We expect real economy stocks to outperform digital growth stocks over the coming decade.
We’re in a new market regime.
Post-pandemic reopening and the Federal Reserve’s aggressive rate hiking cycle have catalyzed a dramatic shift in equity market leadership. The fastest-growing companies—the ones that thrived during the post-global-financial-crisis era of exceptionally low interest rates, and through the more recent period of social distancing—have suffered. Meanwhile, companies that derive their revenues from the “real economy,” and return a larger share of profits to investors, have outperformed.
We believe the outperformance of real economy stocks over digital growth stocks could last for several years, or even through the next decade, if history serves as a guide.
In many ways, this new regime recalls the investing environment of the early 1980s. A spike in interest rates to fight double-digit inflation, known as the “Volcker shock” for Federal Reserve Chair Paul Volcker, marked the beginning of a multi-year stretch of growth stock underperformance. The rate shock led companies to profoundly change how they allocated capital and structured their operations. It also triggered the deep recession of 1981–82.
We see parallels with, and some notable differences from, the current juncture. Today, inflation is cooling, and if the U.S. economy were to slip into recession in 2023 it would likely not be as deep as the recession of 1981-82. But the past year’s interest rate shock, sparked by economic reopening and surging inflation, will have far-reaching effects. We think it will influence both corporate decision making—management teams will prioritize profits over growth—and investor preferences.
It’s the beginning of a multi-year transition back toward the real economy, we believe, with at least four important implications for investors:
- Mega-cap tech stocks will no longer dominate as market leaders
- The energy transition needs capital
- Manufacturing companies could outperform
- Active managers can find ample opportunity to pick secular winners
Lessons of history: When equity market leadership has shifted
Today’s market shift in focus from growth to the real economy echoes earlier market transitions. They were catalyzed by wars, new technologies and energy supply shocks, among other forces.
The chart below, which covers nearly 100 years of data, tells the story. Boom cycles occur when new growth opportunities offer high prospective returns (the dark blue sections of the line). As capital flows toward those opportunities, funds become relatively scarce for out-of-favor sectors of the real economy. Eventually, the high-growth areas become oversaturated, and prospective returns move higher in the areas that have been ignored. The cycle then restarts (the teal sections of the line).
Interestingly, while certain economic sectors tend to outperform during growth cycles (notably technology and healthcare), we find no clear pattern of sector outperformance during real economy cycles. Rather, investors tend to favor the dividend factor and generally prefer value to growth equities.
Real economy cycles may include periods of strong growth stock performance. For example, year-to-date, the information technology sector of the S&P 500 is up about 9.5%. This is a notable gain, but in our view, no harbinger of a new growth cycle.
Over time, equity leadership has shifted between "growth" industries and "real" industries
The chart below, which covers 100 years of data, tells the story. Boom cycles occur when new growth opportunities offer high prospective returns (the dark blue sections of the line). As capital flows toward those opportunities, funds become relatively scarce for out-of-favor sectors of the real economy. Eventually, the high-growth areas become oversaturated, and prospective returns move higher in the areas that have been ignored. The cycle then restarts (the teal sections of the line).
The 2010s: Digital asset bullishness, manufacturing shortages
The roots of the recent market shift can be found in the 2010s. Over the decade, investment in physical capital stagnated, even as expected returns to physical capital remained high. To some extent, this made sense. Investment choices reflected the growing value of nonphysical, digital assets such as software.
But in some cases, the gap between investment in physical and nonphysical assets looked extreme. As investors saw nearly unlimited promise in electric vehicles, videoconferencing, cryptocurrencies and the metaverse (among other new endeavors), their perception created an unprecedented gap between the total enterprise value of the corporate sector and its stock of physical assets.
This ratio is known as Tobin’s q (chart below). In the 2010s, investors essentially dismissed the gap between Tobin’s q and investment in physical assets. Instead, they emphasized the value of intangibles. Capital pricing was reasonable, the argument went, because in the digital age, physical capital should make up less of a firm’s overall value.
In the 2010s, physical investment in the corporate sector stagnated, despite high expected returns*
For the rate of physical investment in the corporate sector, it started it dropped to 9% in 1993 before it went back up to a peak of 12.5% in 2000. Shortly after, it declined to 7.6% in 2003. It then climbed back up to 11.4% in 2008 and came back down immediately to 8% in 2009. Then it fluctuated back up to 10.6% in 2012 and came all the way down to 6.6% as of 2020. For the expected returns Tobin’s q, it started low at 1.4 in January 1990 and reached its peak at 3.3 in 1999. Then it came to a bottom at 1.8 in 2008 but bounced back to 3.2 as of 2020.
Manufacturers are reporting shortages as a primary reason for operating below capacity
In March 2013, the insufficient supply of materials was at 5.6% and it rose to 9.8% in September 2018. It stayed relatively flat until it reached 8.8% in June 2020. Then it skyrocketed to 43.7% in December 2021 and came back down a bit to 38.8% as of June 2022. In March 2013, the insufficient supply of labor came in at 6.8%, which rose to 22% in September 2018. Then it trended downward until it reached a bottom of 14.5% in June 2020. Then it climbed all the way to its record high at 45.8% in March 2022 and came back down a bit since to 44.2% in June 2022.
Then came the COVID-19 pandemic. For various reasons (including supply chain issues), shortages of physical items—cars, houses, furniture, energy—emerged or intensified. Yet investors continued to pour capital into speculative assets such as young unprofitable companies (YUCs), special purpose acquisition companies (SPACs) and cryptocurrencies.
Investment in speculative digital assets outpaced physical asset investments from 2015-2020
The left side column shows the investments in speculative digital assets such as SPACs/Crypto/YUCs during the years from 2015 to 2020, which added to a total of 4 trillion dollars. The right-side column shows the investments in physical asset from 2015 to 2020 which was 2.8 trillion dollars.
In many ways the state of the U.S. economy in 2021 resembled the late 1970s period that set off the Volcker shock: Too much demand against limited supply in the real economy.
Like the Fed of the early 1980s, the Fed in 2022 responded with an aggressive tightening cycle. It aimed to force demand back into balance with limited supply, and thus bring inflation to heel.1 Indeed, the 2022 spike in real interest rates ranks as the most dramatic since the Volcker shock.
Real rates are still low historically
The first data point came in January 1960 at 4.1%, which then declined to 2% in January 1961. Later it reached a new high in April 1970 at 4.5% before it dropped back down to a low of 0.7% in October 1975. It soon climbed to a new high at 5.8% in January 1982, and went back down to 1% in October 1991. Then it peaked again at 4.3% in January 2000 before it dropped all the way down and turned negative for the first time in October 2011 at -0.04%. Later it made its way back to a high point of 1% in October 2018 and turned negative again in April 2020 at -0.5% before it came back up to the latest data point of 1.5% as of October 2022.
In 2022 the Fed induced a shock comparable to the early 1980s Volcker shock
The first data point came in at -2% in January 1961 and went up and down until it reached a peak at 2.9% in July 1981 as a result of Volcker Rates Shock. Then it suddenly came to a low of -2.7% in January 1983 before gradually moving back up to a new high at 1.6% in April 1994. It went down to a low of -1.5% in January 2003 and came back to a high of 0.6% in October 2008 before it went back down to -1.5% in January 2012. It then jumped to a peak of 1% in January 2014 and declined to -1.2% in October 2020. Lastly, it went back up to the latest point of 2.4% as of October 2022 in which the 2022 rates shock played an important role.
What’s next? As we consider how the U.S. economy and markets might evolve in the 2020s, we think it’s useful to look back at the 1980s.
IBM and the demise of the 1980s tech stars
The IBM story and the underperformance of tech stocks in the 1980s offer instructive parallels to the current shift in market regime. Then as now, higher interest rates played a critical role as investors turned away from growth stocks and especially the tech stars of the earlier regime.
IBM was the tech darling of the so-called “Nifty 50,” blue-chip stocks (including Avon Products, Coca-Cola and General Electric) that significantly outperformed the broader market in the decades following World War II.2 Investors thought these stocks could be “bought and held forever” and that “no price was too high for them.”3 Sound familiar?
IBM shares delivered a 5x outperformance relative to overall market through the 1950s and 1960s, with the stock peaking at 6x in 1973. IBM shares then collapsed precipitously relative to the market, continuing to fall through most of the 1980s.
IBM’s stock underperformed through the 1980s even as the company commercialized new and innovative products. In 1981, IBM debuted its first personal computer, the IBM PC Model 5150. Notably, it was among the first open architecture PCs: Other companies could produce hardware and software compatible with the PC5150.
Yet, as the chart below shows, the debut of IBM’s PC came in the midst of IBM’s secular underperformance.
IBM peaked in 1973 and continued its secular underperformance through the 1980s*
It’s indexed at 100 for the first data point from January 1945. It rose across the curve until it reached a high of 599 in June 1973 before it went all the way down to 203 in October 1981. It had a short-lived comeback to 351 in December 1984 and had a sharp decline until it reached the bottom at 45 in September 1993. It then climbed back up to a peak at 237 in August 1999 before it declined all the way to the latest datapoint of 59 in July 2022.
To be sure, various factors contributed to that underperformance. IBM, weighed down by a hidebound bureaucracy, made a series of missteps, ceding the computer operating system business to Microsoft (Windows) and the microprocessor business to Intel.
In addition, IBM found itself bogged down in a 13-year Department of Justice antitrust case that began in 1969. The legal battle may have prevented IBM from stifling younger competitors (Apple and Microsoft) in the PC and software industry.4
IBM’s post-1980s evolution is equally instructive. In 1993, a new CEO (Louis Gerstner) took the reins, keeping IBM intact amid calls for a breakup, and by the mid 1990s, IBM stock once again outperformed during the dot-com boom. Over the subsequent decades, through various corporate strategies and business environments, IBM essentially evolved into a stable, cash-flow-generating company.
Today, IBM is categorized as a value stock. Dividends accounted for more than 70% of its total return over the last 20 years (compared with around 20% for the tech sector as a whole).
Might IBM’s trajectory hold lessons for some of the tech darlings of the past decade? We expect so.
Cutting costs and boosting fixed investment in the 1980s
In the early 1980s, dramatically higher interest rates led to sweeping cost cuts, waves of layoffs and what became known as the first “offshoring recession.” Companies improved efficiencies by shifting production outside the United States (Mexico and China were the main beneficiaries). The recession fell hardest on lower-wage workers. While earlier layoffs were typically temporary furloughs, the 1980s brought the first wave of permanent layoffs. A new term, “displaced worker,” entered the lexicon.
Today, companies are again cutting costs in the context of higher interest rates. But unlike the 1980s, recent layoffs appear to be mainly hitting higher-wage workers (at least so far), mostly in the tech sector. Within this sector, layoffs have typically targeted unprofitable units such as the Alexa unit of Amazon or the blockchain/Libra unit at Meta.
The early 1980s recession hit low wage workers hard*
Higher wage workers refers to all employees less production and nonsupervisory, whereas lower wage refers to production and nonsupervisory employees. The data is indexed so that June 1979=100. For higher wage workers, the first datapoint came in at 87 in January 1976 and it went all the way up to 104 in January 1982. Then it declined to 98 in March 1983 before it came back up to 104 in July 1985. It hovered around the same level until the last data point which came in at 104 in February 1989. For lower wage workers, the first datapoint came in at 89 in January 1976 and it reached 100 in 1979 before it declined to a trough at 81 in December 1982. It then came back up to 88 and hovered around the same level until the last data point of 88 in February 1989.
Employment prospects have weakened recently for higher income workers
For those with income greater than $100k, the first data point came in at 37% in January 2014 and reached a peak at 54% in March 2020. Then it went all the way down to a bottom of 29% in June 2021 before it climb back up to 48% in January 2023. For those with income less than $50k, the first data point came in at 41% in January 2014 and since then it was fluctuating downwards until it bottomed out at 32 in December 2019. Soon after, it went straight up to 50 in March 2020 before it went on a downward spiral again until it bottomed at 32 in July 2021. The last data point came in at 36 in January 2023.
Even as U.S. companies downsized their payrolls in the 1980s, they boosted their fixed investments. The pressure to cut costs forced companies to invest in automation and other new technologies. In addition, businesses streamlined their supply chain systems by adopting new conceptual frameworks such as Six Sigma data analytics. (Motorola was the first to implement the program in the 1980s.)5
Just-in-time production, which Japanese automakers introduced and mastered, aimed to make a company’s manufacturing process leaner and more cost-efficient. In the wake of the 1980s U.S.-Japan trade war, Japanese car companies built U.S. factories—powered by just-in-time production—to avoid tariffs on their auto exports. Their U.S. competitors soon adopted their own iterations of just-in-time production.6
Influenced by these shifts, manufacturing productivity growth picked up speed in the 1980s, reflecting the coincident strong fixed investment cycle.
We see clear parallels to today. Amid costs cuts and layoffs, we expect a significant increase in physical investment in the 2020s.
Business investment soared in the 1980s
For the early 80s recession, it came in at 133 at -2 years from cycle trough and it reached its indexed 0 at 0 year from cycle trough, also being the recession year but soon it soared all the way to the peak of 187 at 4 years from cycle trough. For the average of prior 5 cycles, the curve is much smoother as the first data point came in at 106 at -2 years from cycle trough and reached 130 3 years after cycle trough and declined in the fourth year to 123, which was also the last data point.
Manufacturing productivity growth rose in the 1980s
The first data point came in at 2.7% in March 1965, which then fluctuates and declined to a low of 0.8% in December 1981. Then the data trended upward until it peaked at 4.2% in December 1986. Later it declined to 1.9% in June 1991 before it climbed back up again and reached its peak at 5.4% in September 2003. Since then, the data went on a steady decline until it bottomed out at -1.2% in September 2019. It then recovered upward, and the last data point came in at 0.2% in September 2022.
Investor preferences in the 1980s: Shareholder value, dividends, big box retail
As higher rates catalyzed changes in corporate strategy and practice, they also set the table for a shift in investor preferences.
We see the change most clearly in the rise of shareholder value as a new corporate doctrine. CEOs increasingly emphasized boosting shareholder value by making profits and returns the locus of their attention.
Although high interest rates didn’t directly cause the rise of shareholder value, they did force management teams to make their companies’ equity more competitive relative to bonds. Companies thus raised their dividends to make their stock more attractive to investors.7 Dividends rose as a share of corporate earnings and of overall market capitalization in the 1980s.8
Dividends rose as a share of earnings in the 1980s
For Dow Jones, the first data point came in at 53% in December 1955 and it plateaued at 56% in September 1967 and stayed near that level until it dropped to a bottom of 42% in December 1981. It then climbed up again until it got to 54% in March 1994 before it went down and reached a new low of 37% in June 2007. Then it went through a few more short cycles and eventually ended at 41% in September 2022. For S&P, the first data point came in at 57% in December 1955 and it went up to a peak of 64% in March 1965 before it came down to a bottom of 44% in June 1981. Then it went up and peaked at 63% in December 1991 and later came back down again to a new bottom of 39% in September 2004. Shortly after, it went back up to 53% in September 2009 before another decline. The last data point came in at 43% in September 2022.
And as a share of overall market cap
The first data point came in at 4.3% in September 1952 and it trended downward until it bottomed at 2.8% in March 1973. Shortly after, it went on a wild ride until it reached 7.3% in September 1982 before it went back down again to a new low of 2.2% in September 2000. Then it went up again and peaked at 5.2% in June 2009 before it came back down and ended at 3% in September 2022.
We can see other shifts in investor preferences in the 1980s. Against a backdrop of higher interest rates, investors favored value stocks over growth stocks and sought attractive dividend payouts. High-dividend stocks outperformed both the tech sector (including IBM) and low-dividend stocks in the 1980s (charts below).
New investment themes emerged. Chief among them: big box retail, led by fast-growing Walmart and Home Depot, which benefited from corporate cost-cutting, globalization and automation.
Big box retailers also got a boost from the 1980 Motor Carrier Act that deregulated the U.S. trucking industry. This law slashed the cost of moving goods around the United States by bringing more competition into the sector. Companies that were able to take advantage of the reduction in shipping costs thrived.
So too did their stock prices.
The value factor outperformed growth in the 80s
The first data point started at 100 in January 1945, and it went on an upward ride until it reached 1219 in June 1998. It then had a short-lived pull back until it bottomed at 724 in February 2000. Then it rose again until it reached the peak at 1947 in March 2007. Soon after it went on a long decline until it got to 824 in September 2020. It then had a nice increase until the latest data point of 1356 in October 2022.
And high dividend stocks outperformed both the tech sector and low dividend stocks more generally*
On a separate line, it shows the performance ratio of stocks in the top 20 percentile of dividend yield relative to tech sector. Both lines are indexed at 100 as of Q1 1945. For the top 20 percentile of DY vs the bottom 20 percentile of DY, the first data point came in at 100 in Q1 1945. Then it climbed to a high of 247 in Q4 1977 before it dropped to a low of 124 in Q4 1980. Then it rose again to 288 in Q1 1990 and fell again to 154 in Q1 2000 after which it went on a big rise until it peaked at 487 in Q3 2012. It then had a drawdown and bottomed at 251 in Q3 2020. The latest data point came in at 362 in Q3 2022. For the top 20 percentile of dividend yield relative to tech sector, the first data point came in at 100 also as indexed in Q1 1945. It trended downward and bottomed at 55 in Q1 1970 after which it had a big rally until it peaked at 281 in Q2 1992. Then it declined again and bottomed out at 60 in Q1 2000. Shortly after, it went back up again and topped at 338 in Q1 2007. Then it swinged back down and ended at 143 in Q2 2022.
By any measure, Home Depot and Walmart dramatically outperformed. In the 1980s, the tech sector trailed the overall market by about 50%, while Home Depot and Walmart outperformed by 1,200% and 460%, respectively.
Home Depot and Walmart emerged as new outperformers in the 1980s*
For Home Depot, going from the index level of 2, the relative total return rose from 2 in September 1981 to a peak of 4.1 in December 1999. Then it went down until it reached 3.4 in July 2008 before another long rise until the latest datapoint of 4.1 in September 2022. For Walmart, going from the index level of 2, the relative total return rose from 2 in September 1981 to a peak of 3.2 in December 1999. Then it trended slightly downward for the later years until the latest datapoint which came in at 2.9 in September 2022. For IBM, going from the index level of 2, the relative total return rose slightly to 2.2 in February 1985 before going on a long decline until it bottomed at 1.3 in September 1993. It came back up to 2 in May 1999 and stayed relatively flat until it got to 1.9 in November 2011. Then it went on a slow decline and the latest datapoint came in at 1.4 in September 2022. For the tech sector, also going from the index level of 2, the relative total return for the tech sector has remained nearly flat for the entire data series. First it went down to 1.7 in August 1992 and deviated from the flat line when it peaked at 2.3 in March 2000. For the rest, it has been flat between 1.5 and 2 and the data series ended at 1.9 in September 2022.
Investment implications
What does the shift in market regime mean for your portfolio?
First, if you loaded up on growth stocks during the past decade, your portfolio may not be best positioned to benefit from the change in market regime.
Although it is still in the early days, we think a real economy cycle will give investors the incentive to direct capital into addressing the needs and stresses that have emerged in a wide range of sectors. These include traditional and clean energy, housing, infrastructure and manufacturing.
Investors may continue to prefer companies that deliver consistent real returns to shareholders in the near term, instead of those that prioritize growth at all costs. Management teams will likely renew their focuses on profitability and return to shareholders.
We see four important implications for investors:
- Mega-cap tech stocks may no longer dominate as market leaders. One corollary: Investors should consider prioritizing cash return.
The addressable markets targeted by the past cycle’s mega-cap tech leaders look increasingly saturated. Certainly, their pre-2022 growth rates seem unsustainable. Investors will likely view these stocks as funding sources for investments in other areas. Companies that made ill-considered capital investments in nascent digital growth initiatives, as opposed to those focused on shareholder return, may be particularly at risk.
On the other hand, we think investors will embrace real economy stocks (industrials, commodities, the energy sectors, and other sectors that have prioritized shareholder return over expansion). Similarly, dividends and dividend growth will likely be valued by investors who increasingly view fixed income as a viable alternative to stocks. At the same time, some contingent of the past cycle’s tech leaders will—like IBM in an earlier era—make the transition into a stable, steady grower and high-dividend stock. - The energy transition needs capital. Traditional energy companies have maintained capital discipline and prioritized shareholder return. Going forward, they should still provide investors with attractive dividend and cash flow yields, and relatively undemanding valuations. But the transition to clean energy is very much underway. It will require significant capital in the coming years, and is likely to benefit from government policy support and incentives. The transition offers compelling growth opportunities for long-term investors, we believe.
- Manufacturing companies could outperform. Even though inflation is normalizing, shortages in the real economy still exist. The companies that produce semiconductors, homes and housing-related materials, battery storage facilities, infrastructure and machinery could enjoy a durable tailwind. Small- and mid-cap companies also tend to do well during periods of elevated capital expenditures.
- Active managers should find ample opportunity to pick emerging secular winners. Market indices have become more concentrated in recent years, as the largest companies make up a growing share of, say, the S&P 500. As Michael Cembalest has written,9 central bank policy in the wake of the 2009 recession led to collapsing risk premia and falling relative valuation spreads in equities and risky credit markets.
We expect increased dispersion within equity markets. One key reason: Real economy cycles feature more variability of top performing sectors compared with growth cycles, when returns historically have been concentrated in technology and healthcare. Greater dispersion could enable active managers to deliver excess returns relative to market-cap-weighted benchmarks.
Finally, as companies and investors redirect and redeploy capital, we think active managers can potentially identify the emerging secular winners of the unfolding real economy cycle (just like those who were able to spot the theme of big box retail in the 1980s). That could be a trend with enduring long-term power.
We can help
When market regimes change, it is important to consider a wide array of investment options. Your J.P. Morgan team can help you evaluate what equity strategies may help you achieve your long-term goals.
1We note one important difference between the late 1970s and today: Inflation expectations continue to be anchored at the Fed’s 2% inflation target, whereas in the 1970s, inflation expectations became de-anchored to such a degree that the Fed (arguably) had no choice but to engineer a deep economic downturn to crush inflation. Today’s anchored inflation expectations suggest the Fed has more flexibility than it did in the late 1970s. In the view of many economists, today’s anchored expectations also signal that a recession in 2023, should it occur, likely would not be as deep as the early 1980s recession.
2A full list of Nifty 50 stocks can be found here: https://en.wikipedia.org/wiki/Nifty_Fifty.
3John Brooks, The Go-Go Years: The Drama and Crashing Finale of Wall Street's Bullish 60s, Wiley, 1989.
4 https://www.vox.com/the-goods/2018/11/8/18076440/facebook-monopoly-curse-of-bigness-tim-wu-interview.
5 https://www.brighthubpm.com/six-sigma/69048-the-relationship-between-motorola-and-six-sigma/.
6 Gary Clyde Hufbauer and Euijin Jung, “Scoring 50 Years of US Industrial Policy,” Peterson Institute for International Economics, November 2021, page 31
7Yener Altunbaş Blaise Gadanecz and Alper Kara, “The evolution of syndicated loan markets,” The Service Industries Journal Volume 26, Issue 6, January 25, 2007. Along with high interest rates, the explosion of leveraged buyouts (LBOs) in the 1980s spurred many management teams to boost their dividends (and deploy various “poison pills”) to stave off hostile bidders. Amid a wave of corporate restructurings, LBOs became an efficient way to bring in new management, cut costs and raise dividends. Almost non-existent in 1980, LBOs accounted for more than 400 deals totaling more than $180 billion in transaction volume (3.5% of GDP) by 1988. Over the years, LBOs evolved to become the modern private equity sector.
8Share buybacks also rose in the 1980s following the 1982 SEC rule change that established “safe harbor” guidelines for companies engaging in buybacks. Specifically, the rule change provided a framework for companies to repurchase their own shares without running afoul of securities laws. Buybacks didn’t become a dominant feature of returns until the 2000s, when there was a secular rise in the share of companies buying back their stocks (to 53% by 2018 from 28% in 1980). See: https://www.spglobal.com/spdji/en/documents/research/research-sp-examining-share-repurchases-and-the-sp-buyback-indices.pdf.
9Michael Cembalest, 2023 Eye on the Market Outlook, Jan. 1, 2023
