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How Will This Bull Market End?

How will it end? Will it end in another Great Recession? Will it end with a bout of high inflation? Or will it just continue on and never end?

The Great Depression of the 1930s, like the First Great Depression of the 1830s and the long-lasting Depression of the 1870s to early 1900s, was credit-related. During those economically stressful times, bank runs became panics. When a bank was in trouble, individual depositors, fearing the loss of their money, would rush to the banks to demand their money back. When the panic affected only one bank, that institution could sometimes borrow cash from other banks or sell their loans to raise cash, however, when it affected multiple banks, it became a bank panic. That was the First Great Depression of the late 1830s and 1840s. That was also the Depression of 1874 that lasted on and off for almost 40 years. It was the bank panic of 1929 that brought the crash of the stock market.

In the 1930s, the US government created the FDIC. For 70 years there was no bank panic, (The new term for bank panic is “systemic event”). But it was the shadow banking system which grew up around pension funds, endowments, hedge funds, and other institutions, each of which had hundreds of millions of dollars in deposits. Collateralized Debt Obligations (CDO), credit default swaps, and Repos covered those deposits. Or, they did until the subprime housing market began to collapse and brought down those CDOs, credit default swaps, and repos.

In my opinion, I do not believe the market will be brought down by another credit bubble burst. Banks worldwide have shored up their capital and become healthier. But if not a Great Recession, then what will bring down the market? I believe inflation is a greater risk to both the market and investor portfolios.

Inflation, as a rule of thumb, is a function of commodity prices and labor wages. Commodity prices account for about 1/3 and wages 2/3. “In the 1970s it was normal for politicians to manipulate interest rates to boost their own popularity. That led to a plague of inflation. And so rich countries, and many poorer ones, shifted to a system in which politicians set a broad goal – steady prices – and left independent central bankers to realize it.”[1] Coming out of a bout of high inflation in the 1970s, central banks around the world viewed one of their purposes as controlling inflation. Most central banks set 2% as their inflation target.

Bloomberg Businessweek had a front-page story “Did Capitalism Kill Inflation?” in which the author Peter Coy claimed that inflation was dead and extinct.[2] It is possible inflation is dead, but it seems likely that politicians are again trying to manipulate interest rates. President Trump has demanded that the Federal Reserve should lower rates, and he is not alone. Brexiteers in the UK are trashing the competence and motives of the Bank of England. President Recep Erdogan in Turkey has pressure their central bank. President Modi of India has successfully pushed a reduction of rates.

The 1970s were 50 years ago and the memory of them has faded. Most people who do remember the inflation of that period think of the OPEC oil embargo and the double-digit inflation rates of the 1970s. But as you can see from the chart below, inflation was already increasing in the early 1960s.

In my opinion, there is a great risk of inflation ending this secular bull market than another Great Recession type drop

The DOW hit 999 in 1966 and would fall 20% before recovering to 1,000. The DOW would then fall 30% and recover only to drop 40%. The DOW recovered only to drop 20% again and finally in August 1982 hit 1,000 again and begin a charge to over 10,000.

Inflation is different from a Great Recession or Great Depression. Most stock prices recovered and went on to new highs after 2009, but the purchasing power that was lost in the 1960s and 1970s was never recovered. A portfolio that held its same value from 1966 to 1982 was, in real terms of what it could buy, be reduced by 40%. 

If we have a serious bout of high inflation, the remedy for me is to build a Margin of Safety early in the process. That means now. During the Great Recession we heard of a number of people whose financial plans fell short of providing the retirement or fund children’s education. For those who could wait, there was a recovery. But in inflationary times and beyond there is no recovery.

Building a Margin of Safety of 50% or more into portfolios is the wisest strategy for me and for my clients.

[1] “Central Banks Interference Day,” Economist Magazine, April 13, 2019.

[2] “Did Capitalism Kill Inflation,” Bloomberg Businessweek, April 17, 2019

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