might end. One possibility is what I’ve called wising-up risk. Having learned that companies with monopoly power have in the past been underpriced, investors might now have overcorrected their error and so driven up prices too much.
A second possibility is that tight labour markets (the unemployment rate is now at its lowest since 1969) will raise inflation and hence interest rates. That would hit shares both by increasing the discount rate on future earnings and by partially reversing the rise in the profit share. The fact that the S&P fell sharply in February when the market feared a rise in wage inflation but recovered so much when these fears seemed wrong shows that shares are very sensitive to the threat of inflation.
A third, though perhaps more distant, danger is that monopoly power might not be sustained in the long run. It might be undermined by technical change – Kodak, Polaroid and AOL all had some monopoly power once – or by a political backlash against crony capitalism and monopoly of the sort we saw during the Progressive Era.
In these last two senses, the fate of this bull market depends on the outcome of class struggle.
