The Magic of 1980 – 2000, “The Roaring Twenty”

Here is a link to a chart displaying the Dow Jones Industrial Average (DJIA) for the period October 1928 to January 2016.

http://www.fedprimerate.com/djia-chart-history.htm

You will notice a climb for the period 1980 – 2000.  Let’s focus on that.  On January 2, 1980, the DJIA stood at 824.57.  On December 31, 1999, the DJIA was 11,497.12  The cumulative rate of return (CROR) was about 14%.  Not bad!  There were several factors that we can pinpoint.

The Revenue Act of 1978 included a provision which became known as the Internal Revenue Code sec. 401(k).  The law became effective on January 1, 1980.  You can imagine as the law was applied and brought into various corporations nationally, investment money was channeled (at increasing volume) to the stock market; the result would be an updraft in volume and price over time.

The IBM 5150 was introduced in August of 1981 and, even though there were previously-sold small computers, the IBM proved more popular.  As Wall Street saw the utility of the machine (and similar…), “quants” and mathematicians were hired and told to find a way to make money.  This was a factor in the eventual derivatives market (mid 1980’s through mid 1990’s).

Ronald Reagan changed the tax code/structure in the period 1981-1986. The deductions an individual could take advantage of were decreased to mainly two: mortgage and margin interest on investment.  The highest marginal tax rate was decreased from 70%!  You could make an argument that there was increasing amounts of cash directed to the markets.

In the early 1980’s, Michael Milken and his employer Drexel Lambert had a significant effect on the perception of investment value and cashflow into securities.  Mike took a look at the investment community’s perception of risk as resulting in default and bankruptcy of the companies in the High Yield market. He pointed out that the statistical probability of default for a “junk” company was about the same for quality companies.  He then pointed to the amount of yield or gain the investor left on the table by ignoring the High Yield companies.  How does that matter for the stock market’s climb?

Let’s assume that you’re a securities analyst assigned to a sector within the “junk” market.  In 1980 you review XYZ company that has a cost of capital (amount of interest that the lender, as in bond buyer, demands to buy your bonds) of 13%.  That is, for the company in question, that company wishes to sell 10 year bonds, and to do so, they must agree to a 13% rate of interest on that bond loan to be paid to the bond investor.   You see that XYZ company is making money, even at that cost of capital.  You (as an analyst) make a recommendation to your investor audience to buy the bonds.

In the early 1980’s, Mike Milken convinced investors that the XYZ company and others of the sort were a good risk, much better than anyone had noticed.  As buyers flocked in, the bonds, becoming more popular, enjoyed increasing prices. As the prices went up, yield went down; investors were less concerned about the risk and demanded less interest/income for their money.

Some years later, say, in 1986, you’re reviewing XYZ company and see that now, their cost of capital has decreased to, let’s say, 9%.  You recommended the company some time ago when their cost of capital was 13%, and now it’s 9%!  Likely you’ll recommend more strongly now, knowing that XYZ is much more likely to turn a profit (their interest costs are lower), and actually become less risky as their cost of capital goes down.

But that’s not all!  Now consider the options of XYZ company: they have a growing number of comfortable analysts and investors; a fan club!  Now the company might issue stock instead of bonds, which has no interest (or “coupon”) expense.  The company therefore adds operating capital, decreases their operating expense, and stock comes to the market.  The issuance of stock, of course, must be met with willing buyers, but the company is increasingly viewed positively and the 401(k) phenomenon is moving nicely.  Now multiply this many times.  Mike had a big effect.

We mentioned derivatives earlier.  Rather than get into minutiae, consider that the various types (CDO’s, CMO’s, etc.) essentially came to be and evolved from the mid 1980’s to recently.  Initially the “hedging” aspect of the derivatives allowed for growth in securities purchasing, leading to more issuance and, well, the players grew in numbers and size of holdings.  After the mid-1990’s, the growth in the issuance was considerably higher as trading occurred more for trading’s sake (as opposed to hedging), but the change in complexion of the securities markets was seemingly effecting issuance of stock.

We had the tech interest and beginning of the bubble in the 1990’s, we had low interest rates, creative mortgages…

The first 100,000,000 share day on the New York Stock exchange was in 1982.  The first 1,000,000,000 share day was on October 28th, 1997.

What does all of this mean?  My belief is that the period 1980-2000 was a remarkable period in our history.  The belief that stocks go up, on average, ~10% per year (with fair consistency) seemed to be real then, and was.  But it wasn’t true before that period, and it hasn’t been since.   There is enormous volatility in the world’s markets.  Regardless of the reasons behind that volatility, if we were able to remove it, what would your expectation of the market be?  Would you expect a return on investment of 10% or 4%?  I view the 1980 – 2000 as an aberration.  While the factors that created that period won’t be repeated, I don’t have a crystal ball to suggest never seeing similarly strong factors again.  But again?

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