A New Era in US Financial Markets

A New Era in US Financial Markets

Dr. Bryan Taylor, Chief Economist, Global Financial Data

           A lot has changed during the past three years.  The United States and other developed countries have gone through two bear markets because of Covid in 2020 and rising interest rates in 2022.  Bond markets have suffered the worst bear market in US history.  Inflation has risen to levels not seen since the 1980s and the Federal Reserve has rapidly raised interest rates from close to zero to five percent.  All of this will have a dramatic impact on the returns to stocks and bonds in the 2020s. The US may spend the rest of the decade recovering from the bear markets of the past three years.

               Financial markets may be entering into a new era.  The period between 1945 and 1981 saw bond yields rise steadily while the period from 1981 to 2019 saw interest rates steadily fall.  Interest rates bottomed out at 0.32% in March 2020 and have risen since then.  Rising inflation has led to rising interest rates.  Forty years of declining interest rates may give way to another period of rising interest rates and slower growth as businesses face the consequences of more government intervention in the economy.

Data Sources

               We use the GFD-100 Index to calculate returns to stock markets in the United States between 1792 and 2022.  The GFD-100 is the most extensive index for United States stocks available anywhere.  The GFD-100 index is revised in January of each year.  It uses the largest stocks in the United States from 1792 until 1825, the 50 largest stocks from 1825 until 1850 and the 100 largest stocks from 1850 to date.  The index is capitalization-weighted and only includes liquid stocks that trade on a regular basis.  Stocks from all regional exchanges and the over-the-counter market are included.  This gives the index broader coverage than other indices which ignore the financial sector up to 1976. 

We use the GFD Indices for Bonds and Bills to calculate fixed-income returns. The GFD Index for Bonds is based upon the returns to the Federal Government’s 10-year bond.  Before World War I, individual bonds with a maturity of 10-years or more are used to calculate the total return.  Three-month Treasury Bills are used for the Bill index.  Before 1920, there is no data on the yield for Treasury bills, so we use the minimum of the Federal government bond that is closest to maturity or the yield on commercial paper in New York City. 

Real Stock Returns to Stocks, Bonds and Bills

 

Figure 1.  GFD US-100 Price Index, 1792 to 2022

Figure 1 provides information on nominal returns to stocks in the United States between 1792 and 2022.  There was little change in stock prices in the 1800s.  During the 1800s, most of the return to equities came through dividends, which consistently paid 5% or more until World War II. 

Table 1 looks at returns to US stocks, bonds and bills after adjusting for inflation. Returns are provided by decade, by financial era (Napoleonic Wars (1792-1815), Transportation Revolution (1815-1848), Free Trade (1848-1873), Gold Standard (1873-1914), World Wars (1914-1945), Keynesianism (1945-1981), Globalization (1981-2019) and the current era (2019-present)) and time periods from the past to 2022

The table also provides a measure of the Equity Risk Premium (ERP) and the inflation rate. The return to bonds differed significantly between the 1800s and the 1900s.  In the 1800s, bonds provided a positive return every decade, but in the 1900s, bonds provided a negative return after inflation in six of the ten decades.  The reason for this difference is the combination of inflation and Fed intervention.  The Fed has not been the best friend of fixed-income investors as they have discovered during the past two years.

Years	Stock Price	Stock Return	Bond Return	Bill Return	ERP	Inflation
By Decade
1791-1799	-6.15	-0.65	-1.57	2.03	0.94	3.04
1799-1809	1.5	8.93	9.69	5.75	-0.63	0
1809-1819	-5.15	1.17	6.32	5.26	-4.37	0.34
1819-1829	2.78	8.79	8.75	6.53	0.04	-1.94
1829-1839	-3.3	3.17	1.25	2.45	1.71	2.04
1839-1849	1.45	9.35	10.9	8.86	-1.25	-2.7
1849-1859	-2.68	5.21	4.22	3.86	0.85	1.55
1859-1869	-0.11	8.21	1.65	0.91	5.8	4.19
1869-1879	4.87	12.76	7.6	7.24	4.3	-2.24
1879-1889	0.99	6.62	6.05	3.38	0.48	0
1889-1899	4.23	10.24	4.25	2.44	5.17	0.13
1899-1909	3.7	9.02	-0.79	0.71	8.86	2.39
1909-1919	-5.03	0.51	-6.12	-4.76	6.34	7.34
1919-1929	9.65	15.56	7.22	5.42	6.98	-0.94
1929-1939	-1.58	3.96	6.82	2.97	-2.41	-2.04
1939-1949	-2	3.68	-2.8	-5.13	5.99	5.36
1949-1959	12.06	17.98	-1.99	-0.22	18.16	2.22
1959-1969	1.71	5.3	-0.17	1.67	4.91	2.52
1969-1979	-4.83	-0.61	-1.32	-0.91	0.65	7.36
1979-1989	8.47	12.72	8.15	4.27	3.79	5.1
1989-1999	17.57	18.44	5.47	2.19	11.01	2.93
1999-2009	-7.3	-5.26	4.21	0.23	-8.21	2.52
2009-2019	10	12.77	2.57	-1.29	8.91	1.75
By Era
1791-1899	-0.19	6.07	5.07	4.03	0.95	0.36
1899-1999	3.34	7.57	1.3	0.51	6.18	3.18
1999-2022	0.88	2.95	1.43	-0.69	2.05	1.49
1792-1815	-2.99	3.23	3.36	3.28	6.42	-0.12
1815-1848	0.26	6.21	7.45	6.03	5.95	-1.15
1848-1873	-0.73	6.41	2.15	2.72	7.19	4.18
1873-1914	2.39	7.76	3.81	2.52	5.24	3.80
1914-1945	1.5	7.14	1.81	-0.05	5.57	5.24
1945-1981	1.36	5.54	-1.85	-0.37	4.13	7.53
1981-2019	6.66	8.73	5.25	1.13	1.94	3.30
2019-2022	0.86	2.51	-8.66	-2.13	12.23	4.92
To Present
1791-2022	1.43	6.4	2.92	2.02	4.9	3.39
1899-2022	2.88	6.69	1.24	0.28	3.71	5.39
1919-2022	3.58	7.18	2.12	0.7	3.48	4.96
1949-2022	4.37	7.34	1.65	0.63	2.84	5.59
1969-2022	4.61	6.37	2.89	0.78	1.68	3.37

 

Table 1.  United States Real Returns to Stocks, Bonds and Bills, ERP and Inflation by Decade and Eras

Bondholders received negative real returns for four decades in a row, in the 1940s, 1950s, 1960s, and 1970s as rising bond yields reduced bond prices. Because of this, fixed-income investors were little better off after inflation in 1980 than they had been in 1900.  Between 1980 and 2020, however, bondholders received a positive return, though cash saw a net loss after inflation. Fixed income has suffered large losses since 2020 and inflation has beaten cash. There seems little reason to believe that either bonds or bills will beat inflation in the 2020s. On the other hand, declining bond yields in the 1980s to 2010s generated positive returns to bondholders.  Since the yield on bonds has increased during the past two years, fixed-income investors will no longer be able to benefit from falling interest rates to generate continued positive returns.

Bonds outperformed stocks in the 2000s and 2010s, but with the losses to government bonds during the past two years, this is no longer true.  This is because bondholders benefitted from the capital gains produced by falling interest rates. Although the 10-year bond yield can provide an accurate measure of the return to fixed-income investors over the next decade, no similar measure exists for shareholders. The return to equities will depend upon the business cycle. Since the equity risk premium has been around 2%-3% historically, you would expect no more than a 7% return to equities over the next ten years, and possibly less. 

Between 2020 and 2022, stocks returned 2.5% while bonds and bills have both been beaten by inflation. Since equities have provided double-digit returns after inflation in three of the last four decades, it will take time for investors to adjust to the prospect of lower returns.  Although losses in the bond market of the magnitude of the past two years are unlikely to continue, investors will spend the rest of the decade just recovering from these unprecedented losses.

The 30-year Cycle for Stocks

               The stock market has been moving in 30-year cycles since the 1890s.  Now that the 2010s have finished, we can examine the data and see if this pattern has continued.  And it has! Table 1 provides the real returns to stocks, bonds and bills in each decade since the 1890s.   As you can see, the stock market provided double-digit returns every 30 years, in the 1890s, 1920s, 1950s, 1980s and 2010s. Each of those decades was preceded by a decade in which there were inferior returns, in the 1880s, 1910s, 1940s, 1970s and 2000s.  In fact, both the 1970s and 2000s provided investors with negative real returns to stocks over the course of the decade.

With the exception of the 1990s, each of those decades was followed by lower returns to equities, but with a positive equity risk premium.  It appears that this pattern will be repeated in the 2020s.  Given the fact that there have already been two bear markets in the United States since 2020 and one of the worst bond bear markets in history, lower returns to stocks and a positive equity risk premium over the course of the decade are both likely.

               Bond returns have shown a declining pattern over the past four decades and this is likely to continue in the 2020s. Given the level of the losses to fixed-income in 2021 and 2022, the total return to government bonds during the 2020s is likely to be negative.  Real returns to bonds would have to be 4% per annum for fixed-income investors to break even during the 2020s and this seems unlikely.  The 30-year cycle is likely to continue during the 2020s.

The Equity-Risk Premium

               Figure 19.4 shows the 10-year rolling Equity Risk Premium from 1792 until the present. There were significant periods in the 1800s where the ERP was negative and bonds outperformed stocks; however, this occurred less often during the 1900s.  The periods when the ERP was negative reflected more on the poor performance of stocks during those years than the strong performance of bonds. For the most part, the ERP was consistently positive during the 1900s.  The only exceptions were the 1930s and the 1970s when stocks performed poorly. The 1950s provided the highest ERPs in history as the economy recovered from World War II.  

Because of the bear markets of 2000 and 2008 and the strong performance of bonds, the ERP reached its lowest levels in history during the 2000s and 2010s.  The ERP has bounced back and with little chance of fixed-income investors receiving high returns, the ERP should remain positive for the rest of the decade.  The ERP will turn negative only if stocks produce negative returns in the decade to come, which seems unlikely.

 

Figure 2.  United States 10-year Equity Risk Premium

Bull and Bear Equity Markets

The United States has gone through a number of bull and bear markets. Using the GFD-100 Index as the basis for our calculations, there have been 18 bear markets in the United States since 1792.  If you use the S&P Composite, there have been 23 bear markets since 1871.  The Dow Jones Industrials has gone through 22 bear markets since 1885 and the GFD/Dow Jones Transports has gone through 28 bear markets since 1832.  The record of bull and bear markets since 1871, as registered by the S&P Composite is provided below:

Date	Value	Change	Date	Value	Change	Cause
			05/31/1872	5.19	61.68	Panic of 1873
06/30/1877	2.74	-47.21	06/30/1881	6.58	140.15	Long Depression
08/31/1896	3.81	-42.10	6/17/1901	8.53	123.88	Panic of 1893
11/9/1903	5.85	-31.42	10/9/1906	10.23	74.87	Rich Man's Panic
11/15/1907	6.1	-40.37	11/19/1909	10.6	73.77	Panic of 1907
10/31/1914	6.63	-37.45	11/20/1916	10.55	59.13	World War I
12/19/1917	6	-43.13	7/16/1919	9.64	60.67	Fear of Entering War
8/24/1921	6.26	-35.06	9/7/1929	31.86	408.95	Post WWI Recession
7/8/1932	4.41	-86.16	9/7/1932	9.31	111.11	Great Depression
2/27/1933	5.53	-40.60	7/18/1933	12.2	120.61	Bank Holidays
3/14/1935	8.06	-33.93	3/10/1937	18.68	131.76	Post-Election Fall
3/31/1938	8.5	-54.50	11/9/1938	13.79	62.24	1937 Recession
4/28/1942	7.47	-45.83	5/29/1946	19.25	157.70	World War II
6/13/1949	13.55	-29.61	8/2/1956	49.75	267.16	Post WWII Recession
10/22/1957	38.98	-21.65	12/12/1961	72.64	86.35	Kennedy Crisis
6/26/1962	52.32	-27.97	2/9/1966	94.06	79.78	Viet Nam
10/7/1966	73.2	-22.18	1/5/1973	119.87	63.76	OPEC
10/3/1974	62.28	-48.04	8/25/1987	337.89	442.53	Carter
12/4/1987	221.24	-34.52	7/16/1990	369.78	67.14	1987 Crash
10/17/1990	294.51	-20.36	3/24/2000	1527.46	418.64	Iraq
10/9/2002	776.77	-49.15	10/9/2007	1565.15	101.49	Internet Bubble, 9/11
3/9/2009	676.53	-56.78	2/19/2020	3386.15	400.52	Financial Crisis
3/23/2020	2236.7	-33.95	1/3/2022	4796.56	114.45	Coronavirus
10/12/2022	3577.03	-25.43				Ukraine and Inflation

Table 2.  Bull and Bear Stock Markets in the United States, 1792 to 2019

The worst bear market was the 1929-1932 bear in which the market declined by 86%.  There have been four bull markets in which prices rose by over 400% in 1921-1929, 1974-1987, 1990-2000 and 2009-2020.  There is no pattern in the length and size of either bull or bear markets because they are built on expectations and economic performance.

Government Bond Yields

 

Figure 3.  United States 10-year Bond Yield, 1786 to 2022

               Figure 3 shows the yield on the 10-year Government bond from 1786 to 2022. During the 1780s, the United States was in default on its bonds.  Alexander Hamilton reorganized the debt in 1791 and bond yields showed a declining pattern until World War II.  After the war was over with, rising inflation drove bond yields up between 1941 and 1981 when yields reached 15.84%.  Since 1981, yields have steadily declined, hitting a low of 0.318% on March 9, 2020.  In 2022, bond yields rose as the Federal Reserve raised rates to fight inflation. In real terms, however, government bond yields are likely to remain negative for the next few years.

 

Figure 4. United States Stock Dividend Yield Minus Government Bond Yield

               The stock dividend yield and the yield on government bonds are compared in Figure 4 which provides over 200 years of history. With one small exception in the early 1800s, the dividend yield exceeded the government bond yield from the 1790s until the 1950s.  After 1957, rising bond yields pushed the yield on bonds over the yield on stocks until interest rates peaked in 1981.  The spread has declined from 1981 to the present as bond yields fell, but currently the bond yield still exceeds the dividend yield and is likely to continue to do so.

 

Figure 5.  United States CAPE Ratio, 1842 to 2022

               Although the CAPE Ratio has come down from its peak at the end of 2021, it remains elevated.  The CAPE Ratio is currently around 30, which is equal to its level at the peak of the 1929 bull market.  The only other time that the CAPE Ratio was this high was during the Internet Market Bubble of the late 1990s before the market crashed.  Although the market has already declined during 2022 and additional declines may or may not occur, this gives investors notice that the upside to the market is limited.  The high PE was fed by the low interest rates that prevailed after 2008, but interest rates are unlikely to return to the unprecedented lows of the past few years which will limit the value of the CAPE Ratio in the coming years.

Stock Market Capitalization and Government Debt as a Share of GDP.

               Government debt is now over 100% of GDP and has been climbing since the 1970s as can be seen in the black line in Figure 6.  During the 1800s and 1900s, government debt was driven by war.  Government debt increased during the Revolutionary War, Civil War, World War I and World War II, then declined after each war.  As GDP grew, nominal government debt declined as a share of GDP.  Since 1980, the US government has consistently run deficits adding to the level of government debt.

               At the same time, growth in the capitalization of the stock market has grown even more dramatically than the growth in government debt, though the stock market capitalization fluctuates as bull and bear markets occur. On the positive side, the stock market’s capitalization currently exceeds the government’s debt.  As Figure 5 shows, the government’s deficit and stock market capitalization were inversely related during most of the 1800s and 1900s. The declines in Federal debt after the Civil War, World War I and World War II were accompanied by growth in the stock market’s capitalization.  Since the 1970s, however, both the government’s deficit and stock market capitalization have grown, though stock market capitalization has grown faster.

 

Figure 6. United States Stock Market Cap and Government Debt Relative to GDP, 1792 to 2022

Another Real Estate Bubble?

               The Great Financial Crisis in 2007-2008 was driven by the collapse in the real estate market.  This made everyone aware of the impact of real estate as an asset on the rest of the economy because until then housing prices had been relatively stable during the previous 50 years.  Moreover, more people invest in real estate than in stocks and bonds, so real estate’s behavior as an asset class is an important consideration.  Figure 7 shows the inflation-adjusted price of housing in the United States since 1890 using the Case-Shiller Housing Price Index.  As the chart shows, housing prices were stable until World War I, was at a lower level between World War I and World War II, remained stable between 1952 and 1996, with small peaks at the end of the 1970s and 1980s, and has gone through two bubbles since then. Each decline was the result of higher interest rates, an economic slowdown, or both. It appears that real estate prices have peaked after a second ten-year run up.  With mortgage borrowing rates climbing during the past year, the ability to buy real estate has declined, so we could well see real estate prices declining for the rest of the decade.

 

Figure 7. USA Case-Shiller Housing Price Index Adjusted for Inflation, 1890 to 2022

Conclusion

               This paper provides an overview of returns to stocks, bonds, bills, market capitalization, debt and real estate in the United States. The United States has entered a new decade, and it will be interesting to see how the stock market performs in the 2020s relative to the 2010s. The era of declining bond yields that stretched over the past 40 years has probably come to a close. We are entering into a new era for financial markets. Protectionism seems more important than free trade to some politicians, and government intervention in the economy is on the increase.  Currently, real estate prices, equity PE ratios, stock market capitalization and government debt all seem overstretched.  This will likely restrain the growth in asset prices during the rest of the decade.

Declining bond yields produced capital gains for fixed-income investors between 1981 and 2019, providing fixed-income investors with high returns.  The dramatic rise in bond yields in 2021 and 2022 imposed losses on fixed-income investors throughout the world. Investors will spend the rest of the decade recovering from the fixed-income losses of 2021 and 2022. It seems unlikely that the high returns that fixed-income investors enjoyed during the past four decades will continue.  Until inflation comes under control, treasury bills are unlikely to beat inflation. This means that the 2020s will be a lost decade for fixed-income investors.

Investors need to change their strategy.  Bonds and bills may face a low risk of default, but their total return will be poor during the 2020s. Real estate prices are also likely to have peaked and may decline or be stable for the rest of the decade. The Stock market has already endured two bear markets during the 2020s and has returned only 2.5% per annum so far this decade. The stock market has been going through a 30-year cycle since the 1890s and double-digit annual returns seem unlikely in the 2020s.

In the current environment of higher inflation, greater protectionism, international political rivalry, high debt and an overvalued market, it will be difficult for the stock market to provide sustained, high returns. Investors must face the reality of these facts. The globalization period of declining interest rates is no more.  Countries are trying to reduce their reliance on foreign suppliers by producing more goods domestically and relying less on importing foreign goods, especially from China.  Stock market capitalization is at the highest levels in history in many countries and continued growth seems unlikely.

If the 30-year cycle in stock market returns continues, it won’t be until the 2040s that shareholders will again enjoy double-digit real returns.  Periods of global recovery and expansion, as occurred in the 1920s, 1950s, 1980s and 2010s have been followed by decades of slower growth. Although protectionist policies may appear politically beneficial, in the long run, they hurt the economy both through lower output and lower returns to investors.  This was the lesson that should have been learned from the period between 1914 and 1945 when World Wars and Depression reduced international trade. 

Financial markets are driven by the political prejudices of the times.  Although open markets provide the highest returns to investors and producers, they are not always at the forefront of political thought.  We can only hope that governments don’t seek more protectionism and nationalism, because, as the past has shown us, in the long run, investors, consumers and businesses will all be hurt.