Doctor Doom

In preparation for these blogs, amongst other things we trawl through the news stories of the day to see what may be worth reflecting on.  CNBC ran an interview with Mark Faber on their website from earlier in the day. Mr. Faber is apparently otherwise known as “Doctor Doom” for his continually bearish stance. Mr Faber was once again expressing his believe that equity prices are in for a big correction. This is not a new; he has held this view for several years and several 100 points on the S&P 500.

 

Every generation has its Doctor Doom; one of the most well known ones in the 1980’s was Bob Beckman, his claim to fame was his doom laden predictions on house prices and stock markets. One never quite gets the mentality of being permanently bearish; particularly as house prices and equities go up over time as it means you are wrong for long periods.  The only relief comes when the market does crash and you can tell everyone “I told you”.  Having said that the world would be a dull place if everyone agreed.

 

Mark Faber believes we are at some stage going to face a 1987 style stock market correction, and he will be right one day. We thought therefore it might be worth looking back at the behavior of bonds as well as equities in 1987 to see if there are similarities to today.

 

In 1987 the US equity market would have yielded something close to today, circa 2%.  At the start of 1987 inflation was running at 1.5%, also very similar to today, but unlike today inflation rose to 4.5% by the end of the year. In 1987 the US stock market rose 40% between January and October before falling. At the start of 1987, like today, one would have received a real return on equities of circa 0.5% (dividend yield minus inflation). By the end of that year, that return would have reversed to a point where the real return from equities would have been circa minus 3%. 10 year US treasury yields started the year at 7% and as equities rose, along with inflation so did bond yields. By the end of the year US treasuries were yielding 10%, by coincidence also a 40% rise.

 

At the point the stock market crashed bonds were offering a real return of 5% and equities minus 3%, selling equities to buy bonds was a “no brainer”.  To justify not doing so one would have had to be extraordinarily bullish on the outlook for the economy and company profits.

 

Unlike towards the end of 1987, today US equity and bond real returns remain pretty close to one another, circa 50bp.  What 1987 does remind us is that a rapid tightening of monetary policy leads to volatility in risk assets, that is why the Fed spends some much time deliberating how best to exit this period of ultra low rates.

 

Posted on November 20, 2014 .