Why 30 Years of History Shows the US Stock Market is Going Down

I hate preachers of doom and destruction. I think most of them just want some attention, and instilling fear into people’s minds works better in doing so than painting a rosy future. But something quite concerning recently caught my attention, and – even though you might have already noticed it – I want to point it out.

Governments worldwide decreased interest rates in response to the 2007-2008 financial crisis. The idea was that by decreasing the interest rate, it becomes cheaper for banks (hence people) to borrow, hence increasing the amount of money available to spend, thereby increasing the spending power of the economy.

As a matter of fact, the USA has had such a ‘stimulating’ economic policy for over 30 years to date. If you look at the United States Fed Funds rate, the main determinant of interest rates in the USA, you can clearly detect a down-trend since 1980:

This policy has shown to be effective, at least in recent years. The unemployment rate in the USA has decreased from 10% in 2010 to around 5% in 2016.   This might be a case of post hoc ergo procter hoc, but it seems hard to believe that the US stimulating policy has had zero positive impact on the economy. Furthermore, if you take the S&P 500 index to be the benchmark of the US stock market, you see that it has tripled since the bottom of the financial crisis in 2009; from 700 to 2100. In fact: the S&P 500 index has been in a clear up-trend over the course of the last 30 years:

You see the relationship? What we see here is a clear negative correlation between the Fed Funds rate and the S&P 500 index. The first question you should of course ask yourself when talking about correlations is: are the increasing stock prices a result of the decreasing interest rate, or is the deceasing interest rate a result of the increasing stock prices? The last relation seems to make no sense, for if anything, a higher stock market might be a symptom of a market overheating, hence encouraging restrictive instead of stimulating economic policy. So the relation seems to hold the other way: a lower Fed Funds rate causes the market to increase, which from a perspective of common sense, seems to make sense: lower interest rates means more money to spend, means more money to spend on stocks, means higher stock prices.

But the question that nowadays is very relevant is: what will happen to the stock market when the US government decreases its stimulatory policy? That is: what if the down-trend in the Fed funds rate stops? Currently the Fed has an overnight interest rate between 0.25%-0.50%, which is already higher than the 0.00% it has had for over 6 years. Now it is considering to increase it.  It seems fair to say that we can not go lower than 0.00% (although this has been done in Europe, but following up on this policy will lead to all sorts problem for the banking sector, not to mention a slippery slope). Hence the Fed funds rate can only go up. Given the negative correlation with the S&P 500 index, which is based on 30 years of economic data, there seems only one way for the US market to go, and it is not up.

Why It Is Possible to Make Above Average Returns – Even in Efficient Markets

There is a well-known hypothesis in financial economics, called the Efficient Market Hypothesis (EMH), that spawns a lot of debate. The EMH states that financial markets are ‘informationally efficient’. In other words: a financial asset’s market price always incorporates and reflects all available relevant information. Hence no investor can consistently use such information to find stocks that earn him above average returns. After all: such information is already reflected in the asset’s price; so if there is a lot of ‘positive’ information about the company, the stock’s market price will have increased, and if there’s a lot of ‘negative’ information, the price will have decreased.

I want to make an argument why, even if the EMH holds, it might still be possible to consistently earn above average returns on investments. The argument is basically very simple. Let’s first recall the EMH. We know that an efficient market is a market in which the price of a financial asset (let’s say a stock) always incorporates and reflects all available information. Hence, you cannot benefit from the set of available information in such a way that you can consistently earn above average returns on investing in the asset – or any asset for that matter. But does it follow from this that you cannot consistently achieve above average returns? I don’t think so.

Because what if you are consistently better than other investors in anticipating future information? Then, even though the stock’s market price reflects all available information, you can utilize this anticipated future information to decide whether to buy or sell a stock. And if you can anticipate future information (which is information not yet incorporated and reflected in the stock’s price) better than the average investor, then you can earn above average returns, time after time.

This all sounds pretty abstract. So let’s look an example. Suppose there is a stock of a company that produces wind turbines – call it ‘stock A’. Furthermore, let’s suppose that at this point in time investors are on average not confident about wind energy’s potential. They might think that the cost of producing wind energy is too high, its profits depend solely on the current regulation, or that it will still take a long time before our fossil fuels are depleted, making the switch to wind energy not urgent yet. Given these considerations the stock trades at a price of – let’s say – 10. Let’s assume that this price indeed incorporates and reflects all available information – such as information contained in annual reports, expert analyses etc. Hence it seems reasonable to say that you cannot consistently earn above average returns on this stock by utilizing only this pool of existing information.

But what if you believe that, given the ever increasing energy consumption and ever decreasing level of fossil fuels, society has in the middle-long term no choice but to turn to alternative forms of energy – forms such as wind energy? If you think this is true, then you can anticipate that any future information about the wind-turbine producer will be positive – at least more positive than today’s information is. You can anticipate that the future information will show an increase in the firm’s revenues, or – for example, in case the firm is close to bankruptcy but you know that its managers don’t profit from a bankruptcy – a decrease in costs. Given that the market is efficient, you know that at the time this information will become public, the market price of the stock will increase to reflect this information, to a price of let’s say 20. If you can anticipate such future information consistently, then you can anticipate the future stock price consistently, allowing you to consistently earn above average returns – despite the perfectly efficient market.

An equivalent way to look at this matter is to say that you take into account more information than the average investor in calculating the stock’s fair value. Let’s say that you are doing a net present value calculation, and you have estimated the firm’s future cash flows. In case of stock A, investors used estimated cash flows that lead them to a fair value of 10. However, given your anticipation of future information, you estimate these cash flows to be higher – leading you to a higher valuation of the stock. Again: if you can consistently anticipate future information better than the average investor, you can consistently earn above average returns – even in an efficient market.