Close to the End?
BY: JIM McELROY, CFA | firstname.lastname@example.org
We are now bravely stepping out on a sturdy limb to state that we are closer to the end than the beginning of this bull market in stocks. This bold prediction is based on little more than longevity: at a little over nine and a half years, this bull market for the S&P 500 is now the second longest since 1926; it has endured five corrections and gained 335% from its beginning in March of 2009 to this year’s peak on September 21st. The longest bull market, which ended in March of 2000, lasted twelve and a third years, endured six corrections and gained 582%. The average bull market since 1926 has lasted almost three years and gained 122%. Of course, having said that we are closer to the end than the beginning only argues that we are more than half-way to the onset of a bear market: if we assume that our argument is correct, the end could come this month or nine and a half years from now. Despite this imprecision, there is value in knowing that we have already enjoyed three times the average length of bull markets since 1926 (and about two times the average since WW II) and that a certain level of caution would not be unwise. And there are several potential catalysts for market destruction on the horizon.
Many market observers point to the yield curve as a source of great concern for the economy and the markets. In simple terms, the yield curve is the graph of interest rates (vertical axis) based on maturity (horizontal axis). A positively sloped yield curve is one in which longer term bonds have higher yields than shorter term bonds while a negatively sloped (or inverted) curve is one in which the reverse is the case. A healthy economy prefers a positive slope because it provides liquidity for businesses and generally encourages longer term investing or risk taking. An inverted yield curve discourages risk taking and encourages keeping money close for immediate use. The current yield curve is relatively flat: there’s less than 1 percentage point difference between the one month T-Bill and the ten year Treasury Bond and only about a .2 percentage point difference between the ten and two year bonds. If the curve should turn negative — and we’re not far from it — the prognostication based on history is not good: according to the Wall Street Journal, since 1966, an inverted yield curve has preceded every recession by one year or less. And in the two years following an inversion, stocks have produced disappointing annual returns of 1.5% for large cap stocks and minus 3.1% for small cap stocks. “Safer” investments, such as long and short term bonds, have provided better annual returns over this same two year post-inversion period: 6.2% for long term bonds and 5.5% for short term bonds.
The Federal Reserve’s management of short term rates has, and will have, a significant impact on the shape of the yield curve. The Fed’s government mandate is to promote full employment and price stability, two goals that are often at odds with each other. The maintenance of the current halcyon state of low unemployment with low inflation will require a nearly perfect application of the Fed’s monetary and policy tools over the next year. In pursuit of this perfection, the Fed recently lifted short term interest rates by .25% for the third time this year. The overnight rate now stands in a range between 2% to 2.25%, the highest level since 2008 and a rate the Fed considers no longer “accommodative”. In comments following their recent announcement, Fed members indicated that they expect to lift this rate by another .25% before the end of the year and by another .75% before the end of 2019. This could bring the overnight rate to a range between 3% and 3.25%, a level the Fed has previously described as neutral, neither accommodative nor restrictive. So far, the Fed has been successful in striking the right balance: unemployment stands at 3.9% and inflation remains quiescent at about 2%. But for a 3% to 3.25% overnight rate not to be restrictive over the next year or two, longer term Treasury yields should adjust upwards to prevent an inversion of the curve. And for this rate not to be too accommodative, inflation and inflation expectations need to remain around the 2% level. It’s a tall order, even for a Federal Reserve that has managed it relatively well up until now. A dramatic acceleration in inflation, followed by more aggressive Fed tightening, or persistently low long term rates (say below 3.75%) and a steeply inverted yield curve would upset the Fed’s delicate balancing act, possibly providing the critical ending event for this long-lived expansion and bull market.
Inflation has remained benign for at least the last four years (core CPI between 1.5% and 2.25% on an annual basis); in fact, since the last recession, there has been more concern about deflation than inflation. But a strengthening economy inevitably creates shortages and today’s most widespread shortage is in the labor markets: with an unemployment rate at 3.9% and a participation rate of 62.7%, pressure is building for higher wages, higher labor costs and higher cost push inflation. Higher productivity has so far diminished this pressure — non-farm productivity has been positive for each of the last six quarters (the last report was for the second quarter of this year and was a positive 2.9%) — and unit labor costs declined in the first two quarters of 2018. But the pressure for higher wages continues to build: there is always the possibility that higher productivity will be insufficient to hold inflation in check. And, as we mentioned above, an unexpected acceleration in inflation could create serious problems for the Fed’s gradual approach to normalizing interest rates. At this point, accelerating inflation is not necessarily the most likely triggering event for a market collapse, but it bears watching.
Most bear markets are triggered by the expectation of a recession in the not too distant future, usually in about six to nine months. False positives do occur. But generally, the expectation of increasing corporate earnings fuels market advances and the expectation of falling corporate earnings drives markets lower. Today, the U.S. economy appears to be in very solid shape and Wall Street analysts are predicting that the third quarter just ended will show a 21% annualized growth in net earnings for S&P 500 companies; for the fourth quarter, analysts are forecasting a 17.7% annualized growth rate. And for the full year of 2018, analysts expect that earnings will have increased by 21% over 2017 earnings. But 2019 is the critical time frame: a firm belief in continued growth next year will extend the bull market for at least another six months; conviction that earnings will collapse, however, will bring a quick and violent end to the second longest bull market in history.
We obviously have no crystal ball. There are good reasons for believing that the current expansion and bull market will become the longest one in history: Consumer Confidence remains very strong, a good harbinger for about 70% of GDP; the corporate tax cut continues to provide funds for capital investment, dividends and acquisitions; and interest rates, though somewhat higher than last year and, according to the Fed, no longer accommodative, are still low when compared with rates from before the last recession. There are also reasons for concern: the president’s aggressive stance on trade is likely to raise dramatically the prices for many consumer goods and the costs for most domestic manufacturers; mid-term elections may return control of the House and Senate to members not enamored with the president’s business friendly agenda, thereby creating turmoil and uncertainty in the regulatory arena as well as in the boardrooms of corporations; problems among our trading partners overseas — slowing growth, non-existent growth, national insolvency, potential splintering of the European Union, etc. — could spread damage to U.S. shores; and petroleum supply disruptions due to sanctions on Iran, the collapse of Venezuela and new-found discipline in OPEC and Russia could raise the price of oil to crippling levels. Some or all or none of these things could happen over the next twelve months: we make no predictions. But still, at this point in the second longest bull market in history, we think it makes sense to be cautious.
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