Why 2009 is not 2003

This article was written at the start of September 2009.

There are many parallels one can draw with the stock market rally we have seen since mid-March (earlier in emerging markets) and that of the start of the last major stock market rally that started in 2003 and ended in 2007. Many investors appear to believe that, just like then, this is the start of a much longer bull market that could go on to reach the heights of the previous two bull markets. However, there are a number of reasons why this rally is very different from that of 2003 and many of the others throughout history with which it is being compared.

A good reason for comparing this rally with that in 2003 is that it began in the trough between the peak market levels of 2000 and 2007, both of which shared certain similarities in some important markets. For example, if you look at 15 year charts for the S&P500, the Nikkei 225, the FTSE All Share, the FTSE 100 and the CAC 40 you will see that they all shared double top formations with markets peaking at similar levels in 2000 and 2007. None of them have exactly the same pattern but there are clear similarities in the index levels which all peaked only a few percentage points apart.

The second interesting similarity is that each of these markets also bottomed out at around the same level in 2003 and 2009. Therefore, having peaked in 2007 at the same level as in 2000 and then rebounded from low points in 2003 and 2009 there now appears to be an assumption that we will see a second repeat of the climb back up to the highs of 2000 and 2007.

The bull market in stocks that peaked in 2000 was a big one. By the time the dotcom bubble had burst and investors realised that they may have overestimated the way the internet would change the world, individual stock valuations had reached new heights. The S&P500 had a PE of 46 by the end of 2001, a year in which the September 11th attacks in the US also contributed to negative investor sentiment and were blamed for a large number of companies issuing profit warnings. The market fell until the first half of 2003 before bottoming out.

The story behind the 2000-2003 market decline was very much about valuations. Stock prices had become far too inflated relative to earnings but that wasn’t the case when markets peaked in 2007. At the end of December 2007 the PE for the S&P 500 was 19.84, which is not cheap but is lower than in 2000 when it stood at 26 and especially compared to the 2001 valuation of 46. Instead of a simple overvaluation of stocks, the boom that led up to 2007’s peak was fuelled by increased earnings that had been inflated by a massive expansion in credit at the customer and corporate level.

A stock valuation which is inflated by exuberant investors is easily corrected by a stock market fall but the when the problem is of a more fundamental nature then a simple stock market correction does not solve the underlying problem. I would argue that we are seeing a long-term correction to corporate profits as a result of a global contraction in credit and the spending power that it afforded us, and this reflects a long-term change in the way the global economy works.

The 2000 bull market was fuelled by a bubble in stock valuations and when interest rates were lowered it was followed by a bubble in the accessibility of credit that fed into many elements of the wider economy, leading to a global property boom amongst other things. High market peaks leave investors with high expectations for future market peaks. If we are to see stock markets ‘recover’ to former levels within the next decade then it would appear that we need either a major positive fundamental change to the way the economy works or we need another bubble.

In my view it appears that there are more negative fundamental differences at play today than positive and there are several important differences between the economic environment of today and that of 2003 which suggest that this market rally will not be sustainable.

a) From 2002, US GDP was never technically in recession and in the period from 2000 to 2007 it never contracted for more than one quarter at a time, having shown negative growth on just two occasions. Conversely, from Q2 2008, US GDP contracted for 4 quarters in a row which suggests that the economy is in considerably worse shape today than it was during the last stock market crash. Many countries have experienced negative GDP growth whereas they didn’t during the last downturn.

b) The 2003 rebound was fuelled by pent up consumer demand that had been dampened after the 2000 stock market crash and also by the negative effect of 9/11. The US consumer had been able to continue his spending in spite of the supposed economic downturn and household consumption rose in every year from 2000 to 2007 . In 2003 consumers had the ability to spend whereas today they are far more indebted and they have more restricted access to credit, both of which will severely curtail their spending.

c) Today they are also more likely to be out of work. From 2000 to 2003 the US unemployment rate rose from 4% to 6%, which was a significant increase but was nothing compared to the change since mid-2007, when the US unemployment rate rose from 4.7% to 9.4% by July 2009 .

d) This year we have seen total US household debt shrinking whereas in 2002 and 2003 it was still growing as consumers were able to leverage the value of their properties and use money released from equity for other spending.

e) US house prices rose every year through 2000 to 2006 . This was a major boost to spending power and consumer confidence which is completely missing today. US house prices have fallen substantially since their peak thereby removing the ability and the desire to release equity for spending.


The flipside of the negative factors above is that government intervention directly into the economy during the last downturn was nowhere near as significant as today. Whilst quantative easing and the purchase of government bonds are an attempt to restore ‘normality’ to lending costs, the wider economy should today also feel the positive effects of the subsidies for new cars, tax cuts such as the UK cut in VAT and the US income tax rebates which put money directly into circulation. However, these schemes have had limited success because they encourage a short term spending spree, they bring forward spending that would have occurred later or they have diverted spending away from other areas of the economy. Some of this money has also been used to pay down debt or to rebuild savings. We also know that such methods of stimulation have a finite life, they can’t be sustained indefinitely, and they also have to be paid for at some point in the future.

Another example of ‘distortion’ in the market is that many companies have been kept alive by a combination of support from the government and financiers. In Italy only one publicly traded company has filed for bankruptcy this year even though many more are unable to pay their loans. In a normally operating free market many companies would have gone out of business and this would likely have had a more damaging effect on investor confidence and stock markets in general. It is another example of the difficult and unusual investing environment we have to contend with today.

The evidence shows us that much of the global economy is in a worse state today than it was in 2003 and that many of the problems that led to the credit crunch have not yet been solved. GDP growth in developed economies is forecast to be extremely weak for the foreseeable future, company directors who are selling their own stock outweigh those buying by a record amount, there are a record number of homeowners in negative equity (8m in the US) and 9% of US mortgage holders have defaulted, having missed at least one monthly mortgage payment. We are still at risk from banking collapses where banks have high exposure to commercial property lending, credit card debt or Eastern European investments. Unemployment is still rising in many countries.

It would appear that the global economy, and the environment for corporate profits, is considerably worse today than it was in 2003, yet the major stock markets have rallied significantly since their credit crunch lows. The factors I’ve highlighted above would tend to suggest that a recovery in corporate profits is far less certain than stock markets would have us believe and the higher markets go without a solution for the fundamental problems then the greater the likelihood of a major correction.

Several major stock markets have fallen no further than they did in the last bear market and this is supposed to be telling us that the worst recession since the 1930s actually has a relatively limited negative impact on corporate profits. With the exception of the financial sector, the valuations of most stocks have not fallen to the kind of low levels seen in previous bear markets. This does not make sense to me and it makes me doubt the validity of the forecast upturn. A v-shaped recovery was always seen as the least likely course of events but that is what markets appear to be pricing in. The points I’ve highlighted here suggest that a return to an economy similar to that experienced in 2003 looks like a rather distant possibility and investors could well be disappointed when economic reality fails to catch up with the stock market rally. The question is whether this results in a new downward leg of the bear market to new lows, or whether government intervention ensures that we only suffer a relatively minor correction and the markets remain on life support.

The Japanese were criticised for supporting ‘zombie’ banks during the lost decade of the 1990s, having failed to deal with the problem of non-performing loans in the banking sector, and it was this approach that was blamed for prolonging the severity of the downturn after their own stock and property market bubbles popped. I would argue that the leaders of the US and Europe are equally guilty of avoiding the need to take painful decisions and they are failing to address the underlying problems of the economy. Debt is being shifted from the private sector onto the shoulders of the taxpayer, companies that should fail are being saved from bankruptcy and over-indebted consumers are being incentivised to spend their way out of an economic crisis that was brought about by over-spending. These are short term solutions to long term problems and I fail to see what will provide the power to drive a sustainable stock market recovery from here. The factors that enabled the 2003-2007 bull market are not in place and there are no obvious alternatives in sight.

Some of my views on the Fed move to buy treasuries.

The Fed announced this week that it will spend $300 billion buying US treasuries, presumably to bring down interest rates and to increase market liquidity (weren’t treasuries already liquid?). In the same week we have seen a drop in the Dollar and a significant rise in the oil price, the gold price and other commodity prices. OPEC probably can’t believe their luck, having only just announced that they would not be cutting production quotas further in light of the severity of the economic downturn.

Whilst it is early days, the rise in commodity prices raises some significant questions about the targeting and validity of the Fed policy. As well as bringing down interest rates the buying of treasuries is also another way of putting money back into the financial system, with the aim of feeding through to the wider economy and keeping inflation alive (specifically to avoid deflation).

Real world inflation is generally driven by two factors (ignoring specific supply bottlenecks) that cause prices to rise: wage growth and credit expansion. The 10 year US treasury yield is currently 2.6% which would suggest that it is not high interest rates that are stopping credit expansion. Extra liquidity in the system could help but what is really needed would be widespread take up of new credit by companies and consumers (not just a rolling over of existing debt, which wouldn’t be expansion). I would argue that most companies and consumers are still in deleveraging mode and will be for some time. I think credit expansion on a meaningful scale is unlikely to happen yet, maybe not for a long time.

Will the new Fed spending encourage wage growth? Not unless companies start experiencing increased demand (which won’t happen without greater disposable income for consumers, which itself would be a result of higher wages or lower outgoings). Wage demands that are satisfied by employers, are driven by rising prices in an economy but only where they arise from increased demand for goods and services. In the current environment workers will want higher wages because the cost of basic materials such as food and energy are rising but will employers be inclined to give them without a commensurate rise in demand for the goods they produce? Long gone are the days when an employer such as Henry Ford believed that paying higher wages to his employees would enable more of them to buy his cars.

So what if the Fed’s policy actually turns out to be damaging to the economy? In the period of a few short days the net result of the Feds treasury-buying policy is that it has pushed up oil, metal and various other food and energy commodities. The costs of production just got higher. So far, investor demand for inflation-hedging commodities has been sufficient to move their prices in anticipation of the higher inflation rates that could follow. However, if the net result of the Fed’s policy is to push up commodity prices initially, but it doesn’t feed into wages or credit expansion for the reasons mentioned above, then it is likely to put a brake on any hint of economic recovery that might have been occurring.

We are in unprecedented times and it is entirely feasible, in my humble opinion (!), that the Fed may be on the wrong path and it may actually prolong the pain of a recession. Higher prices are only desirable in the current situation if they lead to wage growth and reasonable credit expansion but if they only succeed in pushing up producer input prices before economic demand recovers then they are unlikely to get a warm welcome from either consumers or companies.