America’s creaking bull stock market may be on its last legs
The convulsions that have shaken equity markets for the past week have hallmarks of something bigger - perhaps an end to the era of tranquility that has reigned on Wall Street for half a decade.
Little in the economic data or corporate earnings indicated trouble was looming. Growth in gross domestic product is projected to be 2.6 per cent, while stock analysts have been upgrading earnings estimates at the fastest pace in six years.
Unemployment is at a 17-year low. None of that has been enough to keep daily stock swings from doubling in 2018, at least over the first six weeks.
The imperfect relationship between late-cycle stock volatility and the economy was on display at the end of the dot-com bubble, too.
In the US, turbulence was rife in equities at a time when GDP was expanding by nearly 5 per cent and unemployment was on its way to a 30-year low.
Things were a little less robust in 2007, though no quarter that year saw an economic contraction or joblessness of more than 5 per cent.
To a greater extent than 24 different previous pullbacks since 2009, this one arrived to distinct signs of froth.
Bitcoin’s 20-fold run-up. Individuals streaming into the market. Equity funds getting record cash. In contrast with euphoria years like 2017, bond yields are rising with increasing momentum, something that has historically spelled trouble.
“What we saw in January was sort of the psychological peak of the entire bull market,” said Doug Ramsey, 51, who helps oversees US$1.5 billion in Minneapolis and cut equity holdings just before the sell-off.
“The sentiment peak usually occurs a number of months, sometimes up to a year, in advance of a market peak. There is a chance that we put in a top somewhere in that window.”
Ramsey has a solid record of prescience. His optimistic view in 2013 proved correct and he was a bull market advocate until late 2014, when he got nervous because of weakening breadth.
While the S&P 500 did not go down as much as he thought, it was locked in a trading range over next 18 months, suffering two 10 per cent corrections.
He joined Leuthold in 2005 after stints at Treis Capital and Principal Global Investors. The Leuthold Core Investment Fund has beat 88 per cent of its peers over the past five years.
How do bull markets end? Sometimes suddenly, but often in a slow burn where signs of nervousness gradually multiply. In 1999, the last year of the internet bubble, the Cboe Volatility Index averaged 24.4 – more than twice its level in 2017.
Declines in the S&P 500 exceeding 5 per cent occurred six separate times that year, even as the index returned 20 per cent. It had three similar retreats before peaking in 2007.
“As different scenarios work through the system, volatility should increase,” said Malcolm Polley, who oversees US$1.2 billion as president and chief investment officer at Stewart Capital Advisors LLC in Indiana, Pennsylvania.
“The end of a cycle tends to happen because of any event – most of these events are either unknown or unexpected so the market doesn’t know how to discount that.”
Ramsey cautioned against one threat, spiking Treasury rates, in a market where valuations are the highest level since the dot-com era.
Their peril was on display last week, when 10-year yields climbed to a four-year high, fuelling the worst stock decline in two years.
To be sure, nothing in the market breadth or price momentum suggests that the S&P 500’s record reached on January 26 marked the end of the rally.
In fact, from small caps to transports, technology to financials, everything hit multi-year highs around that time while the S&P 500’s relative strength indicator spiked, a sign that it’s too soon to claim the death of the bull market.
But danger is growing now that this bull cycle is six months away from becoming the longest in history. For a glimpse of how the topping process may unfold, look to 2007 as a road map, says Ramsey.
Back then, stocks suffered a correction from July to August. As the S&P 500 started bouncing back, fewer and fewer stocks managed to keep up.
Small-cap trailed, transports lagged behind and once tech heavyweights failed to hold up, the sell-off cascaded into a bear market.
“It’s going to be this topping parade,” Ramsey said.
“Maybe now we’ve gone down hard for a few days, something that has been knocked down among these bellwethers don’t come back and make new highs. This crack sets up for the last rally leg.”