Stock investors have been on a roller coaster over the past two years. As measured by the S&P 500 Index, stock prices rose by 20% during the six months ending in January 2018; declined by 10% over the next three months ending in April 2018; rose by 15% through the end of September; and plunged by nearly 20% through year-end 2018. Since the end of December, stocks have risen by nearly 25% to a level within 2% of the all-time peak reached on September 20.
In this edition of Economic Commentary, Robert F. DeLucia, CFA and Consulting Economist for MEMBERS Capital Advisors, Inc., attempts to explain recent market volatility and gauge the likely direction of stock prices over the next year.
Q&A With Robert DeLucia
Are the catalysts in place to indicate a cycle peak in stock prices?
An analysis of the investment cycle must begin with an assessment of the traditional business cycle. The current bull market in common stocks will end when the expansion cycle ends and when recessionary conditions become widespread. As I have discussed on numerous occasions, the typical catalysts for an end-of-cycle recession are currently not in place — implying that the economic expansion and an uptrend in company earnings are likely to persist for a while longer.
The combination of sustained economic growth and rising profitability should support equity markets over the next year, at a minimum. However, the expansion cycle will eventually come to an end and recessionary conditions will ultimately become widespread, with negative implications for stock prices.
How can investors prepare for the inevitable recession, accompanied by falling company earnings and a decline in stock prices?
There are 10 vital indicators that should be monitored as early warning signs of the next equity bear market:
1. Rising Inflation: The equity bull market will not be at serious risk until core consumer inflation — currently at 1.8% — rises decisively above the Federal Reserve’s long-term target of 2%. Free market economies perform best in an environment of price stability.
2. Aggressive Monetary Tightness: Virtually all recessions of the past 60 years were triggered by aggressive monetary tightness in response to a rapid rise in the inflation rate. With core consumer inflation below 2%, monetary policy should remain supportive of growth until there is a decisive change in the inflation backdrop. Similar to the US Fed, world central banks are unwilling to take economic risk and are willing to tolerate higher inflation.
3. An Inverted Yield Curve: Recessions typically begin roughly 12 months following a sustained inversion of the Treasury yield curve. The yield curve is currently flat but not inverted, with the yield on three-month Treasury bills of 2.35% comfortably below the yield on ten-year Treasury bonds of 2.51%.
4. Rising Borrowing Costs: Sustained economic growth is heavily dependent upon credit conditions — an abundance of credit availability at a reasonable rate. With current mortgage rates at only 4% — down from a recent peak of 5% — the housing market should enjoy a powerful rebound over the next 18 months. The US economy has never experienced a recession when the housing market was in an expansion mode.
5. Profit Margins: The trend in profit margins has been a reliable signal of the end of a business expansion. Historically, profit margins have reached a cycle peak roughly six to eight quarters prior to recession. Assuming margins peaked in the fourth quarter of last year, the odds of a recession during the next 12 months are low.
6. Slowing Demand for Labor: Select employment data can be useful as reliable leading indicators of the business cycle. Investors should become concerned when monthly nonfarm payroll growth begins to slow, when weekly unemployment claims begin to climb on a sustained basis, and when job openings begin to shrink. The conventional view of employment as a lagging indicator is incorrect.
7. Credit Problems: Equity bear markets are always preceded by a sustained increase in credit problems, as measured by a rising trend in losses on bank loans and credit defaults on corporate bonds. Credit conditions in the banking system and corporate bond market are currently stable, implying that a recession is not imminent.
8. Widening Corporate Bond Spreads: Equity bull market peaks are always led by a widening of corporate bond risk spreads. Credit spreads are currently in a narrowing trend that should persist over the next year, at a minimum.
9. Large Flows Into Equity Mutual Funds: Equity bull market peaks typically coincide with sustained large retail investor infusions of cash into equity mutual funds. First quarter data from the Investment Company Institute shows that US stock funds suffered a net outflow of $16.5 billion. This contrasts sharply with massive inflows of $110 billion to bond mutual funds. These data are encouraging for stock investors and negative for bond investors, from a contrarian perspective.
10. Evidence of Investor Euphoria: Equity bull markets always begin in an atmosphere of pessimism and despair and end in an atmosphere of euphoria and greed. Investor sentiment has improved from one of maximum fear and panic in December to one of moderate pessimism. Most surveys reveal that institutional investors as a group have below-average allocations to common stocks — and above-average allocations to bonds and cash — which is a positive factor from a contrarian perspective.
Should equity investors be prepared for an unexpected shift in underlying market conditions?
Virtually all warning signs of an equity bear market are currently benign, with very few indicators flashing red. The broad implication is that the path of equity prices will be upward over the next year, at a minimum. However, there are 4 countervailing factors that investors need to consider.
1. Consolidation Phase: The surge in stock prices since late December suggests that a consolidation phase should be expected in coming weeks. Stock prices do not move in a straight line, either up or down, and the nearly 25% jump in prices in less than four months could be followed by a minor interim corrective phase or sideways pattern.
2. Peaking Process in Motion: While the business cycle has not yet reached an ultimate peak — and another two years of sustained economic growth appears probable — the long peaking process seems to already be in motion. In other words, while most classic catalysts for recession have not advanced to a dangerous level, some have begun to move in that direction:
- Inflation: Although far from worrisome, the inflation rate has increased from a cycle low of 1% to nearly 2%.
- Monetary Policy: The Federal Reserve’s rate-tightening cycle is fully underway, with the federal funds rate at 2.5%, up from 0.5%. Further rate hikes lie ahead in 2020 and 2021.
- Company Profit Margins: Although not yet in decline, corporate profit margins have peaked for the cycle and are likely to drift lower in coming quarters.
- Treasury Yield Curve: Although not inverted, the yield curve has been in a flattening pattern over the past several years. An actual inversion of the curve could begin in 2020, which if sustained, would signal a recession in 2021.
The key point is that both the business expansion and equity bull market — both at a record ten years — have reached a mature stage. However, the US equity market should continue to move higher in coming months and is unlikely to end until company earnings peak and the Federal Reserve aggressively tightens monetary conditions.
3. Full Employment: Although productive resources — labor, capital, materials — are far from being totally exhausted, the US economy is approaching full employment. A resumption of above-potential growth expected later this year could result in bottlenecks and price pressures next year and in 2021.
4. Equity Market Valuation: At a price-to-earnings (P/E) ratio of 17x — as measured by the 12-month forward projection of earnings per share (EPS) — the equity market is slightly above fair value, estimated at 16.5x. P/E ratios are down from their 2018 peak of 19x but above their December low of 14x. However, equity valuations appear reasonable in the context of 2% inflation, 2.5% yields on Treasury bonds, and 4% yields on BBB-rated corporate bonds.
The implications of fair valuation are twofold:
a. In the negative column, valuation can no longer be cited as a compelling reason to buy common stocks.
b. In the positive column, the equity market is not vulnerable to a major decline because of excessive valuation.
The bottom line is that prospects for equity investing appear favorable in the medium term. A consolidation phase appears likely in the very short term, and an inevitable market peak is assured in a longer-term context. The medium term — defined as the next 12 months — offers a window of opportunity in an environment of moderate strengthening in GDP growth, continued accommodative monetary conditions, and a rising trend in company earnings.
What does this mean for financial markets moving forward and future recessions?
By definition, financial markets are forward looking and tend to change direction in advance of major changes in the economy. The equity market is the quintessential leading economic indicator. Stock prices have peaked roughly six months prior to the onset of recession, with a majority of instances consistently occurring within a range of three to seven months. The shortest lead time between equity market peaks and recessions was one month (1990), and the longest lead time was nine months (1981).
What does history reveal about the performance of the US equity market in the final stage of an economic expansion?
Montreal-based investment consultants MRB Partners conducted a study of the ten recessions dating back to 1953, calculating returns on stocks during the 18 months immediately preceding an outright recession. Somewhat surprisingly, the study revealed that the equity market performed well during the 18 months leading up to recessions, with a median return of 16%.
For example, the most recent recession began in December 2007. During the 18-month period beginning in June 2006 and ending in December 2007, the US equity market rose by 24% from start to finish. The best 18-month pre-recession period was a 42% rally ending in July 1990; the worst was a loss of 1% for the 18-month period preceding the recession in 1969. The median rally for all ten pre-recession periods was 16%, while the average gain was 18.5%.
As with all historical data, past results should never be perceived as a guarantee of future performance. However, it is encouraging to observe as the economy approached recession, the direction of the equity market was upward in virtually all cases dating back to 1953.
What’s the historic relationship between a bear market and a recession?
History reveals that equity markets always decline in anticipation of recessions. Stock prices reach a cycle peak several months in advance of recessions. Similarly, equity markets always anticipate the next economic recovery with a lead time of several months. Stocks decline during recessions because of accompanying declines in company earnings, cash flow, and dividends. The average peak-to-trough decline in the S&P 500 Index during the ten recessions since 1953 was 30%; the median stock price decline was 25%.
The relationship between the equity market and economic recessions is one of the most consistent and durable in finance theory. It is a virtual certainty that stock prices will once again signal an end to the economic expansion and onset of the next recession. The only uncertainty right now is timing.
What warning signs should investors not ignore?
There are a number of time-tested and proven indicators that investors should closely monitor for clues to the inevitable cyclical peak in stock prices. The majority of these indicators are related to the traditional business cycle, while some involve measures of equity market sentiment and valuation. In combination, these classic early warning signs suggest that the path of least resistance for the equity market is upward over the next six to 12 months.
However, there are three partially offsetting factors that should be noted in order to preclude a sense of complacency. First, the V-shaped surge in stock prices since year-end suggests that a consolidation phase is likely over the very short term, until the current overbought condition is resolved. Second, while the business cycle has not yet reached an ultimate cycle peak, the peaking process is currently in motion. Finally, although far from overvalued, the equity market has transitioned from massive undervaluation in December to a current state of roughly fair value.
The implication is that equity prices are likely to grind higher over the next six to 12 months, but that the upside from current levels is capped because of late-cycle economic and valuation constraints. I continue to believe that the onset of the next cyclical bear market in stocks is further into the future than what is assumed by most investors, but that the path upward could be choppy.
While the business cycle has not yet reached a final cyclical peak, the peaking process is already in motion and pressures are likely to increase. Learn how you can help clients better face the inevitable highs and lows by reading our guide, Preparing for the Next Cycle. Click the button below to download this valuable tool now.
All opinions and commentaries expressed are those of the writer, Robert F. DeLucia, and do not necessarily reflect the opinions of CUNA Mutual Group, CBSI, or its management.