Tea Leaves, Anyone?
BY: JIM McELROY, CFA
How will we know when the longest running bull market in stocks (or second longest, depending on the index) has finally run its course? The short answer is when the market declines by 20% or more, but that of course isn’t very helpful. What we really want to know is when the market will peak so that we can take our profits, invest them in something stable, and wait for the next bull market to begin. Unfortunately, there is no marker, statistic or digitized crystal ball that can provide us with that kind of certainty.
Markets are driven by the sum of all the opinions of individual investors and are often only occasionally informed by economic information. They are a study in mass psychology: it’s not only that to be successful one must accurately predict future news, but that one must also accurately predict the timing and direction of the market’s response to that future news. A somewhat cynical take on this issue is that one doesn’t necessarily need to know the future as much as to know when and if the market will come to believe that it is the future.
For example, a forecast that GDP for the current quarter will be up 5% (not, by the way, our forecast) would encourage investment if we knew it to be accurate, if we knew that the market had not already priced in this forecast and if we knew that the market’s response to rapid growth would not be fear that the Fed would raise interest rates to dampen inflation.
It’s never been easy to predict the future, but that doesn’t prevent us from trying. And although there are no flawless indicators, there are many statistics and relationships that have some history of success in predicting market direction. They’re certainly stronger indicators than tea leaves or haruspex (divination by analyzing the entrails of sacrificial animals)!
Bear markets tend to precede recessions by a time period somewhere between six months and a year. It would therefore seem logical to look to predictions about GDP and corporate earnings to get an idea of market direction.
There are several indices of leading indicators that purport to forecast recessions and expansions, but the Conference Board’s Index of Leading Economic Indicators (LEI) is probably the best known. The LEI is published every month and is based on the previous month’s readings of ten indicators believed to be accurate predictors of economic activity. Included among these indicators are the money supply (M2), the interest rate spread between ten-year U.S. Treasuries and Federal Funds, consumer expectations, manufacturers’ new orders, supplier deliveries, employment data, building permits and stock market performance.
A sharply falling LEI is a good predictor of a faltering and/or recessionary economy in the near future. Unfortunately, “the near future” is too short a period to be useful in avoiding a bear market. Since the stock market is itself a predictor of economic activity — it’s in the LEI, after all — by the time the LEI flashes red, the stock market has often already reacted.
This issue of timing, the hair-trigger response of the market to new information, makes it very difficult to invest on the basis of published economic statistics. At best, these statistics provide context to the investment environment by suggesting what the market is already discounting. According to this logic, the market somewhat agrees with the LEI, which is signaling no domestic recession in the near term. Any news or suspicion of news to the contrary would certainly precipitate a market decline.
Similar to the LEI in forecasting recessions is the shape of the yield curve, or the difference in yield between long term bonds and short-term paper. The argument runs that whenever this difference is negative — yields on cash equivalent funds are higher than those on long term bonds — then banks, which borrow short and lend long, have no incentive to make loans. Liquidity dries up, the overall economy becomes risk averse and a recession is on its way. This “inversion” between short term and long-term paper does not happen very often, but when it does, and remains in place for an extended period (months, not days), it generally precedes a recession.
The last four U.S. recessions were preceded by an inverted yield curve, although the last one, the Great Recession of 2008, occurred two years after the yield curve first inverted. Recently (March 22nd), the yield curve inverted when the ten-year Treasury yield dropped below the three month T-Bill. The S&P 500 lost almost 2% for the day. If this inversion were to continue over the next few quarters, the odds of a recession in 2020 and a bear market six months earlier would increase dramatically. For now, however, our best advice is to remain cautious.
Faced with lightning fast market efficiency — the market’s almost instantaneous assimilation of public and not so public information on the economy — many investment professionals prefer to focus more on psychology than on facts. This approach, often called technical analysis, looks at various market statistics (e.g. share volume on positive and negative trading days, prices above or below 200 day moving averages, ratio of puts to calls on market index options, etc.) and tries to predict the future sensitivity of the market to positive or negative changes in expectations. Much of this is predicated on the notion that market behavior can indicate the degree of fear or greed in the market and therefore distinguish mere reversals in price action from true bull and bear markets.
Technical analysis has a controversial reputation: analysts who put their faith in forecasting economic activity and corporate earnings (sometimes called fundamental analysts) look upon technical analysis as little more than the aforementioned haruspex. That being said, technical analysis is one of the few indicators that considers investor psychology — how the market might respond to future information — and as such it has value. Currently, these indicators suggest that the bull market will continue, but warn that psychology is approaching overconfident territory. Disappointing news to overconfident investors could have very negative consequences.
Markets that become overconfident and therefore vulnerable to a change in attitude can push stocks to extremes of valuation. Probably the most commonly used measure of valuation is the ratio of stock prices to earnings or the P/E multiple. P/Es increase as investors impute higher earnings growth rates to stocks and/or greater certainty about the accuracy of those growth rates; lower growth rates and/or lower certainty will push P/Es lower.
While it might make sense that P/E multiples over a certain level should indicate a vulnerable market and therefore a cue to begin taking defensive measures, history has not supported this approach. As Keynes once remarked, “markets can remain irrational longer than you can remain solvent.” And in fact, the multiples for the S&P 500 are far from irrationally high: 16.7 times forward earnings and 18 times trailing earnings (the averages for the last 35 or so years were 14.8 and 18.4 respectively).
So, where does that leave us? There are no secret clues to predicting the timing of the next bear market. We do know that it’s been a long time since the last one — a little over ten years — and that, barring a new realignment of the universe, there will be another one in our future.
There are economic warning signs that global economies are facing hardships — China is slowing, the U.K. appears to be hurtling off a Brexit cliff with no visible net, Europe is feeling China’s slowdown through declines in exports — but, so far, the U.S. economy is showing only minor effects from malaise overseas. The stock market is up over 11% for the year. But the yield curve recently turned negative.
We’ve never considered ourselves market timers — speculators that jump from stocks to cash and back again based on where they believe the market is heading — and we certainly don’t intend to change now. But, caution has its good points. Now might be a good time to review one’s portfolio — recent equity moves may well have over-weighted stock allocations — and make certain that it’s properly allocated for long term goals. We recommend it!
