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The Great Normalization

By Justin McNichols, CFA
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Over the past 20 years, a series of events starting with the bursting of the internet bubble led to the unprecedented environment we find ourselves in today.  We started with “The Great Internet Bubble” followed by “The Great Housing Bubble” then “The Great Credit Bubble” then “The Great Commodities Bubble,” resulting in “The Great Recession,” and subsequently pushing the Fed to embark on the “The Great Monetary Ease.”  This unique period has left us with multiple extremes that will likely normalize in the 2020s.  These previous bubbles and subsequent extremes will ultimately result in “The Great Normalization.”  Many investors will be dramatically misallocated when the normalization begins.

Let’s begin with a review of the events that led to our environment today.  In many ways, it all began with the internet bubble – a once in a generation, massive, investment asset bubble.  Due to the irrational fear of missing out on investing in world changing technology, the technology focused Nasdaq Composite Index (IXIC) rose from a price of 1,100 to over 5,000 in three short years – an annualized return of nearly 65%.  However, once the bubble burst at a valuation of over 150 times earnings, the Nasdaq fell over 80% back down to 1,100 in a mere three years – an unenjoyable round trip.

The bursting of the internet bubble was so large that it caused a recession.  After delivering staggering GDP growth of 7% at the internet bubble peak in the fourth quarter of 1999, U.S. GDP growth fell to nearly zero just a few quarters later, and was negative by the first quarter of 2001.  A major recession was only avoided because the Federal Reserve instituted very easy monetary policy by aggressively and methodically cutting the Fed Funds rate from 6.50% to 1.75% in less than a year, then later reducing the rate further to 1.00% in 2003.

The aggressive action from the Federal Reserve ended up becoming a main driver of the events that caused an unprecedented triple bubble implosion and “The Great Recession.”  After the Fed significantly reduced the Fed Funds rate to 1.00%, they kept rates extremely low even as the economy recovered.  By the middle of 2004, the recession was over but the Fed Funds rate had barely moved.  This extended easy money policy ended up helping to cause three additional bubbles which popped in 2005 through 2008. 

First, the largest housing bubble the nation has ever seen was caused by the combination of easy money, low interest rates, and easy credit.  Consumers took advantage of low interest rates and very easy credit terms to purchase homes, in many cases well outside their affordability range.  During 2003-2005, home prices, which typically rise 5% per year or so over the long-term, were rising at a 15-20% annual pace in many markets.  Ultimately, the housing bubble burst, along with most homebuilding stocks falling as much as 85%.

Second, the stock market bubble was driven by an unstainable growth in consumer debt. Consumers not only increased their debt in the form of a home mortgage, but they also borrowed heavily to furnish the home, buy a new car, truck, boat, RV, jet ski, second home, or third home.  At the peak, household debt as a percent of average income rose from a relatively high level of about 80% in 1999, to over 120% by the time the stock market collapsed under the weight of the bubbles and debt – the dollar amount of debt more than doubled in the U.S.

Third, a final asset bubble was created in the form of natural resources.  This bubble was fueled by the combination of easy money, a U.S. dollar that fell about 40% over a six-year period, and immense construction growth in Asia.  By the time the global economic growth slowed and the U.S. dollar bottomed, natural resources entered a bear market which would result in an over 70% fall.  The following chart depicts this triple bubble implosion.

These bubbles all contributed to the late-2007 to early-2009 recession which was the worst in a generation.  Unfortunately, this recession was worse than the internet bubble recession, so the Federal Reserve once again aggressively reduced interest rates.  However, they did not stop at 1.00%.  The Fed Funds was reduced to 0.00%.

Once the U.S. slowly exited the recession, and the economy bottomed before most other countries, the environment was set to create the most egregious asset class extremes seen in decades.  What happened?  Imagine an environment where the entire globe is in a recession.  That usually means there will be a bias toward owning the strongest global currency – the U.S. dollar.  Next, the U.S. exits the recession first, adding fuel to the already high U.S. dollar demand.  So the U.S. dollar becomes extremely strong, which is a headwind for foreign stocks and natural resources.

Next, due to the recession being caused by a number of bubbles, most notably a credit and debt bubble, the recovery out of these types of recessions tends to be very slow.  This means companies that are able to grow faster than the overall economy are bid up in price well above their fair value as growth investors pay up for growth, and care less about valuation.

Further, with interest rates at record lows, income investors are willing to pay up for income.  Hence, the very slow growing but higher dividend paying sectors like utilities, consumer staples, and REITs are bid up, and eventually investors do not care about their valuations.

All of these actions taken by investors are not necessarily a surprise.  However, we are now at the point where the performance, investor positioning, and most importantly the valuation differentials are so extreme, that once any type of normalization occurs, these extremes will reverse and crush misallocated investors.

To illustrate this point, the first chart below shows the relative valuation of the U.S. stock market versus the rest of the world.  The U.S. now trades at the highest valuation premium in decades.  However, earnings growth in 2020 may be equal between the U.S. and rest of the world.

This second chart shows the relative valuation of U.S. growth stocks versus U.S. value stocks, which are at a 20-year record.  To buy a basket of growth stocks, an investor now must pay a 55% premium versus a basket of value stocks.  That is correct – 55%.

Next, income starved investors chasing 2-3% dividend yields have resulted in very high valuations for these bond proxies.  Sectors that grow earnings at a rate of 0-5% per year rarely deserve valuations that are well above the overall S&P 500.  At one point late last summer, the utilities index was trading at a similar valuation to Google – both at 22 times earnings. 

Finally, what happens when the U.S. dollar appreciation slows, after a nearly 40% rally, and ultimately starts to fall versus other currencies due to any number of factors like growth outside the U.S. improving, uncertainty about the U.S. election, or the rising U.S. deficit?  Normalization could easily cause the natural resources sector to outperform.  The chart below shows the relationship between the U.S. dollar and natural resources, most of which are priced in U.S. dollars.

The period after “The Great Recession” was arguably the first of its kind in nearly a century.  The last ten-years of slow economic growth, record low interest rates, and an abnormally strong U.S. dollar have resulted in numerous extremes as we start the 2020s.  As the events that caused these extremes slowly reverse, the 2020s could be known as “The Great Normalization” – a period when growth rebounds throughout the globe, record low interest rates bottom, and the U.S. dollar’s stealth appreciation of the 2010s slows.  As the decade unfolds, we believe investors will discover that growth stocks shouldn’t trade at a 55% premium to value stocks, utility stocks shouldn’t trade at 22 times earnings, foreign stocks  offer a  better risk/reward outlook relative to U.S. stocks, and natural resources is an important asset class.  In the meantime, OPCM is slowly shifting portfolios toward this period of normalization.

Justin McNichols, CFA

Justin McNichols, CFA

Justin is the Chief Investment Officer for OPCM, and has over 25 years of experience. Justin is a member of the OPCM Investment Management Team, and became a principal of the firm in 2000. Justin is a member of CFA Society San Francisco and CFA Institute. Justin received a Bachelor of Arts degree in Economics in three years and a M.B.A. in Finance from the University of California at Irvine. Additionally, he is a CFA Charterholder.
The opinions expressed herein are strictly those of Osborne Partners Capital Management, LLC ("OPCM") as of the date of the material and is subject to change. None of the data presented herein constitutes a recommendation or solicitation to invest in any particular investment strategy and should not be relied upon in making an investment decision. There is no guarantee that the investment strategies presented herein will work under all market conditions and investors should evaluate their ability to invest for the long-term. Each investor should select asset classes for investment based on his/her own goals, time horizon and risk tolerance. The information contained in this report is for informational purposes only and should not be deemed investment advice. Although information has been obtained from and is based upon sources OPCM believes to be reliable, we do not guarantee its accuracy and the information may be incomplete or condensed. Past performance is not indicative of future results. Inherent in any investment is the possibility of loss.