There were six special beliefs that could have caused investors to miss this great bull market. All the way up, investors were told stocks were too expensive based on the price/earnings (P/E) ratio of the S&P 500 Index. Second, in 2010, some investors took the double-dip recession scenario to an extreme and predicted deflation. Third, corporations were buying back shares of their stock, which for some reason was viewed with suspicion. Bearish investors believed the buybacks were the primary force driving stock prices higher and reasoned, if they quit, look out! Fourth, some observers dismissed the earnings growth because they were disappointed with slow revenue growth. Fifth, by 2016 investors feared that corporations had excessive amounts of debt, which could lead to bankruptcies. Finally, in 2019, an inverted yield curve drove many investors to the sidelines in fear of a subsequent recession. Overpriced? Deflation? Corporate buybacks? Inadequate revenue growth? Excessive debt? Inverted yield curve? Looking back, we know investors should have ignored these situations and bought and held stocks. Let's take them one at a time.

Overpriced?

Besides the imperfect economic recovery, which could have persuaded investors to avoid stocks, there was regular commentary on TV, radio, and in print that the market was expensive, or overpriced. Throughout the multiyear market advance, we have seen analysts caution investors with regard to owning stocks. They have cited the P/E ratio for various indexes such as the S&P 500 Index. Their case has been that a lofty P/E, and therefore apparently expensive stock prices, could predict lower stock prices from that time forward. With our ICON valuation readings in disagreement with this cautious commentary, we published a paper in early 2017.

A stock price should be a function of four variables: earnings, expected growth in earnings, risk, and an interest rate. As interest rates drop, it is mathematically sensible for P/E to increase, all else being equal. In the low and declining interest rate setting of 2009–2019, it was rational for P/E to increase and be higher than its historic average.

Ignoring the connection between pricing multiples and interest rates isn't new. In the early 1990s we competed against a manager that used price-to-book value to allocate among cash, stocks, and bonds. We can only guess they did their back testing in the 1970s and 1980s with higher interest rates and, therefore, lower price-to-book ratios. By the early 1990s, they thought stocks were too expensive based on a higher than average price-to-book value ratio and held mostly cash. Missing the stock rally of the early 1990s, their performance caused them to lose a lot of assets under management and eventually they went out of business.

Deflation

Over most of this bull market, potential inflation bothered investors as they feared it would result from the expansive monetary policy. In 2010, however, deflation was the headline concern, a byproduct of the double-dip recession fears. Although they didn't like potential deflation alone, they reasoned it would cause many other bad things, such as the inability of borrowers to repay debt. Although we didn't agree and did not expect deflation, we reasoned it wouldn't be all that bad anyway. Here is a paper we wrote for investors in late 2010. We called it “We Do Not Worry About Deflation. Here's Why.”

As we know now, deflation fears subsided and the market moved higher.

Corporate Buybacks

Public companies can buy back their shares from public investors. They use cash so on the balance sheet cash is reduced and so is total shareholder's equity. The shares show up as treasury stock, which accountants call a contra account. These buybacks have to be approved by the board of directors and announced to the public. They usually state a total amount but do not state exactly when they will be buying.

Some analysts view this activity from the negative perspective. They suggest it means the company doesn't have anything better to invest in, such as growth opportunities. They also worry that the buying artificially inflates the stock price and when the repurchasing stops, stock price might revert back to previous levels. Here is an example of a negative view. Craig was on CNBC TV, “The Exchange,” on March 1, 2019. After Craig gave his view that the market should go higher, Kelly Evans asked the other guest, Brian Reynolds, “Brian, what about you? How much of a tailwind does this bull market have?” Mr. Reynolds replied, “I think it has a very big tailwind. We had a panic in 2015 and 2016 that launched two years of debt-fueled buybacks, merges, and LBOs. I think we are going to have the same thing: another couple of years of debt-fueled buybacks.” The other guest and Craig agreed that the market could move higher. Craig based his on value. The other guest said the move would be supported by “debt-fueled buybacks.” Sounds almost sinister and implies the only reason the market is moving higher is because of the “debt-fueled” buybacks.

From the positive side, when you own the stock it is comforting knowing there is a big buyer out there. Some buyback purchases may be in regular intervals; others may wait for dips and add support. Managements and boards are in the best position to see the prospects of the company. Buybacks suggest they like the prospects and think the stock is cheap. Buybacks reduce the number of shares outstanding, which boosts earnings per share when accountants divide earnings by the number of shares outstanding.

By 2010, buybacks were increasing and the voices with the negative view were much louder and more prevalent than those with a positive view. Given the stubbornly high unemployment and fears of double-dip recession at the time, skeptics argued the buybacks falsely inflated stock prices and were the only thing keeping stock prices from dropping. We disagreed and found the buybacks to be a positive signal and addressed it in our October 2010 Portfolio Update, our monthly letter to investors. Here are parts of it.

That was back in October 2010. Corporations were issuing bonds and buying their stock. Investors were selling stocks and buying bonds. With two groups with completely opposite behaviors, one side had to be wrong. We thought the corporations would be proven right. They were.

We addressed corporate buybacks in October 2010 from an investment perspective, making a case that the broad market could move higher. The discussion on buybacks continued throughout the multiyear bull market from not only an investment perspective but also from a social view. An article in the December 9, 2019, issue of Bloomberg Businessweek by Peter Coy titled “CEOs Goose Their Pay with Buybacks” focused more on the social side and began by stating the magnitude of buybacks. “In 2018, S&P 500 companies bought back a record $806 billion worth of shares, a 55% leap from the year before. They're on track to buy back about $740 billion worth this year.” The article then went on to mention two social criticisms. First is that they benefit shareholders but are bad for workers. “This was the line taken by Democratic presidential candidates Elizabeth Warren and Bernie Sanders, who support banning or restricting open-market stock buybacks.”

The article then dug into a second, less familiar line of criticism that the buybacks aren't necessarily good for shareholders but benefit corporate executives and directors.

Leading the charge for this cause is Robert Jackson, a Securities and Exchange commissioner who's been agitating for more than a year for his agency to schedule hearings on the issue… Jackson had his staff study 385 recent buybacks. They found that shares rose by about 2.5% more than would otherwise have been expected in the days after a buyback announcement. They found that, compared with an ordinary day, twice as many companies see executives and directors sell shares in the eight days after a buyback announcement. The value of sales goes up too. In the days before a buyback, selling by insiders averages less than $100,000 a day. In the days after a buyback, that average climbs to more than $500,000 a day.

As for insiders and directors, regulations for their buying and selling activity are already established. Adding restrictions on selling into buybacks would be an easy add-on for regulators if Mr. Jackson can successfully present adequate evidence and make his case.

The stock market helps allocate the limited resources of land, labor, and capital for our society as stock prices set the terms for companies to get capital. An efficient allocation of resources promotes low unemployment and low inflation, whereas an inefficient, wasteful allocation does the opposite. As time passes, society's demands for goods and services change due to technology, inventions, demographics, and many other influences. Therefore, the allocation of our limited resources must be fluid. Initial public offerings (IPOs) and buybacks are just part of the ebb and flow of the free market system. Some companies may have needed and obtained capital a few decades ago to produce what society wanted then but now they don't need the capital. They can buy back shares. The investors selling the stock can use the proceeds to invest in a new IPO, a company producing some new good or service that society wants and is willing to pay for. For example, tobacco and coal companies can repurchase their shares while Uber, Facebook, and Netflix go public and receive capital. It seems simple and suggests buybacks perform a function for society in allocating its resources and are nothing to worry about in a bull market.

Lackluster Revenue Growth and Earnings

In Chapter 2, Figure 2.2 showed how earnings per share grew for the S&P 1500 companies during the eleven-year bull market. Yet many skeptical observers with a predetermined bearish mindset dismissed those earnings. They stated that there was lackluster growth in revenue (sales) so the earnings growth was simply due to cost cutting. They would not acknowledge the earnings growth and we presume did not embrace the bull market.

It turns out it is normal for earnings to grow more than revenue. That relationship between revenue and earnings is due to operational and financial leverage, topics covered in a chapter in undergraduate and graduate corporate finance textbooks. Both types of leverage happen in the income statement due to fixed costs. Companies have variable costs and fixed costs. Variable costs vary with revenue such as sales commissions for the sales force, overtime for production, or cost of goods sold, like steel for an automobile manufacturer. Fixed costs are stable and independent of revenue such as salaries and rent. Fixed costs provide operational leverage and interest expense provides financial leverage, as illustrated in Table 10.4.

In year one, sales are $100 for a company and variable costs are 30% of sales, or $30. Fixed costs are $40. Subtracting $30 and $40 from $100 leaves $30 earnings before interest and taxes, or EBIT. The $5 of interest is subtracted to get $25 net before taxes, or NBT. An easy tax rate of 25% is used to compute taxes of $6.25. Subtracting taxes from NBT gives $18.75 net income. Let's say from year one to year two sales grow by 10% to $110. Variable costs, at 30% of sales, grow to $33, but fixed costs, being fixed, remain at $40. EBIT has grown by 23.3% to $37. So a 10% growth in sales produced a 23.3% increase in EBIT because of operational leverage. In year two, interest expense remains at $5, so NBT grows to $32, a 28% year to year increase. With the same 25% tax rate, net income increases 28%. A 10% increase in sales produced a 28% increase in net income, so it is normal for income to grow faster than revenue because of operational and financial leverage.

We suspect that the new-age technology companies have a greater percentage of fixed costs and a lower percentage of variable costs than manufacturing firms. The new-age technology companies have salaries that are independent of sales, whereas manufacturing firms buy raw products directly associated with sales. Information technology was the best-performing sector over the eleven-year bull market. So the sweet spots of the bull market benefited from operational leverage and didn't need rapidly growing revenue.

Corporate Debt

Concern began to build in the later years of the bull market that corporations may be carrying excessive debt. As reported in Reuters by Jay Withermuth and Kristen Haunss in an article titled “Yellen Warns of Corporate Distress, Economic Fallout,” Janet Yellen, former Federal Reserve chairperson, stated February 27, 2019, “I do think non-financial corporations have run up really, quite a lot of debt. What I would worry about is if the economy encounters a downturn, we could see a good deal of corporate distress …. And I think that's something that could make the next recession a deeper recession.”

We did our research and wrote the following paper in November 2016, but before getting into it we need to examine Dr. Yellen's track record in securities analysis. Jeff Cox of CNBC.com picked up on it and wrote an article June 2, 2015, titled “Remembering Yell's Awful Biotech Call Last Year.” The article began, “As a stock market analyst, Janet Yellen makes a pretty good Federal Reserve Chair. Nearly a year ago, on July 16, 2014, Yellen famously warned of ‘substantially stretched’ valuations in biotechnology and social media stocks.” No wonder he had fun with the article; the S&P 1500 Biotechnology Index gained 42.9% from July 16, 2014, to July 16, 2015. The S&P 1500 gained just 9.4% over that same period. Now back to our research in November 2016 addressing the corporate debt concerns, which offers evidence she may have been equally wrong about corporate debt as she was about biotechnology.

There seems to be a belief among investors that corporation managements and boards of directors easily walk away from debt and default. From our perspective, they do not. They have many tactics available, and they go to great lengths to avoid default. We don't know what started the belief in excessive corporate debt. It just seemed to gain a life but was not supported by various debt ratios used by financial analysts. We also know that corporate debt did not cause massive problems (distress) in the next recession, which occurred in 2020.

Inverted Yield Curve

Oh my gosh! The yield curve is inverted! Sell everything and hide under the desk. That was a popular message spring and summer 2019, but obviously ill-advised as the market charged on to record highs February 2020. First, what is an inverted yield curve?

A yield curve is a graph of the yield on government-issued debt instruments with time to maturity on the horizontal axis and yield on the vertical axis. Going left to right, time to maturity increases from three months to six months to one year to two years to five years to ten years and out to twenty years to maturity. Usually the line of those yields slopes upward to the right because long-term interest rates are usually higher than short-term rates. Longer-term bonds have greater price sensitivity to changes in interest rates, so investors usually require a higher yield to compensate for the greater price volatility. But sometimes they don't.

Sometimes the yields from one year out to twenty years are about the same resulting in a “flat” yield curve. Sometimes the yields on the longer-term notes and bonds are less than the yields on the shorter-term paper, resulting in the dreaded inverted yield curve. Economists have noted that recessions have been preceded by inverted yield curves. So when the yield curve went inverted spring and summer 2019, many investors, economists, and money managers predicted a recession and sold stocks.

We do not believe that an inverted yield causes a recession. Rather, whatever causes the recession also causes the yield curve to invert. Here, all arrows point to the Federal Reserve. When the Fed sees a robust, perhaps overheated economy and the potential for increased inflation, it raises its Federal Funds target interest rate. Then, through Open Market Operations, it sells T-Bills to banks, drains reserves, and slows the growth of the money supply. Sometimes it goes too far and causes a recession by accident. Sometimes it may think that the resulting recession is necessary to fight inflation. In either case, it is the raising of the Federal Funds rate, the Open Market Operations, and the resulting slower growth of the money supply that causes the recession. As the Fed is raising short-term interest rates it can also cause the inverted yield curve by moving the short-term end of the yield curve up to and above long-term rates.

What if instead the yield curve inverts because long-term rates come down to short-term rates? Say the Fed is not tightening (not raising short-term rates) but instead, for whatever reason, investors buy long-term bonds and drive long-term rates down to or below short-term rates. It doesn't seem that a recession would necessarily follow that situation. Our theory is that if the inversion is caused by the Fed raising short-term rates, a recession will follow, but if the inversion is caused by the investors buying bonds and driving long-term rates down then there is no recession.

Analysts who monitor the slope of the yields have different measuring tools. Some compare the yield of the 10-year Treasury to the 2-year Treasury. Some compare 5-year maturity to 6-month T-Bills. For our analysis we are using the 10-Year Treasury and the Federal Funds rate because the Federal Funds rate is a specific tool of the Fed. Based on weekly data we found six times when the Federal Funds rate went above the yield on the 10-year Treasury note back to 1980. In Table 10.5 we note the date of first inversion and the Federal Funds rate and the yield on the 10-year Treasury at the time. Just below are those same two rates twenty-six weeks (six months) prior except for 1980. We used fifteen weeks prior because twenty-six weeks before was also an inversion. For the inversions on top a recession did follow. For those on the bottom, there was no subsequent recession and the stock market moved higher.

Change is the increase or decrease in the rate in the weeks leading up to the inversion. Notice for the times that a recession followed (left), the Federal Funds rate increased by at least one full percentage point in the weeks leading up to the inversion and it increased more than the long-term rate, thereby causing the inversion. On the right, when no recession followed, the Federal Funds rate was either unchanged or barely budged in the weeks leading up to the inversion. The cause in those cases was clearly the drop in the yield on the 10-year Treasury. The data support our theory. If the Fed causes the inversion because of raising short-term rates, a recession is likely. If, instead, the Fed is not tightening and the inversion is caused by investors buying bonds and driving down long-term rates, there is no recession.

Regarding the inversion of May 2019, the Fed had raised the Federal Funds target rate four times in 2018 but held it steady from late December 2018 through the May 2019 inversion, so the Fed was not tightening in the months immediately preceding the inversion. The inversion occurred primarily because of the drop in the yield of the 10-year Treasury note. The Fed dropped the Federal Funds target rate three times in 2019 and the S&P gained 20.8% from that inversion, May 24, 2019, to its peak February 19, 2020. It should be noted that there was a recession in 2020 but it was not caused by the 2019 inversion or tight monetary policy. We shut down the economy on purpose to attempt to contain the spread of COVID-19.

Summary

Although these six situations appear unrelated, they all bothered investors and gave skeptics a reason for selling and missing all or part of the great bull market. Based on the P/E of the S&P 500 Index investors thought stocks were expensive. The fear of deflation sent some investors to the sidelines. Many investors were put off by the corporate buybacks. Some analysts dismissed the earnings growth incorrectly requiring lofty revenue growth. Since 2016, the belief that there was excessive corporate debt was reason for some investors to be cautious, and in 2019, an inverted yield curve proved to be a false alarm. A little simple research, however, defused those concerns. Buying and holding wasn't dull or easy, but it was rewarding.

• P/E is useless in predicting future market returns.
• Deflation isn't necessarily bad.
• Corporate buybacks were correct. Investors were wrong.
• Earnings can grow more than revenue.
• Basic debt ratios show corporations are not overleveraged.
• The cause of an inverted yield matters.