A key part of my recent research has been the link between energy prices, the economy and stock markets. Today, I will try to establish the existence of a roughly 30-year energy cycle, which my hypothesis says is the key driver of the global financial cycle.
To begin, let’s do a brief recap of the findings in my last report. The red line in the chart below is the ratio between the S&P 500 price index and the WTI price for oil, detrended by the post-1900 1.3% growth rate. The detrended ratio is mean reverting: there are times when the market is expensive versus oil and times when it is cheap, but it always heads back to the mean.
Below are my key conclusions so far, which I reiterate to show the relationship between energy prices and the creation of value in the economic system:
- Inflationary periods (blue shading) mean that inflation in the last two years grew faster than in the last 10 years. This happens when the market to-oil ratio (red line) is falling, meaning energy prices are rising.
- Bear markets occur at the end of inflationary periods, when oil prices have, by definition, been on the rise. They enter Ursus magnus territory (a sustained bear market with a peak-to-trough decline of -50% or deeper) when the market-to-oil ratio is below 60 (e.g. 1948, 1979, 2009-2012). • When the S&P rises faster than the oil price, the economy enjoys a “deflationary boom”, the bottom right of my “four quadrants” framework (see Four Quadrants: A Wicksellian Analysis). During these periods, which are unshaded in the chart above, investors should hold long duration equities and bonds, and avoid gold and scarcity assets. Inflationary periods only occur when energy prices are on the rise During a deflationary boom, investors should avoid gold and scarcity assets.
- Bubbles always occur towards the end of deflationary booms, when the market-to-oil ratio moves above 210 (e.g. 1966, 2000, 2021).
- Moves in the market-to-oil ratio have often been violent. An exception to this was in the 1930s, when economic activity and the price of oil fell in tandem for quite a while. The deflationary bust (bottom left of the four quadrants) of the ‘30s lasted much longer than later deflationary busts.
- However, the price movements of oil itself tend to occur over a much longer period of around 20 years.
- We are back in a period of rising energy prices, placing the US economy in the top two quadrants, cycling from inflationary boom to inflationary bust. Bonds and equities are positively correlated in such periods; and as a result, risk-parity funds are a disaster.
Having completed this work, I was pleased with myself (always a bad sign) and began to muse on possible new research topics. But at this point, I realized the key insight of my work on the energy/equity link: there is likely a 30-year cycle linking US stock market returns and energy prices.
- There has never been an inflationary period when energy was cheap and rising less quickly than the S&P 500. So much for central bank activity! Inflation is therefore not the direct result of central banks printing money, but of energy prices rising too quickly. Of course, rapidly increasing energy prices may themselves be the result of too much money printing.
- Every energy crisis has so far taken place 30 years after the previous one: 1920, 1950, 1980 and 2010. This cycle seems to be holding, as the ratio has already begun its descent to a potential 2040 nadir.
My understanding of the capitalistic cycle therefore runs as follows:
- We start with an energy crisis and therefore energy prices rise significantly.
- The return on invested capital for energy production rises for fossil fuels and falls for energy consumption. There is a bear market in “efficiency” equities and a bull market in “scarcity” assets.
- The high ROIC earned by energy producers spurs a big increase in capital spending for the sector and a big fall in the capital spending of energy consuming industries. A recession ensues.
- After a few years, demand and supply for energy begins to balance out as demand falls and supply increases. Oil prices start to fall, resulting in the market-to-oil ratio turning upward. The disinflationary boom begins.
- In the following 15-20 years, energy is plentiful. Capital spending in the sector plunges and surges elsewhere. Investors should seek out the “innovative” new technologies that rely on this cheap energy.
- Nobody invests in energy. It is time to buy hedges against the next energy crisis using gold or long-dated bonds issued by countries that have kept investing in energy production (today, Russia and China).
- Wash, rinse and repeat.
In order to “prove” this 30-year cycle theory, consider the chart below.
In red is the now-familiar market-to-oil ratio. In blue is the same ratio, pushed forward by 15 years and inverted. What it shows is simple: the previous cycle is a good forecast of the next cycle. If true, the forecast is grim: the next 10-15 years look as if they will be very hard for most markets. The exception is those, like China and Russia, that kept investing in energy production.
The scale of the coming stock market falls can be guesstimated with the chart overleaf: it replaces the S&P 500-to-oil ratio with the Shiller P/E ratio.
At the bottom of the last Ursus magnus—which took place when oil peaked versus the S&P—the Shiller P/E remained below 10. This is not encouraging: as energy prices rise, it will become hard for earnings to grow structurally.
We have seven lean years in front of us and I am already seeing many miserable looking cows, some of which were unusually fat only a year ago. I conclude that investors should avoid illiquid assets, as there is a time to make money and a time to lose as little as possible. I suspect we have entered the latter period, so it is time to fire the offensive team and bring in the defensive one.
Investors should follow a number of my fairly longstanding recommendations and overweight fossil energy, gold and Chinese government bonds. They should sell long-dated assets with a negative real return such as US and European government bonds. They should also sell US corporate bonds as spreads are widening and get out of energy-intensive assets. They should raise cash and put it in Emerging Asian currencies and buy call options on the yen.
I suspect this energy crisis will badly dent economic growth, and so corporate earnings. Higher energy prices are a tax on the consumer, and I am almost certain that the political choice made in favor of renewable energy sources will lead to massive blackouts. Watch California.
But the apex of the crisis will be the eurozone. Demand should collapse due to tax hikes and the shuttering of the nuclear industries in Germany and Belgium. But even in this grim situation, the existing energy stock will likely fail to satisfy demand and power outages will occur.
To badly paraphrase Winston Churchill: “Never in the field of energy policy has so much been wasted by so few [ecologists]”. Compared to the next few years, the 1973-74 equity crash could look tame. I say that as someone who experienced the early ‘70s bust, and never fully recovered psychologically.