Getting a fix on how far US stocks can climb further.
By Nicholas Colas
The current move higher for US stocks may look like a bull market, but it shares few characteristics with an actual bull.
We need to look beyond the barnyard comparisons to understand the future direction of US equities. The real risks are entirely human and centre on how investors factor long-term uncertainty into asset prices.
One example is the "ageing bull" objection: Stocks have run for too long and the bull is too old to be productive. Most market observers use April 9, 2009, as the starting point for these measurements. By that reckoning, US stocks have risen 250 per cent over seven-plus years.
This is an extraordinarily long-lived rally, surpassed only by the record move in the 1990s and the surge during President Franklin Roosevelt's first terms in office.
A better approach, however, is to exclude the gains from 2009 and 2010. Why? Recall that the S&P 500 fell 37 per cent in 2008 on fears that the global banking system would collapse.
When that did not happen, stocks recovered by 26 per cent in 2009 and 15 per cent in 2010. Those moves essentially removed an "end-of-the-world" discount from equity asset prices.
Total annual returns from 2011 through 2016 have averaged 12.8 per cent, not far off the 11.5 per cent average return history of the S&P 500 for the last 50 years. Keep in mind that those five decades include not only 2008, but also 2002 (a 22 per cent decline) and 1974 (a 26 per cent decline).
By this reckoning, the current rally is unremarkable for its duration and its total increase in value.
Another objection to the current market move is its lack of volatility. The bull must be getting tired if it won't kick any more, right? History shows this is incorrect.
Look at the CBOE VIX Index back to 1990 and you will see a series of smile-shaped patterns. Volatility peaks in recessions (the corners of the "mouth"), and then spends many years at below-average levels as the US and global economies recover. The long-run average of the VIX may be close to 20, but it doesn't spend very much time there.
The current spate of low volatility is explainable as a function of expected corporate earnings and interest rates. After more than five years of economic recovery, the market has a solid handle on the underlying earnings power of most public companies.
And after a decade of low global economic growth and inflation, the same holds true for interest rates. With little uncertainty for either factor, why would we expect volatility to be higher?
Bull markets should be big and broad. This one isn't, with stocks such as Amazon, Apple, Facebook, Microsoft and Google responsible for close to a third of the S&P 500's move this year.
This reminds many of previous periods of market concentration, including the "Nifty Fifty" of the late 1960s/early 1970s or the dot-com boom of the 1990s. Both were harbingers of broad-based market declines.
In fact, the concentration of equity-market performance now is mostly a function of the tech-enabled "winner-take-all" economy of the 21st century. It is not laziness or myopia guiding investors toward a handful of names.
It is the belief that these companies have unique software-enabled business models and the scale to keep winning. And their results show that this confidence is so far well-placed.
If you want to start identifying the real problems with US equities, you need to look at valuation math. At 18 times forward earnings, the S&P 500 discounts a future that is very similar to the last five years of steady earnings growth and low interest rates. That seems overly optimistic.
The first place to look for a negative catalyst is geopolitical risk, simply because an 18 times market clearly puts the odds of a shock at close to zero. To endanger the current market rally, such an event would have to hurt consumer confidence materially and/or raise the spectre of inflation.
That's the historical recipe for a bear market, and there's no reason to think the ingredients are different now.
Uncertainty over Federal Reserve policy could also pull equities lower. The chances of this are greater now than at any point since the early 1990s, given that the Greenspan/Bernanke/Yellen era may be drawing to a close.
President Donald Trump's choices for chair and Fed governorships could remake the central bank, or at the very least put in place a new team for markets to learn to trust.
The last important factor to consider is probably furthest from most investors' minds: What happens in the next recession?
Worries over artificial intelligence and workplace automation are far more likely to be the subject of TED talks than market-moving investment themes. After all, since economic growth is stable and stock markets are high, there is little pressure on corporate America to implement large-scale productivity improvements.
The next recession will likely coincide with broad and cheap access to many new workforce-reducing technologies. This may cause a broader dislocation in the labour force than the scope of the economic decline would imply.
Remember: To continue, high valuations and low volatility require both stable economic growth and predictable earnings. The current bull market discounts continued high employment and corporate earnings for years to come.
Disruptive technologies may not allow for that outcome.
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