Throughout
the history of the U.S. stock market, there have been many bull and bear
markets. Studying these market cycles can teach investors a great deal
about how the market behaves and the underlying reasons behind it. If you
can identify the driving forces of a bull or bear market, you can make more
intelligent decisions to either protect yourself against a looming bear market
or take advantage of a bull market.
In the
20-year history of our firm, we’ve seen several of these market cycles and have
studied countless others. While no bull or bear market looks exactly the
same, the past provides us with useful insights about the future. In the
words of Mark Twain, “History doesn’t repeat itself, but it does rhyme.”
Today,
we are going to see how the current bull market “rhymes” with years prior and
what information we can gather from its historical patterns.
Anatomy
of a Bull Market
The
anatomy of almost all bull markets can be broadly defined by four primary
characteristics that make up the acronym B-U-L-L, which you can read more about here.
1. Breadth
2. Unrelenting
3. Leadership
Rotation
4. Loud
The
“Loud” part of the equation is of particular interest in today’s market.
Bull markets attract a lot of attention from media and Wall
Street. Everywhere you turn, it seems like you hear about the stock
market. The local newspaper, CNBC, Wall Street, and even outings with
family and friends can turn into investment discussions.
That’s
typical of bull markets. They grab you and force you to pay attention.
For all of those investors who have been out of the market since 2009,
the run-up in stocks over the past five years has shown them just how wrong
they have been.
Bull
markets attract their fair share of commentators on both sides of the fence.
Some say the bull market will keep going, while others continually
predict it’s demise. The longer the bull market goes, the louder the
shouting on both sides become. Amongst all of the noise, it’s difficult
to discern between what is truly relevant information and what is just that -
noise.
A lot
of the chatter lately has been speculation about when the current bull market
will end. If you look back on nearly every bull market we have ever had
in the United States, you will find that the vast majority of them don’t die of
old age, they are killed. There are two primary killers of bull markets:
(1)
Recessions
Pullbacks
and corrections can occur at any time, but it is really difficult to have a
real bear market unless there is an economic recession that negatively impacts
company fundamentals. Remember, prices will always follow valuation in
the long-term. So if long-term values are increasing, the long-term
trajectory of the stock market should also be increasing.
The
majority of the data we see coming out of the economy have been very positive.
We thought the Q1 economic data were mostly weather-related, which turned
out to be correct. Employment numbers have improved significantly.
The economy has now added at least 200,000 jobs for the past five
consecutive months.
As the
economy starts to heat up, we should see increased activity from consumers and
better sales growth for U.S. corporations. Unless there is an unforeseen
major geopolitical issue or natural disaster that disturbs the global economy,
neither our Macroeconomic Team or the economists we follow foresee any
recessions on the horizon.
That
leads us to the second major killer of bull markets...
(2) The
Federal Reserve
In the
absence of any major economic shocks, the Fed is the primary suspect in the
death of most Bull Markets.
When
interest rates are low, investors look outside the safety of U.S. Treasuries
and into more traditionally risky assets such as stocks. As the stock
market increases from the inflow of funds, people begin to experience the
“wealth effect” from watch their account values go up. As consumers feel
more wealthy, they increase their spending, which puts upward pressure on
capacity. To meet the rising demand, businesses hire more people and
invest in new factories and technology to push up supply. When the Fed
raises interest rates, the opposite tends to occur.
Even
when the Fed raises rates, however, the stock market has historically been very
slow to respond. Looking back to previous bull markets, it has taken
several months of interest rate increases before the stock market has had any
meaningful reaction. This is not to say that this time will be the same -
but it does contradict the widely held belief that the stock market will be
hurt by the Fed raising short-term rates in the coming year or two. Using
history as our guide, that just doesn’t seem to be the case.
Furthermore,
the small body of evidence we have about Federal Reserve Chair Janet Yellen
suggests that she isn’t going to be quick to raise interest rates. Yellen
believes wholeheartedly in the Fed’s dual mandate of both maintaining price
level control (inflation) and in promoting employment. As long as the
economy continues to have above average unemployment, it is very likely that
Yellen will push the Fed to keep rates low. And as long as rates stay
low, there is nowhere for investors to go but stocks.
When Is
The End?
While
we would consider ourselves to continue to be optimistic about the future of
stocks, we certainly are not raging bulls. We know that all bull markets
must come to an end at some point, we just don’t believe that will happen in
the near-term.
While
no one can know for sure when the bull market will end, there are often signs
that start show up ahead of time. One of the things we look for are the “one
percent days.” If stocks start moving up rapidly with a series of these
large increases, that is likely a sign that Mr. and Mrs. America are starting
to get tired of sitting in cash. As they pour into the market, the buyers
dry up and leave nothing but sellers. On the flip side, a long string of
negative one percent days typically indicates that the market is going through
more than just a batch of profit taking.
We get
a lot of questions about what we would do if we sense weakness in the market. When
we see potential trouble on the horizon, we don’t just immediately move to cash
or try to time the market. We find it in our clients’ long-term interests
to “take air out of the ball.”
If
things were to get rowdy, we would strategically reduce more volatile positions
(“A” stocks) and look to add more “Royal Blue (RB)” stocks to stabilize our
portfolio. This does two things: (1) it reduces the volatility of our
portfolio and (2) provides solid earnings growth and dividends to get our
clients through the worst of the storm. In bad markets, the RB stocks
become defensive strongholds. They are so big and strong that they can
absorb huge amounts of shock without damaging the intrinsic value of their
businesses.
Current
Outlook
At this
moment, we don’t see much sign of weakness. Despite the geo-political
issues in Russia, the market has continued to move higher. If shooting
planes out of the sky doesn’t spark even a small pullback, that’s a pretty
strong indicator that the market can continue to drive north.
Valuations
for some companies are getting frothy, but the overall market is about fairly
valued and well within its normal statistical range. With interest rates
so low, even higher valuation multiples than we are currently seeing would not
be out of the question. While that’s a possibility, we don’t anticipate
getting any additional return from valuation multiple expansion.
In our
opinion, stocks are likely to return what they generate in net earnings and
dividend growth over the next 6-12 months. If Q2 earnings are any
indication, growth is starting to accelerate along with the economy. As
long as the companies continue to be the stars that they have been, this bull
market still has strength to keep charging on.
