As we all know, the stock market has been in a bull run for a very long time. By the time you read this, it will be the longest bull market on record.
In the nine and a half years since the final down month of the previous bear market (February 2009), the S&P 500 Index has increased by almost 300%. That makes it an average compounded annual growth rate of over 15%. Add in an annual dividend yield of around 2%, and the past decade has been a very good time for stock investors.
The current environment seems favorable to a continued boom in the stock market. Corporate earnings are at record highs and GDP growth is strong; while unemployment and inflation are both very low. It’s a Goldilocks economy again – not too hot, not too cold, just right.
Even so, we know that every economic expansion, and its associated bull market, does eventually come to an end. In hindsight it is usually easy to see what the cause of the reversal was. But in real time, it almost never is – each new bear market seems to come out of the blue. We don’t know what the cause will be this time, tariffs, a trade war, a shooting war, the short-term stimulus coming from the corporate tax cut running out of steam or, equally likely, something that is just not on the radar at all right now. But one day the bull market, it will end.
Currently, there are three things that are possibly worrisome early-warning signs:
The Yield Curve
The yield curve is the relationship between the interest rates on short-term debt and the rates on long-term debt. The normal relationship is that for a given borrower (and the U.S. Treasury is usually used as the benchmark borrower), debt that matures sooner should have lower rates than debt that matures farther in the future. This is to compensate the buyers of long-term bonds for their increased risks, chiefly that of inflation. The farther out in time the date is when an investor will recover his or her principle, the more the compounding of inflation reduces the purchasing power of that principle in the interim.
A normal yield curve is favorable for lenders (banks), whose business is borrowing short term and lending long term.
In rare situations, when long term interest rates are stubbornly low, the relationships get upset. The long-term rates are not as closely under the control of the monetary authorities (which in the U.S. is the Federal Reserve) as short term rates are. Low long-term yields are a sign that global bond investors are skeptical of long term growth prospects and are willing to accept low yields for the relative safety of long-term bonds. Meanwhile, the central bank may feel the need to raise short term rates, as the Fed has been doing since late 2015. If the short term rates rise above long-term rates, then the yield curve is said to be inverted.
At this time, the yield curve is not quite inverted but it is very flat and headed toward an inversion, which could happen after one or two more Fed increases in short-term rates.
An inverted yield curve has historically been followed by a recession, after a lag of 6 to 24 months. It is not known what the exact mechanism is that underlies this phenomenon, which means it could conceivably be a coincidence. Or it could have something to do with the fact that banks are less able and willing to lend when their margins are negative. In any case, it is undeniably true that every recession since World War II has followed an inverted yield curve; and that in that time period there has only been one false positive – an inverted yield curve (in the mid 1960’s) that was not followed by a recession. In that one case, there was a significant slowdown that didn’t quite meet the definition of a recession. So, as an indicator of a market slowdown and end to a bull market, an inverted yield curve is not a sign to treat lightly.
The Average Price/Earnings Ratio
The price-earnings ratio is the ratio of a stock’s price per share to its latest annual earnings per share. For example, if a company earns $5 billion in a year and has one billion shares outstanding, it has earned $5 billion / 1 billion shares = $5 per share. If that company’s stock is trading at $100 per share, then its price-earnings ratio is $100 / $5 = 20 to 1.
The average P/E ratio for a basket of stocks can be calculated by averaging their individual P/E ratios. The average P/E ratio for the S&P 500 is often watched as an indication of the cheapness or expensiveness of stock prices in relation to their earnings.
At this time, the S&P 500 average P/E is a little over 25. This compares with a long-term average of about 16. In its history, the S&P 500 average P/E has reached its current level of 25 or higher only three times before: once before the crash of 2008, once before the crash pf 2000, and once before the panic of 1897. So, at 25 to 1, stock prices are now extraordinarily high.
Recent Market Behavior
The earnings season for reporting earnings for the second quarter of 2018 is just about wrapped up. Earnings came in at all-time highs, with 4 out of 5 companies reporting earnings that were better than forecasts. Even with these blowout earnings, the S&P 500 index only briefly breached its January high on August 21 and then fell back below it in the regular session then dropped another 1.5% after hours. This relative lack of strength could be a warning of the end to the bull market.
So, what can we do as investors when the party ends, whenever that might be? And how can we prepare for it?
That is a long story. The broad outlines are:
- Diversification. No one should have so much of their wealth tied up in the stock market (or any one asset type) that a 50% drop in that asset would wipe them out. If you are too exposed to the stock market, consider taking some profits and moving money to less volatile assets.
- Have a clear exit plan and stop losses on your market positions.
- Consider the use of options as protection.
Russ Allen can be contacted on this link: Russ Allen