My recent article pointed out that after adjusting for inflation, it took 30 years (or until 1959) for the stock market to recover to its 1929 high. The revelation prompted me to conduct additional empirical research on GDP and its components from 1929 to 1942. My goal was to use empirical data to assess the potential risk for an increase in inflation from the 2020 global economic collapse. Inflation is a market’s worst enemy since it results in a contraction of the PE multiple, a stock’s key valuation metric.
During the period of 1929 to 1937, the culprit which caused the 20-fold increase in inflation, at its peak, was the significant decline in capital spending. The chart below depicts that capital spending as a percentage of total GDP went from 11.6% of GDP in 1929 to 1.6% in 1932. For all but three of the years from 1930 to 1942, capital spending as a percentage of GDP lagged 1929.
The subpar capital spending from 1930 to 1942 resulted in a decline of output or manufacturing capacity. However, the recovery of the economy (depicted in the chart below) along with population growth of 7.3% from 1930 to 1940 resulted in consumption reaching a new all-time high in 1936. The paradox was the demand for goods and services outstripping the supply during an excessively high unemployment environment.
The chart below depicts a June 2019 forecast for a decline in global capital spending for 2020 and 2021. Due to the unforeseeable event of the Coronavirus wreaking havoc on the world economy since the June 2019 forecast, the decline in global capital spending will likely be much greater and will last for years, as was the case for 1929 to 1942.
The unavoidable result from the rate of inflation increasing significantly will be following.
- An increase in interest rates: The US Federal Reserve and the rest of the world’s central banks would have to raise their discount rates to ensure that inflation does not get out of control. Therefore, the Federal Reserve could go from the stock market’s best friend to its worst enemy. The increase in interest rates would be devasting for the prices of all long-term government and corporate bonds. Interest rate increases would also be devastating for the prices of residential and commercial real estate since mortgage rates would also increase.
- A contraction for PE multiples: The math that a market utilizes to determine the assignment of a PE multiple is earnings growth minus inflation. For example, if a consumer goods manufacturer is growing at 10% and inflation is 5%; the net growth for the company is measured at 5%. In a zero-inflation environment, the standardized multiple for a 10% earnings growth rate equates to 10. For the same 10% growth under a 5% inflation scenario, the PE multiple is discounted by 50% and would be 5 instead of 10.
The chart below depicts the extreme polar opposites for PE multiples and inflation through 1949. Inflation steadily increased to highs of 5.1% in 1937, 13.2% in 1942 and 19.7% in 1947. The PE multiples steadily declined as the inflation increased.
An increase in the inflation rate is perhaps the most important of all risks for an investor to consider. Another consideration is that the SCPA algorithm has forecasted that the US market as well as the dozen other countries experiencing market crashes in 2020 to decline by 79% to 89% from their 2020 highs. This will happen when they reach their bottoms in the fourth quarter of 2022. The table below depicts three of the SCPA’s March 2020 forecasts which were extraordinarily accurate.
For an investor to get a real or an adjusted for inflation positive return through a least 2030, requires the deployment of a defensive investing strategy. All shares trading above $5.00 should be liquidated. The cash can be allocated into the trend trading strategies of the Bull & Bear Tracker and Bear Trader algorithms to generate cash flow. A percentage of assets should be allocated for alternative investments which can produce capital gains.
One alternative asset class that can produce capital gains which are in excess of the rate of inflation in any economic environment is private equity. The new technologies and business models which emerge during a secular bear market and a lackluster economy provide their investors with significant upside and become the leaders of the next bull market.
Federal Express shares, which my clients purchased from its IPO, is a good example. It was founded in 1971, which was during the 1966 to 1982 secular bear market. From 1978 to the end of the secular bear market in 1982, its share price increased by 600%. The shares have since multiplied by another 20 times. The range for US inflation was 6.5% to 14.7% from 1978 to 1982.
Investors in the current secular bear market have a significant advantage over those who participated in the two prior secular bear markets, which occurred in 1966-82 and 2000-09. The passage of the JOBs Act in 2012 enabled anyone to invest small amounts in private startups to populate a diversified portfolio. The act also created secondary market liquidity for those who invest in private startups.
Dynasty Wealth, for which I am the director of research, specializes in identifying startups which have the potential to appreciate by 1,000% to 10,000% within five years. The video of my six-minute interview at the NYSE below:
- Includes an overview for Dynasty Wealth.
- Covers a private startup that I identified which IPOed and grew to $800 million of revenue before it was acquired.
A visit to BullsNBears.com, which I founded to specialize in providing educational content and investing products and services for secular bear markets, is highly recommended.