Global Market Commentary

What Kills Bull Markets?

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When Investing, We Must Keep the Big Picture In Mind

The U.S. and many global stock markets have continued to move ahead.  Even rising tensions on the Korean peninsula, and the theoretical prospect of nuclear war, were met by markets with a brief shrug — and this during a seasonal period when markets are often unsteady and experience corrections.  As we write, the S&P 500 index is just 2.4% down from its all-time high of 2490.87 set on August 8.

Markets are showing resilience in the face of geopolitical concerns, turmoil and gridlock in U.S. politics, and poor seasonals.  That resilience is leading many market participants, analysts, and observers to murmur the same thing they’ve been saying under their breath for years now: “The market is near a top; it’s overvalued; we’re in bubble territory; I just feel something coming; this can’t go on.”

If this murmur is running through your mind as well, fear not: we are here to reassure you.  If the usual seasonal correction continues, we will be prepared to buy the weakness, and we are constantly reviewing and revising our buy list.

The reason is simple: a bull market does not die of old age.

How does it die, then?   From recession.  (Perhaps by extension, one could blame the conditions that bring about a recession, when those are unusual, such as a bona fide financial crisis like the one that threatened the foundations of global financial stability in 2008.  But “recession” is the fundamental answer.)

Navigating corrections is indeed difficult, but not impossible.  Most investors are well advised to stay put during corrections unless a particular investment’s fundamental rationale has become untenable, or they have cash that they want to put to work.  (Of course, as Canaccord Genuity strategist Tony Dwyer is fond of saying, corrections are always “natural, normal, and healthy” until they’re actually happening.  Particularly if they’re associated with political or financial turmoil, they can be truly fearsome.  It takes courage to ride them out, and long experience and skill to trade them effectively.)

However, true economic recessions and their associated bear markets are another story.  Here, our decades of experience have shown us many of the critical warning signs of an oncoming bull-killing recession — warning signs that are available in  public data about (1) business sentiment; (2) the trend of corporate earnings growth across the whole economy, and sector by sector; (3) various macroeconomic and financial conditions, including trends and events in foreign economies and banking systems; and (4) the U.S. yield curve.

These warning signs are not precise, and can result in reducing market exposure before the bull market’s peak, or failing to re-enter markets until after the bear market trough has already passed.   However, as many investors can attest, the value of avoiding a 50+% peak-to-trough decline can be inestimable for the health of a portfolio and, perhaps more importantly, for an investor’s sanity.

Our monitoring of these warning signs suggests to us that currently, recession risk is not elevated.   The preponderance of indicators currently suggests that a recession, and the bull-market peak that will precede it, are probably still several years away.

The Key Indicators

In this summary, we draw on the analysis of Canaccord Genuity strategist Tony Dwyer — the best U.S. market strategist we follow.  Tony has been a steady voice drawing attention to these fundamentals throughout the bull market that began in 2009.  Those who have listened to his clear thinking have benefitted greatly, especially during bull-market corrections and periods of anxiety.

The last of the critical indicators mentioned above, and in our opinion the most important, is the yield curve — the spread between long-term and short-term interest rates.  Exactly which rates is not particularly important as long as you’re consistent; Tony prefers the 10-year and 6-month rates.  When that spread becomes negative — that is, when short-term rates are higher than long-term rates — the yield curve is said to be “inverted.”

Recessions Are Invariably Preceded By a Yield-Curve Inversion

Source:  Guild Investment Management, Inc.  

How quickly the yield curve inverts depends on the actions of the Fed and the market’s view of long-term economic prospects.  Market expectations currently envision an extremely slow pace of increases to the Fed funds rate.  Another reading of the Fed’s intentions can be sought in the “dot plot,” in which the Fed’s Open Market Committee tells the world the interest-rate path envisioned by its own members at its meetings.   The dot plot, which suggests a pace of rate rises more aggressive than the market is currently anticipating, now suggests that the yield curve will not invert until late in 2018.

The time between yield-curve inversion and the beginning of a recession is variable.  Over the past seven recessions, yield-curve inversion has preceded its subsequent recession by an average of 13–15 months.  Putting together these pieces, we’re led to the conclusion that the next recession will not occur until at least 2019 or 2020.

Just to reiterate: bull markets are killed by recessions, and the next recession is unlikely to occur before 2019 or 2020.  This does not mean that we can’t have precipitous and terrifying declines in the meantime, of 15% or even 20%.  But after they run their course, it is likely that the bull will resume its run to greater highs.

Of course, recessions are identifiable only in hindsight; they are not useful to investors, who will be in a recession (and its associated bear market) long before any official government statistics confirm it.  So it’s interesting to examine the relationship between yield curve inversion and the market.

In mid-June, a drop in the 10-year Treasury rate brought the spread between the 10-year and the 6-month to about 1%, or 100 basis points.  If we look back at the seven recessions shown in the graph above, we see that this initial flattening of the yield curve to 100 basis points is a very bullish event, even though it’s an early sign that a recession is coming into view.  Investors know that substantial profits are made in the final stages of a bull market, and by studying the evidence provided by the yield curve, we can confirm this insight.

Data Source:  Bloomberg

Bull markets are ended by recessions.  Recessions do not occur unless the yield curve inverts.  On average over the past 50 years, more than a year and a half has passed between the initial flattening of the yield curve to 100 basis points, and the subsequent market peak — and during that time, on average, the S&P 500 returned a nearly 30% gain.  

Of course, investors cannot consider the yield curve in a vacuum.  We mentioned other critical variables above.  An important one is the momentum of corporate profit growth; we also study conditions of ease or stress in the financial system, the direction and momentum of inflation trends, and several other key indicators.

Vigilance is still required; the recession of 1981–1982 in particular shows that the yield curve can invert quickly.  Further, the yield curve does not indicate exactly when the market peak will occur.   However, the message is clear: investors who let fear and political noise scare them out of an ongoing bull market will probably leave substantial gains on the table. Harvesting some of those gains, and moving to the sidelines when conditions indicate that a real bear is approaching, seems to us to be a preferable way to build wealth.

Tony Dwyer summarizes his view thus:  “Despite the possibility of a bit more correction, we would add to our favored sectors on weakness because: (1) our positive fundamental core thesis remains in place; (2) a synchronized global recovery and domestic economic re-acceleration continues; (3) EPS and market valuations remain in an uptrend; and (4) the possibility of corporate tax cuts.  We believe our SPX 2017 and 2018 targets of 2,510 and 2,800, respectively, may prove to be conservative.”

Investment implications:  Listen to your nagging concerns, but subject them to critical analysis.  History shows that bull markets don’t die from old age; they die from recessions.  History also shows that recessions are preceded by an inversion of the yield curve.  When the spread between long-term and short-term interest rates makes its first narrowing to the region of 1%, that is usually a sign not that a bull market is about to end, but rather that it is about to accelerate to its peak.  Investors who do not keep focused on economic and financial fundamentals will let fear and political noise scare them out of a bull market — just when it is about to make a significant part of all its returns.  If this fall gives you a buying opportunity, we suggest that you buy the dip.

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