Introduction – the longest bull run
In 2017, the Dow hit a record high 71 times. In 2018, the S&P reaching an all time high during the 9 year global bull run. On 22 Aug 2018, it officially became the longest bull run in history for S&P and it was almost impossible to tell then whether the market has peaked or when it would peak. However, with the Fed raising the interest rates and the recent sharp drops in prices in the S&P 500 Index that follows, there are talks by men on the street suggesting that the bull run is ending? Is the bull run really ending soon or there is still some juice left for prices to continue to push upwards?
What is a bull run?
A bull run is a prolonged trend of rising prices without decline of 20% or more. A ‘Market Correction’ is when the decline in prices is 10% or more. A ‘Bear Market’ when there is a decline of 20% or more. Any price movement less than 10% are considered ‘Market Fluctuations’. As the Bull starts to weaken, it is usually seen through several rounds of ‘Market Corrections’ (of 10% or more). The Bull will continue to struggle with the Bear, until a downturn (decline of 20% or more), which signals the start of a bear market.
Relationship between the stock market and business cycle
There is a strong relationship between the stock market and the business cycle. Wharton professor Jeremy Siegel pointed out in his book ‘Stocks For The Long Run’ that almost without exception, the stock market will peak prior to the business cycle. Similarly, the stock market will bottoms out before the business cycle does. Since 1802, 43 out of 47 recessions have been preceded by declines of 10% or more in the stock market. This means that the bull run in the stock market can reach it’s peak and start on it’s downtrend before the business cycle reaches it’s peak.
The current business cycle is lengthen-ed by the slow recovery following the 2008 crisis. The US economy is going into the late stage of the expansion phase of a business cycle. The expansion is supported by a strong labor market and low unemployment rate. The strong wage growth over the past months – that has given households more power to spend – has started to slow. Disposable income is not affected as debt repayment and servicing is still going strong; the confidence in consumer spending has not been affected.
The tax reform in Dec 2017 would help further extend the expansion phase of the business cycle. It increases the take home pay of workers and encourage spending. Tax benefits for businesses will encourage further business investments and growth. Supported by healthy household spending and borrowing, and a strong labor market and continued strong business investments; the US economy is expected to expand for at least a year.
What are the signals that the bull run is ending?
We could look out for economic signals and other characteristic of the business cycles. There are some common observations between a late bull market and the later stages of expansion of a business such as rising interest rates, inflation and over valuation of stocks over. Historical analysis suggests that cyclical fluctuations in the economy have often followed similar patterns. The more signals that have been triggered, the closer we are to the end of the bull run.
Macroeconomics Signals (ME)
After prolonged economic expansion, there is a low unemployment rate and rising wages. Consequently, the increase in household and consumer wealth leads to rising inflation and high cash rates. The rise in prices lead to inefficient allocation of supply. Companies overproduce to capitalize on the higher wealth to reap higher profits. An economy entering a late business cycle will see a slow down in earnings growth, and shrinking profit margin. Some of the macro economics signals include:-
ME #1: Rising inflation
The Personal Consumption Expenditures (Excluding Food and Energy) (PCE) index measures price changes in consumer goods and services. Compared to the more popular Consumer Price Index (CPI), PCE has a broader range of household expenditures than CPI’s fixed basket. PCE also allows for short term changes in consumer behavior are not adjusted for in the CPI formula. Currently, it is at 2.0% compared to the 20 year peak of 2.5% in 2007.
ME #2: Rising wages
Rising wage is a key driver of rising inflation. Employment cost index that measures wages rose 2.8% QoQ for July 2018. This is only slightly behind the highest level of 2.9% in 2008 (in a report released by Bureau of Labor Statistics). I’d consider it relatively high!
ME #3: Other leading economics indicators
Other leading economic indicators used to signal recessions are
- Composite Index of Leading Economic Indicators (LEI) 6 month rate of change < 03.00%. The LEI comprised of 10 economic components from working hours, to new residential building, new orders for consumer and capital goods, S&P 500 stock index, yield curves, consumer sentiments etc.
- The Dow Jones Transportation Average tumbled 3.1% over the last month, under-performing the Dow Jones Industrial Average’s drop.
- The ISM Manufacturing Index based is also considered a lead barometer of recessions. Previous peaks in ISM is usually followed by a peak in the S&P 500. Credit spreads and Yield Curves
Credit and Yield Signals (CY)
CY #4: Widening credit spreads
Widening credit spreads is a signal that recession is coming.. if High Yields Spreads > 4.25%
Credit spread is the difference in yield between a U.S. Treasury bond and another corporate bond with the same maturity; but of lower quality. Credit spread is the additional returns an investor requires to bear the risk of a credit default for a given company. In a strong economy, the credit spread is narrow as there is low risk of default. In the later stages of the business cycle, business risk increases. Investors will demand higher returns to bear the higher risk of default. Currently neither investment grade nor high yield spreads have shown significant widening.
Investors can rely on the ‘Option adjusted spread of Bloomberg Barclays US aggregate bond index’ and ‘Bloomberg US corporate high yield bond index’ respectively as broad based US dollar denominated measurements of fixed rate ‘investment grade taxable bond’ and ‘high yield corporate bond’.
CY #5: An Inverted Yield Curve
An inverted yield curve is a mechanism in the regulator’s toolbox that can slow an economy down to a recession.
After prolonged economic expansion, inflation accelerates due to increased consumer wealth. The rise in prices lead to inefficient allocation of supply as companies overproduce to capitalize on the higher wealth. The yield of a treasury note is a tool that the Fed uses to decelerate inflation and prevents the economy from overheating. A yield curve is ‘inverted’ when the 2 year US Treasury note has a higher yield than the 10 year US Treasury note.
Companies tend to borrow money to fund their operations. A higher interest rates increases the cost of borrowing. This reduces the available cash and discourages the company from over producing, and breaking the growth momentum of the company. While every recession was preceded by an inverted yield curve, not every yield curve has resulted in a recession. Whether it results in a recession depends how much cooling the regulator intends.
Every recession since 1955 has been preceded by inverted yield curves of 6 to 24 months. As of Oct 2018, the 2 year and 10 year treasury yield at 2.88% and 3.17% respectively. Short term interest rates are increasing and the yield curve is flattening; but the yield curve is not inverted yet. If the US Fed continue to raise interest rates, then there is a likelihood of a US recession in 2020. Red Flag: Yield Curve < 0% and 10 Years Treasury Yield > 5.00%
CY #6: Lower corporate profits
Consequently, lower corporate profits is also a closer signal that recession is coming soon. However, the tax changes in 2017 is pro business and is likely to extend the expansion cycle by another year.
Investors Sentiments (IS)
IS #7: Investors complacency
Late in the long bull run, investors may remain calm even with every bout of volatility. The consumer feels confident as unemployment is low and wages are are rising. Many will continue to believe that the market will climb higher. When when volatility or correction returns, many investors will be surprised and overreact to a downturn. Red flags in consumer over confidence can be when Conf board Consumer confidence index rises > 100, or if VIX exceeds 20% or even when Investopedia Anxiety Index (IAI) > 110.
IS #8: Over Valuation
Potential asset bubble. New cash tends to enter the equity market in the latter stages of a bull market run, due to investor’s fear of missing out on earnings. when the valuation rises above historical averages, investors are buying assets at a premium price, which might lead to an asset bubble. Are most assets fairly valued at this time? Red Flag: Trailing Price to Earnings (P/E) ration with the headline consumer price index inflation > 20. i.e. CPI + Trailing PE > 20. Or Price to book and Price to Earning ratios
Stock Market (SM)
SM #9: Sectors Rotation
Throughout the entire business cycles there are different sectors that are the star performers. In stock markets, technology sector tend to perform better in the early and mid-cycle phase when economic growth strongest. Best performing sectors in the late bull cycles are typically energy, materials and industrial; and maybe commodities (?). Post peak, defensive sectors such as healthcare and consumer staples tend to perform better.
SM #10: Technical Indicators
- Strong run up in stocks: Trailing S&P 500 24 month returns > 30%
- Declining prices: When 50 DMA > 200 DMA?
- Momentum: RSI 59 to 60 suggest that there is still some upside momentum still.
What can you do during a late bull cycle?
Depending on your age, investment objective, investment horizon, risk appetite, and current allocation, you should think about reviewing your asset allocation and re-balance your portfolio. Some of the things you could do.
For retirees and investors living off their portfolio returns, in addition to the above they should
- Limit your current exposure to equity. Start having some cash on hand.
- Adding lower risk products such as short term Treasury bonds that are having higher interest rate
- Set aside enough and prioritize their living expenses over investing when the market is down.
- If you are planning to take profit on part of the equity holdings to ensure that the market correction doesn’t take away your capital gains; while making sure there is enough flow to support your living expenses.
There is still some reasons to stay in equity. As of Oct 2018, the earnings yield for S&P 500 at 4.36%. It is still higher than the 2 year and 10 year treasury yield at 2.88% and 3.17% respectively. For investors who have bigger risk appetite and are still planning to invest.
- Invest tactically and take opportunities during price correction to buy in on the dips and average down their positions
- Diversify part of your equity portfolio into international equities in developed markets in Europe and Japan. These economies are still maintaining low interest rates, compared to the US. In addition, their economic recovery started later than the U.S.
- Look to invest in more defensive sectors like healthcare, and energy. Avoid Technology stocks.
- Bureau of Economic Analysis
- Bureau of Labor Statistics
- Wells Fargo: Investing in a late bull market
- Think Advisor: How to invest late in this atypical bull market
- The Street: This Bull Market Isn’t Dead Yet — Here’s How Investors Can Make the Most of It
- The Street: A Bear Market Is Coming — This Is How Investors Can Prepare
- The Street: How to Survive a Turbulent Stock Market This Summer
- Investopedia Anxiety Index