The bull’s long gallop might be nearing an end. But there are ways for investors to ensure that they won’t be trampled when it does.
Scaling great heights, whether climbing a Himalayan peak or watching the market rise, comes with risks that must be monitored every step of the way. And the higher you go, the greater those risks become. Climbers feel numbness in their fingers and toes, and lightness in their heads; investors can feel the same things, if for different reasons, as the market lurches from peak to peak. The question becomes whether to turn back, or to keep trudging higher.
That’s particularly pertinent for investors, who have watched stocks more than triple since the depths of the financial crisis in a bull market that is now the second-longest on record. And with dangers—both real and imagined—seemingly lurking in every dip and drop, the urge to turn tail and run from equities might be particularly strong.
Time to freak out about the imminent end of this great bull run? We think not. Neither longevity nor high stock prices, nor political turmoil usually are enough to send stocks into a protracted slide. The culprit in nearly every case is recession. The mystery is what will cause the next one. Fortunately, there likely will be plenty of clues.
MOVES THAT VERY RECENTLY might have been written off as a run-of-the mill market pause now raise questions about this bull’s durability. After all, the S&P 500 is up 265% since bottoming on March 9, 2009. Stock valuations have surged to extremes rarely seen except at market peaks. And expectations for market-friendly legislation seem to be as up in the air as ever.
Two conditions now exist that could increase the chances of a sharp selloff. The first is valuation. The S&P 500 is trading at 17.7 times 12-month forward estimated earnings, near the highest price/earnings ratio since the dot-com boom. As a short-term measure, such high valuations have almost no predictive value. But bear markets almost never begin when stocks are cheap.
At the same time, the Federal Reserve is normalizing interest rates. That, on its own, won’t precipitate a bear market, but it could be a catalyst for one if the central bank hikes too much, too fast. The interest-rate backdrop, combined with high valuations, suggests the risk to the bull market is higher now than at any time in the past eight years. “The two most important pieces are there,” says Antti Ilmanen, manager of the portfolio-solutions group at AQR Capital Management. He stresses, though, that neither means a bear market is imminent.
Recession is the key factor here. Markets tumble all the time, but have a way of coming back, as long as the economy continues to grow.
During the past three years, the S&P 500 suffered a drop of 7.4% in less than a month of trading in 2014, an 11% tumble over six days in August 2015, and another 11% decline during the first 30 trading days of 2016. All three downdrafts, although frightening, turned out to be buying opportunities. Even the mother of all corrections—the 22.6% plunge in the Dow Jones Industrial Average on Oct. 19, 1987—was followed by a relatively quick snapback that saw the blue-chip benchmark hitting a new high in less than two years. “Those are steep corrections, not bear markets,” says David Rosenberg, chief economist and strategist at Gluskin Sheff.
But when a drop is accompanied by a recession, watch out. It was economic slowdowns that made the Great Recession, the tech bust, and the bear market of 1973-74 so painful. And it’s safe to assume that when the market’s rally does finally end, it will be a sharp economic downturn that drives a stake through its heart.
SOME OBSERVERS SUGGEST that we could be on the cusp of a major downturn right now, and there’s no shortage of data to make the case, if one is so inclined. There are signs that the consumer might be tapped out, with the savings rate near its lowest level since the financial crisis, implying that spending could slow. The Federal Reserve seems intent on raising interest rates, even as inflation remains below its 2% threshold. And even the housing market shows signs of cooling off; new-home sales plunged 9.4% in July.
More worrisome: The Philadelphia Fed coincident economic activity index tumbled to 36 in July, from 68 in May. Such a decline “is pretty infallible” in predicting recessions, Rosenberg contends. “Recessions are like carbon monoxide,” he continues. “They sneak up on you without you realizing it.”
ANOTHER SCENARIO REMAINS a possibility, however—that instead of rolling over, the economy heats up. It’s not that far-fetched. Jobless claims remain low, while small-business sentiment is strong. And while inflation remains muted, there are signs that it could be ready to pick up, particularly if the U.S. dollar stays weak, says James Paulsen, chief investment strategist at the Leuthold Group.
A weak greenback makes American goods more attractive for U.S. consumers and international shoppers alike, and as a result leads to an increase in demand. That doesn’t lead to inflation if there’s slack in the economy, but when the economy is at full employment, that could cause prices to rise. If that were the case, the Federal Reserve might decide that it must pick up the pace of its rate hikes—helping to thrust the nation into a recession. “Every postwar recession was preceded by some semblance of overheating,” Paulsen observes. In other words, this time might not be so different after all.
The economy could get a further boost if progress is made on the president’s economic agenda. Jason DeSena Trennert, co-founder and chairman of Strategas Research Partners, points to regulation as one area in which the president can make changes without relying on Congress.
In some investors’ view, the financial system is particularly ripe for deregulation. To start with, regulators could make banks’ stress tests less stringent. If that happens, banks would likely take on more risk and more leverage, which could lead to an increase in demand for money. The upshot: “If the Trump administration gets its economic agenda through, the irony is that you could get a better economy and weaker equity prices, simply because you’ll have higher inflation and higher interest rates,” Trennert says.
IN ADDITION, some unforeseen wild card could sic the bear on stocks.
A hard landing in China, fear of which caused the August 2015 selloff, could lead to a global economic slump. The threat of antitrust action against tech titans, such as
Apple(ticker: AAPL),
Alphabet (GOOGL),
Facebook (FB), and
Amazon.com (AMZN), which have helped lead the market higher, could also trip up the bull. And don’t forget the almost unprecedented response to the financial crisis—which saw interest rates globally pushed toward—and, in some countries, below—zero, with central banks buying up massive amounts of bonds and other financial instruments.
As the Fed starts shrinking its balance sheet, it could cause unexpected problems, even as Yellen expresses confidence that it should come off without a hitch. That’s doubly true if other central banks start slimming their balance sheets as well. “They have corporate bonds, government bonds, euro-denominated bonds, and they’re a big buyer of stocks too,” says Baird senior analyst Allen Root. “The one thing I think everyone thinks is that the next bear market will come from some form of central bank liquidation.”
That means we can’t take anything for granted, especially something as unpredictable as a recession or a bear market. There are warning signs: Widening credit spreads—the difference between the effective payouts on high-yield bonds and Treasuries—often signal trouble ahead, though they produced a false reading during the 2016 selloff.
But right now, the difference between yields on junk bonds and equivalent Treasuries is just under four percentage points, according to Bank of America Merrill Lynch. That’s up from a low of 3.55 percentage points earlier this year, not enough to be worrisome. Historically, an inverted yield curve—which arises when longer-term bond yields dip below the fed-funds rate (the rate banks charge one another for overnight loans)—has been among the most accurate indicators of a coming recession. In fact, it’s presaged the past seven recessions, though the timing often leaves something to be desired. For instance, while the yield curve inverted in 2006, a recession didn’t start until the following year. Right now, the difference between the fed-funds rate and the 10-year Treasury yield is about one percentage point.
Leuthold’s Paulsen, meanwhile, is watching the gap between the S&P 500’s trailing 12-month earnings yield—the inverse of the market’s price-earnings ratio, it’s calculated by dividing earnings per share by a stock’s current market quote—and bond yields. With stocks trading at an earnings yield of 4.71% and the 10-year Treasury at 2.16%, that leaves a still-sizable gap of 2.55 points. But if the spread starts to close, it could be a sign that investor preferences will shift toward bonds, especially if it’s due to higher bond yields, Paulsen says. “The math starts to change, and rates start to become a hurdle for stocks,” he adds.
BECAUSE OF THE FED’S extraordinary monetary policy following the financial crisis, not everyone is convinced that the yield curve will be the early-warning signal that it usually is. As a result, Michael Darda, chief economist at MKM Partners, recommends that investors keep a close eye on the jobs data, which also have a solid record of signaling recessions. For instance, a 0.5 percentage point rise in the unemployment rate from the previous year would suggest that the economy might already be in recession, but the unemployment rate has dropped 0.5 percentage point during the past 12 months.
Unemployment insurance claims, too, can be a sign of a looming recessions. An increase of 12.5% or more in the ratio of jobless claims to the size of the labor force on a quarterly basis typically occurs a quarter before a recession, Darda says. But that metric has dropped 6.9% over the past 12 months. “Investors could—and probably will—do far worse than if they simply watch these real economy data points and only climb into the bomb shelter when the data starts to reflect elevated recession risk,” he suggests.
AND DON’T EXPECT the next downturn to be just any bear market. The market works differently than it did even 10 years ago, with exchange-traded funds now playing a far more dominant role. Some $2.4 trillion sits in equity ETFs, up from $534 billion at the end of 2007. These funds now account for more than 20% of equity assets under management, according to Morningstar.
Why does this matter? Imagine that there’s a selloff, and investors move to lighten their stock positions. If they have different portfolios of individual stocks, they’ll pick and choose among them, spreading out the selling, says Michael Shaoul, CEO of Marketfield Asset Management. But if they all own the same ETFs, everyone selling will be dumping the same stocks at the same time, exerting enormous downward pressure on their prices. “A bear market dominated by passive investing will be more volatile,” Shaoul warns.
But that might be the least of our problems. Trading is now dominated by machines, as algorithms battle other algorithms for shares of stocks. And even stock- pickers are using quantitative tools to help boost performance, a fact driven home by
BlackRock’s(BLK) decision in March to make some of its active funds more programmatic. But machines make mistakes, just as humans do. Remember, it was the rise of portfolio insurance—a fairly simple system designed to protect against losses that involved quickly selling into market downdrafts—that turned what could have been a run-of-the-mill selloff on Oct. 19, 1987 into Black Monday.
THE INVESTING ARENA’S COMPLEXITY has only grown since then, leading to “flash crashes”—violent and sudden price movements as market liquidity disappears, cautions Andrew Lo, a professor of finance at the MIT Sloan School of Management. “That creates vulnerabilities in the financial ecosystem that hadn’t occurred before,” he says.
That has some investors wondering if they can get out of the way.
Baird’s Root says that clients have been asking him for “orphan stocks,” those that aren’t a big part of indexes and hence won’t be caught in the downdraft. But when stocks are strong, there’s a price to be paid for owning such issues. After President Trump’s election win, the
Industrial Select Sector SPDR ETF (XLI) rose 12.6% through March 22, as investors bet on his make-America-great-again policies. The 10 largest industrial stocks not in that index—including
Nordson (NDSN),
HD Supply (HDS), and
IDEX (IEX)—returned a median of just 5.4% during that same period. However, the same phenomenon could work in reverse during a bear market, Root says.
In any case, if individual investors have an advantage, it’s that they needn’t buy and sell during a panic, if their time horizons are long enough. That means getting their asset allocations right, no easy task, given that everything—stocks, bonds, real estate, etc.—appears expensive now. AQR’s Ilmanen suggests diversifying not only across the usual asset classes, but into alternative investments, such as long-short and momentum funds. “Let’s diversify across many different things,” Ilmanen counsels. “And then you hope that this ugly event won’t happen so synchronously.”
It might even be prudent to hold more cash. That reduces portfolio volatility on the way down, and provides the means to buy stocks on the cheap after a selloff. Of course, an investor must be willing to earn next to nothing on that money while waiting for the bottom to fall out. But remember: Out of every bear, a new bull is born.
