Bull market’s future is a muddled storyline
If bull markets were three-act dramas, the election of an unapologetically pro-business president would mark what novelists and screenwriters call Plot Point 2, or the surprise event that spins the action into a third and final segment comprising almost precisely onequarter of the whole.
Most readers and theater-goers stick around to see how it all ends. History suggests that investors should remain seated as well, even if the plot line has jumped the shark. Which, according to some students of stock market history, the now 8-year-old rally surely has.
Over the 12 bull markets since 1940, stocks have gained an average of 37% over the final 13 months, a period that corresponds to one-quarter of the average rally’s total duration. Since the election of Donald Trump in November, the broad U.S. equity market has jumped 14%, suggesting there still could still be serious money on the table.
The current bull market, which began in the final months of the Great Recession, already ranks as the second longest and third most profitable since the baby boom market of the 1950s. That could be good news, since the longest post-war bull runs also generated the largest late-cycle gains. Rallies that began in 1949 and 1990, for example, averaged 8.2 years and generated about half their total gains over their final two years.
With no sign of recession on the horizon, it’s understandable that investors are reluctant to leave early, especially with cash returning a pittance and bonds barely keeping pace with inflation. But to an unnerving degree, the steady climb in stock prices since March 2009 has been enabled by unnaturally low interest rates that compensated for unusually slow economic growth.
Where stocks go from here will depend largely on two questions: whether the reflation trade that underpinned the so-called Trump Bump will eventually emerge from Congress, and if the Fed will tighten monetary conditions significantly in a preemptive strike against inflation.
Investors seem confident that growth will accelerate later this year and that the Fed will be loath to kill the economic patient it so carefully nurtured back to relative health. An index that measures bearish sentiment has fallen to near the bottom of its historical range.
Yet the absence of fear is a worrying sign in itself. Peaks in complacency often foreshadow sharp market corrections.
Though the worst bear markets are associated with recessions, an economic downturn isn’t always needed to induce selling. Stocks crashed in October 1987 without the economy shifting into reverse. Bear markets also began in 1946 and 1966 without an accompanying recession.
Economic expansions have a strong Malthusian element; they generally don’t die on their own accord, but more often are killed by the Fed, which responds to the possibility or reality of rising inflation by hiking benchmark interest rates. Each of the 10 recessions since 1950 was preceded by a significant tightening of monetary conditions, and with the U.S. at or near full employment, inflation hawks already are sounding the alarm despite core inflation continuing to run well below the Fed’s own 2% target.
Besides the likelihood of higher short-term rates, the Fed soon will begin shrinking its balance sheet by not reinvesting principal from maturing bonds, thereby removing a source demand from the fixed-income market. Also, Trump will have the opportunity to appoint several new members to the Fed’s rate-setting committee; some of the rumored candidates are thought to be fond of the Taylor Rule, which if applied, would push benchmark rates up to 3%, or almost triple the current level. One name being mentioned to succeed Fed chair Janet Yellen is John B. Taylor, the Stanford University economics professor and originator of the Taylor Rule.
Of course, bull markets don’t always adhere to narrative arcs. And plot points aren’t always what they seem at the time.
In January 1973, the Paris Peace Accords that brought an end to the Vietnam War could have been viewed as a catalyst to propel equity prices higher for longer. Instead, stocks peaked within days of the agreement and didn’t climb above that level to stay for nine years.
You might want to hold off on the popcorn.