Status Report: Aging Bull
Cycles are prevalent in all aspects of life. They range from the very short term, like the life cycle of a June bug, which lives for less than a year, to the life cycle of a planet, which takes billions of years. Markets are cyclical too. No matter which market you are referring to, all have similar characteristics and go through the same phases. They go up, peak, go down and then bottom. When one cycle is finished, the next begins. Currently, most indicators of investor positioning, fund flows, asset valuations, and aggregate risk metrics are consistent with the latter stages of an investment cycle. The current bull market in stocks is maturing and risks are gradually rising, but there are only a few red flag warnings that an end is drawing near that could trigger a bear market.
The S&P 500 hasn't suffered a downturn of 5% or more since June 2016, the longest streak since May 1996, according to Bespoke Investment Group. The rally has been steady, not just long. The closely watched VIX volatility index has remained near all-time lows the past year. The lack of market craziness is a relief to many Americans, but some are wondering whether Wall Street is due for a drop. They worry that the market has become a little too quiet; particularly when you consider the relentless noise from Washington and global hot spots like North Korea. Markets are rarely ever this calm for long, and market pullbacks can be healthy, preventing stocks from overheating and allowing investors on the sidelines an opportunity to get in.
We caution against extrapolating this data to try and achieve a forecast, since each cycle can vary substantially, especially in the current abnormal macro landscape. Instead, investors should focus on market positioning and macro catalysts that will ultimately be required to trigger the next bear market. Most recessions and bear markets are caused by tighter global monetary conditions. Monetary policy is unlikely to become materially restrictive anytime soon. Global government bond yields remain depressed, helping to encourage aggregate global growth and boost equity markets. However, yields appear to be set to move higher. For now, we expect any backup will add volatility into equity markets and potentially cause a near-term correction, rather than being substantial enough to destabilize the global economy and trigger a bear market. Until the appropriate catalyst(s) falls into place, the market could experience corrections, but the bull market is likely to remain intact. There is even a possibility that this last phase of the cycle plays out in a series of waves over an abnormally prolonged period.
We are now nearly 450 weeks into the current bull market, which is roughly equivalent to the historical average duration of the entire investment cycle (i.e. combination of a bull and bear market). Indeed, the current investment cycle has been very long, but the nature of the underlying economic expansion has been abnormal as well. More than half the world economy hit a private and/or public sector debt ceiling in the late-2000s and began a prolonged period of intense deleveraging that has only recently faded. The low growth and low inflation backdrop also meant that there was less of a cushion to absorb the repeated shocks this cycle. Along with distorted monetary policies, these forces kept investors nervous and slow to add exposure to riskier asset classes. That said, one upshot of this volatile trading backdrop is that it has materially dragged out the investment cycle, helping to potentially postpone the next bear market. Sustained bear markets in the global equity markets typically only occur if the aggregate global economy suffers a recession. Historically, such events have been led by the US economy. Fears of a global recession can cause intense selling pressure as witnessed earlier this cycle in 2011-2012, and again at the end of 2015 and early 2016, but will not typically end the cyclical bull market unless these fears are proven correct.
The global economy has become increasingly resilient to adverse macro shocks, although there is still a chance of something sizable enough to weaken overall economic confidence and activity. For now, this is merely a risk to monitor. Stocks are being supported in part by distortions in the government debt market, which flatters comparisons of equities versus bonds. An unwinding of this distortion (i.e. a sharp move higher in bond yields) would increase equity risks, even if stocks do not move materially higher in the interim. Regardless, government bond yields typically experience a cyclical move higher at this point in the investment cycle, which we anticipate will unfold in the year ahead. The corollary is that this should act to temper the pace of price appreciation for the overall equity market and heighten financial market volatility. In turn, it will become increasingly important to be selective in holdings of riskier asset classes and to invest in less-correlated private investments. At WMS Partners, we employ unique investment strategies that have non-traditional risk profiles and act differently from the rest of the capital markets. Most of these non-correlated assets are not impacted by the market’s swings and give you the opportunity to experience a more successful cash flow stream to complement your traditional asset class exposure. Overall, this should help smooth out the volatility of the market cycle.