This Isn't Going to End Well...

Key Concepts

• Inflation-Adjusted Stock Market Returns: The performance of the stock market after accounting for the decrease in purchasing power of money due to inflation.
• Secular Bull Market: A long-term upward trend in stock prices.
• Revenue Growth: The increase in a company's or index's income from its primary business activities.
• Corporate Profit Margins: The percentage of revenue that remains as profit after all expenses have been deducted.
• Workforce Growth: The increase in the number of people employed or seeking employment.
• Globalization: The increasing interconnectedness of economies worldwide, often involving outsourcing and international trade.
• Interest Rates: The cost of borrowing money, set by central banks.
• Business Cycle: The recurring pattern of expansion and contraction in economic activity.
• Recession: A significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.
• Schiller PE Ratio (CAPE Ratio): A valuation metric that uses inflation-adjusted earnings over a 10-year period to smooth out business cycle fluctuations.

S&P 500 Performance: Inflation-Adjusted vs. Nominal

The video highlights a critical distinction between the nominal (unadjusted) and inflation-adjusted performance of the US stock market, specifically the S&P 500. A significant portion of the apparent returns in the nominal S&P 500 is attributed to the "steady erosion of our currencies" due to inflation. When adjusted for inflation, the S&P 500 has experienced multiple periods of decline, indicating that stocks were poor investments during those times.

Recent Market Resilience Amidst Crises

Despite the historical context, the S&P 500 has shown remarkable resilience over the last decade, even when adjusted for inflation. This upward trend has persisted through several significant crises:

• 2020 Pandemic: Stocks experienced a correction but quickly rebounded to all-time highs.
• 2022 Inflation Surge (9%): The Federal Reserve initiated an aggressive interest rate hiking cycle. While stocks corrected, the secular bull market continued.
• Recent Tariff Announcements (Donald Trump): These triggered a brief market panic but were followed by a swift snap-back to all-time highs.

The presenter notes that "there seems to be nothing that can stop the stock market from rising."

Fundamental Drivers of Recent Stock Market Growth

The strong performance is not considered random but is supported by real fundamental forces:

• S&P 500 Revenue Growth: Revenues have roughly doubled over the last decade.
• Expanding Corporate Profit Margins: Profit margins are currently at all-time highs.

This combination of high revenue growth and high profit margins is identified as the primary driver of the inflation-adjusted S&P 500's rise over the past decade.

Workforce Growth as a Key Momentum Driver

A significant contributor to the S&P 500's upward momentum is its intimate tie to the growth of the US workforce. As more people enter the workforce, they earn wages, increasing spending power for goods and services.

• Historical Workforce Growth Drivers:
  • Late 1990s: Strong population demographics and increased female participation in the workforce.
  • Recent Decades: High levels of immigration.

Reversing Structural Trends and Potential Headwinds

However, these key drivers of workforce growth are showing signs of slowing down or reversing:

• Workforce Participation: Declining for both men and women.
• Immigration: Slowing down due to current administration policies.
• Demographics: Aging population in the US presents a headwind.
• AI Job Replacements: Potential future impact on workforce size.

The presenter suggests that "one of the key fundamental driving forces behind the S&P 500's secular run could be at risk of turning lower."

Reversal of Profit Margin Drivers

Similarly, the record corporate profit margins are also facing reversing trends:

• Low Interest Rates: Rates dropped from approximately 7% in 2000 to 0% by 2021, providing corporations with cheap access to capital. This era is considered "very likely come to an end."
• Globalization: Allowed companies to outsource manufacturing and reduce costs. Donald Trump's tariffs are seen as marking the "onset of much more protectionist policies that may completely reverse globalization."

Investor Optimism and Market Valuations

Despite these reversing structural themes, investors continue to bid up the S&P 500. The market is seen as "looking forward and discounting future revenues."

• Inflation-Adjusted Returns: Currently at the "very top of that historical range," indicating extreme investor optimism.
• Schiller PE Ratio (CAPE Ratio): Stands at 39 (as of the video's creation), exceeding valuations at many previous historical peaks. This suggests investors are not pessimistic about future revenues and profit margins.

The Role of the Business Cycle and Recessions

The video argues that while structural themes influence the long-term trajectory of the market, month-to-month price action is primarily driven by the business cycle.

• Recessions as Catalysts for Market Peaks: Historically, economic recessions have coincided with periods where the S&P 500 declined in inflation-adjusted terms.
• Corporate Profit Margins and Recessions: Profit margins only tend to contract heading into or during economic recessions. Since 2008, there hasn't been a significant recession, leading to sustained profit margins.

The presenter states, "the current runup in the stock market is justified. And as long as the current business cycle continues, it could run higher."

Future Outlook and Investment Strategy

The video anticipates that the next recession could lead to an "exacerbated move down in stocks" due to the discussed structural shifts. However, this short-term pain is expected to create long-term opportunities, as "over the long run the stock market does move up even adjusted for inflation."

The presenter's firm, Bravos Research, believes a recession is not imminent but is approaching. They advocate for macro traders to "take advantage of these kinds of strong market returns while they last" and currently have exposure to market segments expected to remain strong towards the end of the secular bull market. Their strategy focuses on maximizing winners and limiting losers.

Conclusion

The S&P 500's recent strong performance, even when adjusted for inflation, is driven by robust revenue growth and expanding profit margins. These, in turn, have been supported by workforce expansion and favorable global economic conditions (low interest rates and globalization). However, these fundamental drivers are showing signs of reversal. While the current market run-up is justified by the ongoing business cycle, the potential for an exacerbated downturn in the next recession is acknowledged. The long-term outlook for the stock market, adjusted for inflation, remains positive, with recessions presenting opportunities for astute investors.