With prices rising and economic growth slowing, many investors are looking to the past in a bid to divine where U.S. markets might be headed next.
While the "stagflation" of the 1970s brings back memories, investors may want to revisit the mid-2000s instead.
In both periods, energy prices, inflation expectations and bond yields rose, alongside anemic growth and central banks moving toward tighter monetary policy. The mid-2000s were, however, far milder.
While all economic and market cycles are unique — none more so than the last 18 COVID months of recession, rebound and inflation caused by supply bottlenecks and shortages — the conditions that exist today are more akin to the ones that occurred in 2005.
Like 2005, U.S. equity valuations are now gently falling. The S&P 12-month forward price/earnings ratio is now around 20.5, down from over 23 a year ago, mirroring the decline to 14 from 16 over the course of 2005.
That downward drift continued into 2006. Given that P/E ratios are still historically high, there is every reason to expect this trend extending into next year, and potentially accelerating if guidance from third-quarter earnings is gloomy.
The S&P 500 experienced two mini-corrections in 2005, the first of 8% in March-April and then a 6% drawdown in September-October. The index just had its first 5% fall in almost a year and, according to nearly two-thirds of more than 600 market professionals recently surveyed by Deutsche Bank, a 5 to 10% correction by year-end is in the cards.
Some analysts have started to point to the mid-2000s as a possible case study. Morgan Stanley's Andrew Sheets wrote in a note last week that 2005 was "an interesting, recent example of a stagflation scare after a mid-cycle transition."
