Surprise: Long Term Equity Trends Intact
“One of the funny things about the stock market is that every time one person buys, another sells, and both think they are astute.” – William Feather, Author of: Business of Life (1889-1981).
While chatting with a friend, who works at a large wealth management firm in San Francisco, I wanted to hear his take on whether we have seen a market top in stocks. He answered “…how many times have we asked this question in the last five years?”
This truly has been one of the most hated bull runs in history, and a stubborn question has been stuck in investors mind about whether we’ve reached a top. This skepticism coincides with all major US stock indexes being at all-time highs. The last time this condition was seen back in 1999, we all know what followed: the tech bubble crash.
In addition to stocks, real estate and fixed income markets have been in an extended uptrend as well. The only major asset class that hasn’t joined this party has been commodities.
By some valuation factors, stocks, along with real estate and fixed income securities, are too expensive to invest. For some market participants, global economy is losing steam if not approaching a recession. This sentiment is supported by data flowing from countries in Europe like Germany, which is at borderline recession and fighting negative interest rates. A similar situation can be seen in Japan. The situation is even sketchier in the United Kingdom as the Brexit boat is undocking to leave the European Union, and this surely hasn’t helped the economic projections of the island’s economy for the near future.
We have been in a growth cycle since 2009, which makes 2016 the eighth year in the current one. On average every six years a recession knocks on the US economy’s door. To add insult to injury, presidential election is fast approaching and the FED is getting ready for a rate hike. Who in his or her right mind would have a bullish view in the midst of all this?
Well, I guess I will cautiously be one of those crazies arguing for further growth in stocks and the US economy.
By no means do I dare to suggest that a 5- 15% pull back in stocks is inconceivable. On the contrary, now that we are in the last third or the second half section of a secular (long term) stock market up trend cycle, I do believe short and shallow corrections will be more frequent and volatility will rise.
The legendary economist John Maynard Keynes famously said “When information changes, I alter my conclusions. What do you do, sir?”. I try not to fight the FED, the trend, and facts, so I will change my mind when presented by information that suggests otherwise, but currently, I conclude a longer-term equity price appreciation hasn’t reached a capitulation phase – just yet.
Why is this? Please read on.
Accommodative Monetary Policy
In addition to the US Federal Reserve Bank, the European Central Bank, the Bank of Japan, and Central Banks of the UK, Switzerland and Canada, have been implementing their own versions of accommodative monetary policies. Add to this, Chinese interventions to stimulate growth and similar tactics implemented by governments and/or central banks around the world, and it is easy to determine that we are in an era of global accommodative monetary policies.
Even though the effectiveness of these policies has been diminishing, and going forward, fiscal policies will be needed to replace them, a dovish central bank still creates a stock friendly environment.
It would be stating the obvious to say that the US Federal Reserve is getting ready to increase interest rates, which scares many investors as this, in theory, is not only bad for stocks, but also fixed income securities, real estate and business in general. But it is important to note that neither inflation nor the economy is heating up to a level that would back the Fed in to a corner. In fact, the current sluggish growth environment allows for plenty of patience. There is more than a 50% probability for a December rate hike, but a speedy increase is a low probability event, and this is more important than the timing. Since the current starting point is close to zero, there is some room before new levels start hurting the stock market strongly enough to push it to the next bear cycle, though the reception of information will surely result in volatility.
Another important point is that a rate hike would suggest that the economy is strong enough for such an action on FED’s part, which would justify expectations for further earnings growth and valuation expansion.
The US Economy
Another reason why the existing uptrend may have further legs, is that the economic data currently doesn’t suggest a recession. As long as the leading indicators and coincident economic figures point to a non-recessionary period, the chances of being stuck in a deep bear market is, historically speaking, low. Plus, being a leading indicator, the stock market would see a recession approaching and kick start a correction, well before the recession is officially announced. Once again, based on leading indicators, even though growth may tend to stay below average levels, the probability of a recession seems low, which supports the uptrend.
Length of Previous Cycles
As indicated above, a typical business cycle lasts anywhere between 5 to 7 years. With 2016 being the eighth year in this current business cycle, it raises eyebrows. I, myself, am a believer of studying historical trends (aka technical analysis) but the devil is always in the details. Not only the duration of a cycle, but also the level of growth in the cycle is a factor to consider.
Wages have started going up only recently and we still haven’t recovered in aggregate terms matching past recoveries. My point here: current below average growth creates a potential for an elongated business cycle. To reach historical averages, at current growth rates, the economy needs another three or four years to catch up.
Having said this, good reasons to be skeptical of continued growth are high valuations and how expensive investments have become. There is more than one way to look at this, and by some absolute calculations, stocks are in a bubble territory. However, when you look at relative valuation measures (stock returns in relation to returns from other asset classes), one gets a different result. In other words, when investing in Treasuries become cost prohibitive in a rising rate environment, and the sweet deals in real estate are harder to come by, a high dividend paying stock may appear more attractive. To gain some perspective, operating price/earnings ratio of Standard & Poor’s index is now around 20, which was around 50 in 2000, before the tech bubble burst.
Past Market Cycles
Last two long-term (secular) stock market periods were between 1942-1966 (24 years) and 1982-2000 (18 years). Current bull cycle, which started in 2009, is in year eight, and it could very well be in the second half or two thirds of a secular cycle. In other words, based on historical periods, the current cycle might very well have more time to run.
Overseas markets such as China, India, South America and Japan, may start seeing reversal of their past downtrends, which will most likely help US markets. This view has already been supported by recent traction seen in these markets. It may also be important to note that more than 50% of Standard & Poor’s company earnings come from overseas. Recent stabilization of the US dollar has created a tailwind for these markets. This is good news for globally diversified investors.
Leaving best for last, full employment, increasing participation rates, wage increases, spillover effects of the price appreciation in stocks and housing, low commodity prices, low inflation, and low interest rates, all contribute to the relatively decent shape the US consumer is in. The US economy is 80% consumer driven. The state of the sentiment in this area is extremely important. The reasons I have listed above may go back and forth in mild rates, but a major change doesn’t appear likely in the near term, which supports the consumer theme being intact, as well as the economy and the stock market.
In summary, I am still cautiously optimistic about the US economy and its stock market, and I believe that the uptrend is intact. At all-time highs, markets are exposed to shocks and higher volatility. These shocks will probably be shallow and short-term, which should be seen as buying opportunities until proven otherwise and data points to a different direction.
Thanks for reading my commentary and as always, you can reach me at email@example.com for questions and comments.
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