A correction or a bear market? Making sense of the recent turbulence
It may be that this is a late-cycle bull market that isn’t quite finished yet
The longest US bull market in history has been looking shaky recently. October was the worst month since November 2008 for the tech-heavy Nasdaq index, while broader US indices followed the lead of their down-trending international counterparts and suffered a double-digit correction.
After a 9½-year rally, is a bear market looming for US stocks? The question holds an obvious relevance for investors. Firstly, financial losses are much steeper during bear markets. Stocks lose a third of their value during the average bear market, according to Vanguard, compared to an average decline of 13.7 per cent during corrective episodes.
Secondly, they tend to be much longer affairs; whereas corrections are typically forgotten in a matter of months, stocks take much longer to bottom (on average, more than a year) and even longer to recover their losses (on average, 798 days, according to Vanguard) during bear markets.
Stocks’ strong recovery in early November should not be taken as evidence the storm has passed, bears argue, given that bear markets are also characterised by strong but ultimately unsuccessful counter-trend rallies. Of course, bulls can point out that bears have been calling time on the current bull market for many years now, but that each correction has ultimately been met with buyers who have driven stocks on to new all-time highs. Bears can point to a laundry list of current concerns – a slowing global economy, trade wars, rising US bond yields and rates as financial conditions tighten after more than a decade of easy money – but bulls counter these concerns are not new and that stocks, underpinned by strong corporate earnings and decent economic growth, remain poised to continue climbing the proverbial wall of worry.
‘Rolling bear market’
Still, investors have become increasingly concerned by the deterioration in market breadth this year. Typically, individual stocks tend to top out long before stock markets peak, with a declining number of large-cap heavyweights often holding indices aloft even as more and more stocks and sectors fall by the wayside.
Even before the recent selloff, Morgan Stanley was arguing we were witnessing a “rolling bear market”. Instead of a “simultaneous and large repricing across risk assets”, this bear market “rolls through different assets and sectors at different times with the weakest links being hit first”. Growth and technology stocks were “among the final holdouts”, the bank added recently, but they fell hard in October.
These falls, coupled with the fact that almost half of US stocks have already fallen into individual bear markets, suggests the rolling bear market is “morphing into a proper cyclical bear market”. Other strategists have also noted that market pain has become increasingly widespread, especially outside of the US. Only 20 per cent of asset classes have generated positive returns this year, JPMorgan noted recently. Only twice in recent history – during the stagflation episodes in the 1970s and the global financial crisis in 2008 – have so many asset classes failed to deliver.
Stocks in China and Greece have fallen more than 30 per cent, notes Ned Davis Research (NDR), while eight other countries have also fallen at least 20 per cent (official bear market territory). History suggests no country can buck the trend during a global bear market, says NDR, which expects “increased downside participation from the overvalued US market and technology sector that helped the US outperform”.
The increased volatility of the US market is also concerning investors. Volatility tends to be low during good times, but sharp falls in February and again in October mean the S&P 500 has now suffered two double-digit percentage falls this year.
In bull markets, it’s rare for stocks to suffer two sharp one-month falls in the same year, cautions Fat Pitch blogger Urban Carmel, a former president of UBS Securities in Asia. Carmel could find only three instances in the past where market action mirrored 2018’s – in 1980, 1990 and 2000, each of which was followed by a recession and a bear market within a year.
Today’s market also carries echoes of 2007, he adds. Although stocks hit multiple all-time highs that year, they also suffered a number of unnerving plunges, with market volatility escalating as it became clear that global bank woes were more serious than first imagined. US indices also “have a topping pattern in place”, adds Carmel. Typically, technical metrics that measure market momentum peak “before an eventual price high as the uptrend falters”.
Although stocks hit all-time highs in August and September, the S&P 500’s momentum high was in January. “This pattern is how every major top in the past 40 years has started”, notes Carmel. “Risk is higher, greater vigilance is warranted”.
Nevertheless, Carmel adheres to the consensus view on Wall Street that recent travails represent a correction in an ongoing bull market. Recessions have accompanied eight of the last 10 bear markets but there’s little indication of a near-term economic downturn. Recent research from the San Francisco Federal Reserve shows that, over the last 60 years, every recession has been preceded by a yield curve inversion – that is, when 10-year bonds yield less than two-year yields, an indication markets are concerned over increasingly restrictive monetary policy.
The yield curve has flattened in 2018 but has yet to invert. Historically, there has been a long lag – at least eight months, sometimes two to three years – between inversion and the start of the next recession. That indicates the current expansion will likely last into mid-2019 or longer, says Carmel. Bears might say that investors are forward-looking and that stocks tend to decline in advance of recession. However, the idea stock price action leads economic fundamentals is misplaced, says Carmel, who says the norm is for employment, housing and consumption to weaken before – not after – the final equity top.
Far from weakening, US unemployment hit a 49-year low in September. Retail sales are at their second-highest level ever. The one concern is housing – new US house sales peaked 11 months ago, and the weak housing has resulted in indices of homebuilding stocks losing a third of their value since January’s all-time high.
Nevertheless, most leading economic indicators are at or near new cycle highs, all of which strongly indicators the bull market isn’t about to die just yet. The strong economic backdrop (and tax cuts) is reflected in corporate earnings data. Third-quarter earnings are projected to rise by 25 per cent and estimates continued to increase in October – “a great sign amid all the market volatility”, said LPL Research strategist Ryan Detrick. The S&P 500 has barely gained in 2018, despite the huge increase in earnings.
Rejecting Morgan Stanley’s bearish take, Goldman Sachs argues the selloff has “overshot the fundamentals”. JPMorgan data indicates valuations have returned to their 25-year average, says Carmel; thus, further earnings growth in 2019 means stocks could be driven higher in 2019 by both corporate growth and an expansion in valuation multiples. So, correction or bear market? Merrill Lynch data suggests 14 of 19 bear market signals have already triggered. That’s concerning, but it’s common for all 19 signals to trigger before stocks top out. Amidst all the conflicting data, it may be that this is a late-cycle bull market that isn’t quite finished yet.