The S&P 500, having endured its worst-ever beginning to a year, has suffered a double-digit correction since hitting all-time highs last May. After seven years of gains, is this finally bear market time?
One way of assessing the likelihood of further declines is to compare current market behaviour, sentiment and valuations to past market peaks. Some measures suggest trouble lies ahead, but most of the usual bear market warning signals appear absent – for now at least.
Valuations
Even bulls admit the current market isn’t cheap, while bears argue stocks are extremely overvalued. The latter point to the S&P 500’s cyclically-adjusted price-earnings (Cape) ratio, which averages earnings over a 10-year period. The current Cape, 26, is way above its historical average of 16, and has only ever been higher on three occasions – in 1929, 2000 and 2007, all major market peaks. Additionally, other valuation metrics suggest the median US stock is now more expensive than it was in 2000 and 2007, Ned
Davis Research
noted recently.
That’s not the whole story. Cape readings have been rising for decades – in fact, the current reading is only barely above its 25-year average, according to JPMorgan data. Other valuation metrics suggest stocks are richly valued relative to history but not at extreme levels.
Bear markets usually require a catalyst, which is why periods of elevated valuations can persist for extended periods. Nevertheless, stocks have ultimately gone nowhere over the last 18 months, indicating both that current valuations are proving a headwind for equities and that stocks are vulnerable to negative economic surprises.
Sentiment
The late
John Templeton
famously said bull markets are born on pessimism, grown on skepticism, mature on optimism, and die on euphoria. Euphoria has been conspicuously absent since the bull market began in 2009, however. Even at last May’s all-time highs, sentiment measures indicated no excitement among ordinary investors, while retail sentiment surveys show bullish sentiment has been below its historical average for 42 out of the last 44 weeks.
Fund managers, too, have been wary, with Merrill Lynch’s monthly fund manager survey showing global money managers consistently underweighting the US throughout 2015. The deterioration in sentiment has been especially marked in recent weeks, according to Merrill’s bull and bear index. “The best reason to be bullish right now”, Merrill said recently, “is there are so few reasons to be bullish”.
If last May really was the top, then it will have been a very atypical market peak, one marked by indifference rather than euphoria.
Ageing bull?
Stocks have tripled since March 2009. If the bull market lasts beyond April, it will have become the second-longest rally in history. This extended duration, coupled with the fact the bull market looked very tired in 2015, is habitually cited by bearish commentators.
However, there are some important caveats. First, rallies do not tend to peter out; rather, history shows the biggest gains often accrue in the final two years of a bull market. Second, the S&P 500 nearly suffered an official bear market – defined as a 20 per cent decline – in 2011, when stocks fell 19.4 per cent. If one dates the current rally from that date, then the bull market suddenly appears less elderly.
Third, there have been stronger bear markets; larger gains were recorded between 1949 and 1956, 1982 and 1987 and 1987 and 2000.
Finally, note the longest bull market (1987-2000) lasted 13 years.
Clearly, the current bull market is long in the tooth, but the lesson of the 1990s is that old age alone is not enough to bring on a bear market.
Catalysts
So what are the obvious bear market catalysts? JPMorgan’s latest quarterly
Guide to the Markets
notes recessions have accompanied eight of the last 10 US bear markets. Extreme valuations preceded five bears, while commodity spikes and aggressive Federal Reserve tightening occurred on four occasions. Of those four catalysts, only one – valuation – is arguably present today, indicating any market downturn is more likely to be a correction rather than an extended bear market.
Still, that doesn’t mean 2016 will be good for stocks, says JPMorgan. For the first time in seven years, it recommends selling the rallies rather than buying the dips, saying that markets are likely to be lower over the next 12 to 24 months.
Bear market checklist
The thesis that the usual bear market triggers are largely absent today is shared by
Citigroup
strategists. The firm keeps a global bear market checklist of 16 warning factors measuring the fundamental and technical health of international stock markets. In 2000, “almost all” these factors were “flashing red”, says Citi, while there were 12.5 warning signals in 2007. Today, there are only 3.5 warning signals.
This doesn’t mean the coast is clear for stocks. In 2012, global stocks suffered a 14 per cent correction, despite the fact only 2.5 signals were flashing red. Overall, however, Citi says that the bull market is “definitely showing signs of old age but may not be finished yet”.
Market breadth
Investors could be forgiven for thinking that nothing was amiss until recently. After all, stocks eked out a slight gain last year only to tank hard in January. However, sub-surface trouble has been brewing for some time. Lowry’s Research technical analyst
Tracy Knudsen
recently noted that 12 per cent of S&P 500 stocks were in individual bear markets at last May’s all-time high. In July, that number had risen to 19 per cent, despite the fact the index was within touching distance of fresh highs.
By early November, markets had again rallied to just below May’s high but almost a quarter of stocks were in bear market territory. Near the end of the year, the S&P 500 was again within 2 per cent of May’s highs, but by then 30 per cent of stocks had fallen into bear markets.
Performance has been even worse in indices measuring mid-cap and small-cap stocks. Almost half of stocks in the S&P 600 small-cap index, for example, ended 2015 in bear market territory.
Clearly, strong performances among a select group of large-cap stocks have been keeping the indices afloat, masking the underlying deterioration in market breadth.
Bulls will argue this does not guarantee that a bear market is under way. After all, any recovery in the down-trending stocks would obviously lift indices higher again. However, past history suggests it’s more likely that weakness spreads to the small band of high-flying stocks, dragging the indices down with them. In short, the ongoing deterioration in market breadth is classic bear market behaviour, according to Lowry’s, with similar patterns evident at a host of previous major market peaks.
Conclusion
The overall picture, then, is a mixed one. Valuations are a concern, although that has been true for some time now. The bull market has lasted longer than normal, but old age alone is not enough to kill a cyclical advance. The sentiment picture is an encouraging one for bulls, while the usual bear market catalysts appear largely absent today. Market breadth, however, has been unequivocally bearish for some time, indicating that stocks are about to endure a bear market rather than a run-of-the-mill correction.
Confused? Well, timing market tops and bottoms is a tricky game, one that appears easy only in hindsight. For long-term investors, the usual advice remains the best advice: sit tight, rebalance once or twice a year, and don’t check your portfolio too often.
