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Economy & Markets

A shift in market leadership

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

This chart shows the relative performance of high dividend stocks to business equipment stocks from 1933 to 2022.
Source: Tuck/Dartmouth as of January 1, 2022.

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*

The chart shows two separate lines with one line representing the rate of physical investment in the corporate sector (shown on the left axis) and the other representing Tobin’s q (shown on the right axis).
Source: Compustat. Data as of January 13, 2023.
*Data measures the nonfinancial corporate sector and comes from "The Economics of Intangible Capital" by Crouzet, Et Al.

Manufacturers are reporting shortages as a primary reason for operating below capacity

This chart describes two lines of data from Bureau of Labor Statistics, one is the insufficient supply of materials and the other one is the insufficient supply of labor.
Source: Bureau of Labor Statistics, Haver Analytics. Data as of January 17, 2023.
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 chart shows the investments in speculative digital assets vs physical asset from 2015 to 2020.
Source: Bloomberg Finance L.P., Haver Analytics, and Statista. Data as of December 2020.

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 chart shows the real rates since January 1960 and this shows quarterly data since then.
Source: Goldman Sachs. Data as of January 13, 2023.
*Backcast of inflation expectations comes from "Introducing a backcast history of traded inflation" by William Marshall

In 2022 the Fed induced a shock comparable to the early 1980s Volcker shock

This chart shows the YoY percent change of 10-year real interest rate since January 1960.
Source: Goldman Sachs. Data as of January 13, 2023.

*Backcast of inflation expectations comes from "Introducing a backcast history of traded inflation" by William Marshall

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*

The chart shows IBM total return relative to the average of the overall market.
Source: Bloomberg, Tuck/Dartmouth. Data as of January 13, 2023. *Prior to 1968, IBM's total return is proxied by the Computers sector. Overall market refers to an average across the 30-industry portfolio.

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*

The chart shows the index of manufacturing employees since 1976.
Source: Bureau of Labor Statistics, Haver Analytics. Data as of January 13, 2023.

*Higher wage workers refers to all employees less production and nonsupervisory, whereas lower wage refers to production and nonsupervisory employees.

Employment prospects have weakened recently for higher income workers

This chart describes the probability that unemployment rate will be higher in the next year since 2014 for workers with income greater than $100K and for workers with income less than $50K.
Source: New York Federal Reserve, Haver Analytics. Data as of January 31, 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

The chart shows real nonresidential fixed investment indexed at 100 at the year of recession. There are two lines with one representing the early 80s recession and the other one being the average of prior 5 cycles.
Source: BEA, Haver Analytics. Data as of January 13, 2023.

Manufacturing productivity growth rose in the 1980s

This chart describes real manufacturing output per hour since 1965 until 2022.
Source: BEA, Haver Analytics. Data as of January 13, 2023.

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

The chart shows the 10-year moving average of the dividend payout ratios of two indices, Dow Jones Industrial Average and S&P 500.
Source: S&P, Dow Jones, Haver Analytics. Data as of January 13, 2023.

And as a share of overall market cap

The chart is about the 4-quarter moving average of dividends paid as share of market cap.
Source: Federal Reserve, Haver Analytics. Data as of January 13, 2023.

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 chart shows the value/growth performance since January 1945 indexed at 100.
Source: Tuck/Dartmouth. Data as of January 13, 2023.

And high dividend stocks outperformed both the tech sector and low dividend stocks more generally*

The chart shows the performance ratio of stocks in the top 20 percentile of dividend yield relative to stocks in the bottom 20 percentile of dividend yield.
Source: Tuck/Dartmouth. Data as of January 13, 2023. *DY stands for dividend yield. Tech sector is proxied by the Business Equipment industry in the Tuck/Dartmouth.
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*

The chart shows the total return of three companies and the tech sector (Home Depot, Walmart, IBM, and Tech Sector) relative to market average since 1981, indexed at 2 for September 1981.
Source: Bloomberg, Tuck/Dartmouth. Data as of January 13, 2023. Tech sector is proxied by the Business Equipment industry in the French data. Market average refers to average across the 30-industry portfolio.

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:

  1. 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.
  2. 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.
  3. 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.
  4. 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. 

  • We 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.
  • A full list of Nifty 50 stocks can be found here: https://en.wikipedia.org/wiki/Nifty_Fifty.
  • John Brooks, The Go-Go Years: The Drama and Crashing Finale of Wall Street's Bullish 60s, Wiley, 1989.
  •  https://www.vox.com/the-goods/2018/11/8/18076440/facebook-monopoly-curse-of-bigness-tim-wu-interview.
  • https://www.brighthubpm.com/six-sigma/69048-the-relationship-between-motorola-and-six-sigma/.
  • Gary Clyde Hufbauer and Euijin Jung, “Scoring 50 Years of US Industrial Policy,” Peterson Institute for International Economics, November 2021, page 31
  • Yener 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.
  • Share 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.
  • Michael Cembalest, 2023 Eye on the Market Outlook, Jan. 1, 2023

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