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The 1982–2000 Great Moderation
Eighteen years. +1,165% total return. The greatest wealth-creation window in American history.
From 102.42 on August 12, 1982, the S&P 500 ran to 1,527.46 by March 24, 2000. Fifteen times the starting value in eighteen years. With dividends reinvested, closer to twenty-two times. No other secular bull in American history, not 1949-1966, not 1921-1929, not any smaller window from any era, delivered compounding returns at that scale over that long a period.
Three forces drove the arc. Interest rates fell relentlessly, compressing from fifteen percent to three as inflation stayed low and the Federal Reserve under Paul Volcker and Alan Greenspan earned the market’s trust. The personal computer, the mobile phone, and the internet arrived in sequence, built the three largest fortunes in the world, and reshaped every industry they touched. And the Cold War ended, the Berlin Wall fell in 1989, the Soviet Union dissolved in 1991, releasing a trillion-dollar peace dividend and expanding American capitalism into markets it had never served.
Only three cyclical phases interrupted the arc: the greatest bull from 1982 to Black Monday 1987, the four-month flash crash of 1987 itself, and then twelve-and-a-half years of V-shaped recovery that would end at the top of the largest valuation bubble in American history. The investors who held through all of it, through Black Monday, the Gulf War, the Mexican peso crisis, LTCM, Y2K, made the compounding returns that would define the Baby Boomers’ retirement wealth. The ones who waited for the right moment to buy, mostly, waited too long.
Numbered bands mark each cyclical phase; the sections below walk them in order. On measurement: we use the S&P 500 throughout this series rather than the Dow Jones Industrial Average. The S&P samples five hundred companies against the Dow’s thirty; it is the only common ruler that spans every secular era from 1929 to today.
1
▲ CYCLICAL BULL
The Greatest Bull Begins
Sixty months. Up 211%. The Reagan boom, the PC revolution, and the LBO era arrive together.
On August 13, 1982, one day after the Mexico default confirmed the Latin American debt crisis and one day after the S&P 500 touched its 102.42 secular low, the market opened up two-point-six percent. Within three months it would be up thirty. The combination of Paul Volcker’s inflation victory and Ronald Reagan’s 1981 tax cuts had broken the macroeconomic deadlock of the 1970s. Interest rates were going to fall for the next forty years. Marginal tax rates had been cut from seventy percent to fifty. Corporate profit margins, released from the pressure of input inflation, could finally expand. And the generation of Americans that had come of age during the 1970s stagflation suddenly had a reason to re-enter the equity market.
The technology arrived on schedule. On January 26, 1983, Lotus 1-2-3 shipped for the IBM PC and became the first truly useful application outside of word processing, a spreadsheet that corporate America could install at every desk, which Lotus did, becoming a billion-dollar company in eighteen months. On January 24, 1984, Apple ran its “1984” Super Bowl commercial and introduced the Macintosh. On October 22, 1986, the Tax Reform Act collapsed fifteen brackets into two and dropped the top rate from fifty to twenty-eight percent, the single largest base-broadening tax simplification in American history, achieved through a bipartisan coalition that neither party could reconstruct afterward. The merger-and-acquisition boom was already underway: Michael Milken at Drexel Burnham had built a market for high-yield debt that financed the leveraged buyout era (RJR Nabisco, Beatrice Foods, Federated Department Stores) at scales that had been inconceivable a decade earlier.
The S&P 500 ran from 102.42 to 336.77 over sixty months, a 229 percent gain, almost tripling. The Dow Jones crossed 1,000 permanently in late 1982, 2,000 in January 1987, and 2,700 in August 1987. Price-to-earnings multiples, which had bottomed at seven in 1982, had reached twenty-three by August 1987. Portfolio insurance, a derivatives-based strategy that promised to hedge equity exposure by dynamically selling stock-index futures as the market fell, had been sold to over sixty billion dollars of pension-fund assets by 1987. The strategy worked beautifully in simulations. It had never been tested in a real decline.
On October 19, 1987, it would be tested in the largest single-day percentage decline in Wall Street history.
“The strategy worked beautifully in simulations. It had never been tested in a real decline.”
2
▼ CYCLICAL BEAR
Black Monday
Four months. Minus thirty-three percent. The fastest full cyclical bear on record.
The week of October 12, 1987 began with the market already nervous. Treasury Secretary James Baker had publicly feuded with West German counterparts over interest-rate coordination; the trade deficit for August, reported on October 14, had come in worse than expected; the market fell 3.8 percent Wednesday, 2.4 percent Thursday, and 5.2 percent Friday, the worst week in postwar history, going into a weekend when portfolio managers reviewing their positions decided to reduce exposure Monday morning. Portfolio insurance algorithms, programmed to sell futures as the market fell, began selling Sunday night in Asia. By the time New York opened on Monday October 19, the futures market was in free fall and the equity market opened down three percent before the first NYSE order filled.
What followed was the largest single-day percentage decline in Wall Street history. The Dow Jones Industrial Average fell 508 points, twenty-two-point-six percent in one session, approximately twice the worst Depression-era one-day decline. The S&P 500 fell twenty percent. Volume reached 604 million shares, triple the prior record. The specialist system on the NYSE floor nearly broke; some specialists ran out of capital to make markets in the stocks they were obligated to make markets in. The futures market disconnected from the cash market as portfolio-insurance selling overwhelmed the ability of index arbitrageurs to transmit prices back. By 4 PM many retail brokers were unreachable by telephone.
On Tuesday October 20, before the opening, Federal Reserve Chairman Alan Greenspan, who had taken office exactly two months earlier, issued a one-sentence statement: “The Federal Reserve, consistent with its responsibilities as the Nation’s central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system.” He meant it operationally. The Fed flooded the banking system with reserves, ordered the money-center banks to keep lending to brokerage firms, and privately coordinated support from major Wall Street houses that would otherwise have cut credit to their counterparties. The Tuesday rebound was five-point-nine percent on the Dow. By December 4 the S&P 500 had reached its final low at 223.92, down thirty-three percent peak-to-trough but already in a V-shaped recovery. The “Greenspan Put”, the implicit promise that the Fed would provide liquidity whenever the market demanded it, had been established on its second trading day.
What followed was twelve-and-a-half years of uninterrupted bull market, the single greatest wealth-creation window in American history.
“The ‘Greenspan Put’, the implicit promise that the Fed would provide liquidity whenever the market demanded it, had been established on its second trading day.”
3
▲ CYCLICAL BULL
The V-Shaped Decade
Twelve-and-a-half years. +582%. The Cold War ends, the internet arrives, and American capitalism briefly convinces itself it has won.
On November 9, 1989, East German border guards, without instructions, acting in the confusion of a Communist bureaucracy that had announced liberalized travel rules without specifying when they took effect, stepped back and let a crowd of East Berliners walk through the Berlin Wall into the West. The wall had stood twenty-eight years. Within hours, Germans on both sides were climbing it with sledgehammers. Within two years, the Soviet Union itself would dissolve, on Christmas Day, 1991, Mikhail Gorbachev resigned as president of a country that had already stopped existing. The Cold War that had defined every element of American foreign and economic policy for forty-four years was over, and the United States was going to spend the next decade figuring out what to do with the peace dividend.
What it did was absorb a mild 1990-91 recession (triggered by the August 1990 Iraqi invasion of Kuwait and the oil-price doubling that followed), elect a Democrat in 1992 on the campaign slogan “It’s the economy, stupid,” and then enter the longest sustained economic expansion in American history. Bill Clinton signed NAFTA in December 1993, raised taxes on the top bracket in 1993, cut the capital gains rate in 1997, and presided over a federal budget that moved into surplus by 1998, the first surplus since 1969. The Federal Reserve under Alan Greenspan raised rates sharply in 1994 in a preemptive strike against inflation that triggered a bond-market massacre and the Mexican peso crisis of 1994-95, then eased through the late 1990s as productivity growth from information technology absorbed inflation without triggering it.
And the technology arrived in a wave the United States had not seen since the 1920s. On August 9, 1995, Netscape Communications went public at an offering price of twenty-eight dollars, opened at seventy-one, and closed at fifty-eight on its first day of trading, a company founded sixteen months earlier, with revenue of eighteen million dollars and no profits, briefly worth two-point-two billion. The dam broke. Over the next five years, more than four hundred internet companies would IPO, and investment capital of a scale that had previously financed railroads and electrification would flow into companies named Pets.com, eToys, Webvan, and Theglobe.com. The S&P 500 ran from 660 at the end of 1995 to 1,527.46 on March 24, 2000. The Nasdaq Composite ran from 1,000 to 5,048.62 over the same window, a five-fold increase in four years. Price-to-earnings multiples on the S&P 500 reached thirty. On the Nasdaq, forty percent of the companies in the index had no earnings at all.
What ended the era was its own excess. In early 2000 a wave of mutual-fund redemptions and tax-driven profit-taking collided with the first serious internet-sector bankruptcies, a dozen dot-coms would fail in April alone. The Fed had raised rates five times in 1999-2000 to deflate the bubble, bringing the federal funds rate to six-and-a-half percent by May. On March 24, 2000, the S&P 500 made its final high at 1,527.46. Within two years the Nasdaq would be down seventy-eight percent, the S&P 500 down fifty, and three-point-eight trillion dollars of American household wealth would be gone.
What was waiting was a thirteen-year sideways grind, two cyclical bears averaging over fifty percent, and the single greatest central-bank intervention in American history.
“On the Nasdaq, forty percent of the companies in the index had no earnings at all.”
Eighteen years. The index fifteen-folded. The Cold War ended. The internet arrived. Three generations of American retirement wealth were created.
The 1982-2000 secular bull was the economic consequence of winning the inflation war. Volcker’s 1979-82 shock broke the back of expectations-driven inflation; Reagan’s 1981 tax cuts and 1986 reform rebuilt corporate-investment incentives; the end of the Cold War released a trillion-dollar peace dividend; and the information-technology revolution delivered productivity growth at a rate the US economy had not seen since the 1920s. Interest rates compressed from fifteen percent to three. Price-to-earnings multiples expanded from seven to thirty. Both compounding effects worked on the same cash flows at the same time.
Investors who entered equities in 1982 and held through all three cyclical phases earned returns that, properly compounded with dividends, would have turned ten thousand dollars into roughly a quarter-million. Investors who waited for the right moment to buy, after the 1987 crash, after the Gulf War recession, after the 1994 bond massacre, after LTCM, mostly waited too long.
The lesson of the Great Moderation is not that the Fed can always catch the market. The lesson is that when the ruler is being disinflated instead of inflated, equity capital compounds under favorable mathematics for the entire ride. Just as the inflation of 1966-1982 destroyed real returns regardless of what any investor did, the disinflation of 1982-2000 generated real returns regardless of what headline anyone panicked at.
The Lost Decade
The 1980s and 1990s had taught the Baby Boom generation that stocks always come back, that patience was rewarded, that buy-and-hold worked, that the Greenspan Fed would catch any fall before it mattered.
The next thirteen years would challenge every one of those assumptions. The S&P 500 would fall forty-nine percent, recover for five years, then fall fifty-seven percent in a global financial crisis so severe that the Federal Reserve would effectively guarantee every money-market fund in the United States and acquire four trillion dollars of long-dated Treasuries and mortgage-backed securities. Investment banks that had been around since the Civil War would disappear in a week. The U.S. government would take 80 percent of AIG and the senior claim on Citigroup and General Motors.
And when it was over, the index would be below where it started. Chapter five.
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