Born from Financial Crisis, Bull Market Turns 10 Years Old
March 9, 2019 will mark the 10-year anniversary of the S&P 500’s bull market run, the longest in history. While this is great news, it is also a good time to reflect on how we got here. On March 9, 2009, the S&P 500 closed at its lowest point during the financial crisis - a closing level not seen since the mid-1990s. Loose lending standards and low interest rates encouraged banks to lend money to less creditworthy customers and even issue NINJA loans (loans that required no income, no job, and no assets). Knowing the embedded risk in these loans, banks sold them to Freddie Mac and Fannie Mae, government-sponsored enterprises (GSE’s) that guarantee the loans. The GSE’s and banks also bundled loans in mortgage-backed securities (MBS) and sold them to investment banks, hedge funds, insurance companies, and other investors. These investors eventually had to write down these loans when they started going bad, causing liquidity problems which in turn caused investors large and small to go bankrupt. To calm investors and prevent further losses some unprecedented actions were taken:
September 2008: The Freddie Mac and Fannie Mae were taken over by the U.S. government.
October 2008: The Troubled Asset Relief Program (TARP) was passed into law to allow the U.S. Treasury to purchase up to $700 billion in troubled assets, providing liquidity to prevent more bankruptcies.
December 2008: The Federal Reserve cut short-term interest rates to zero and started to engage in quantitative easing (QE), buying longer dated mortgages and other securities to lower long-term yields. The Fed’s balance sheet increased from around $1 trillion to $4.5 trillion.
The fallout from the financial crisis was devastating. More than 8.6 million jobs were lost in the U.S. between 2008 and 2009, the housing market crashed, and the S&P 500 lost more than 50% of its value during the 18-month bear market in stocks. Today, the unemployment rate is 4% and labor market growth is accelerating. Although the S&P 500 had a negative calendar year return for the first time since 2008 last year, the index is off to a strong start this year and is near its all-time high. While the Great Recession is behind us, the memory of it still is fresh in many investor’s minds. All bull-markets come to an end and many fear it could end in the next year or two. In fact, this bull market nearly ended in 2011 and last December. In both cases, the S&P 500 had a drawdown of 19% based on closing prices. The technical definition of a bear market is a drawdown of 20% or more based on closing prices. Even with the many corrections that have occurred since the market bottom of March 9, 2009, the S&P 500 has managed to generate an annualized total return of over 17% in the 10 years since. Below are three reasons why the bull market may be ending and three reasons why it may be continuing. We will balance these headwinds and tailwinds out at the end.
Bull Market Headwinds
Economic Growth Slowing
The biggest threat to the bull market is an economic recession in the U.S. Although a 2019 recession is not our base case, there are signs of the economy slowing, both domestically and abroad. The risk is that economic activity will stall and trigger a recession. The global manufacturing PMI (Purchasing Managers Index), a proxy for the path of the global economy based on a survey of manufacturing firms, has been slowing since November 2017. The U.S. Manufacturing PMI peaked in the summer of 2018 and has been trending lower since. Both readings are still in expansion territory, but they are showing signs of weaker economic growth. Additional signs of softer growth are evident based on the recent slowdown in retail sales, weakening housing market activity, and slowing capital expenditure. For now, labor market activity has remained healthy, but labor weakness typically doesn’t appear until an economic expansion is about to end.
Last year, earnings growth accelerated to 20% year-over-year and revenue growth expanded to 6.6%. The strong economy and corporate tax cuts boosted corporate balance sheets. However, the earnings landscape is likely to change this year and the current Factset earnings growth forecast for 2019 is only 4.5%, while revenue growth is projected to slow to 4.9%. Projected earnings growth for 2019 has been trending lower since the fourth quarter and a slowdown in the economy could cause an earnings recession. The current projections for first quarter earnings growth is -2.7% and only 0.7% for the second quarter. These are low hurdles for companies to exceed when they report, but the trend is disconcerting and could spell trouble for the bull market if there is sustained weakness in earnings growth.
Fading Fiscal Stimulus
Another threat to the bull market is the fading impact of fiscal stimulus. The Tax Cuts and Jobs Act was implemented last year and provided sweeping changes to the tax code for both individuals and corporations. Tax reform, combined with a rise in defense spending, provided a boost to economic growth and corporate earnings in 2018. The downside of fiscal expansion is that the impact fades over time. Moreover, rising deficits and a split Congress limit the opportunity for additional fiscal stimulus in the near-term. Slower projected economic growth and the anticipated slowdown in earnings this year are partially the result of fading fiscal stimulus. Additionally, it is not yet known how consumer confidence will be impacted by the decline in fiscal expansion.
Bull Market Tailwinds
Don’t Have to Fight the Fed in 2019
Arguably the biggest headwind for markets in 2018 is potentially the biggest tailwind this year. We are referring to the Federal Reserve. Stocks cratered last December, as markets sent a message to the Fed to slow down around the time of the fourth interest rate hike of the year. Anxiety over the accelerated pace of rate hikes overshadowed a strong year for the economy and corporate earnings. The Fed softened its message in early January, signaling a more patient approach and the market has recovered in response to the more dovish stance. Based on Fed Futures market odds, there is only a 2% chance rates will be higher at year-end. This is a positive sign for equity markets this year as the S&P 500 looks to avoid consecutive negative calendar year total returns for the first time since the fallout from the tech bubble (2000-2002).
Valuations are No Longer a Headwind
Stock valuations reached a cyclical peak in January 2018 before trending lower by year-end. The Price-to-Earnings (P/E) ratio for the S&P 500 reached 24X trailing 12-months earnings, which was the highest level since the tech bubble. Valuations fell last year because stock prices dropped while earnings growth was very strong. Valuations at the start of 2019 were at or below historical averages for most major equity categories. Even after the recent rally in stocks, valuations remain favorable and are not at a level that would make another leg-up in stock prices challenging. Inflation and interest rates are still relatively low compared to history and that provides an environment where valuations can drift above their historical averages. Valuations were a headwind for stocks in 2018, but they are not likely to pose a challenge this year if earnings growth remains positive.
Trade War Winding Down
Finally, the uncertainty surrounding international trade may have been part of the reason for slowing exports globally. The threat of additional tariffs did have an impact on weakening business and investor confidence. The good news, based on recent media comments made from both sides, is that China and the Trump Administration seem to be making progress on producing a comprehensive trade deal. The deadline for additional tariffs on Chinese goods was recently moved back to the end of March to create additional time to negotiate. Both sides have a lot of incentive to work out a deal. China’s economy is showing signs of weakening and President Trump is looking for a deal to help his reelection campaign in 2020.
Putting It All Together
After the Great Recession, investors have been very leery of equity markets advancing. The longest bull market may be the most hated bull market of all time. Since the start of the long run, many investors have been fearful it won’t last. However, those fears are more than justified. Bull runs do not last forever. Fears of an economic slowdown, stagnant earnings, and fading fiscal stimulus are real. These are also known risks and much of it is priced into equity prices. The big dip that almost cost the S&P 500 its longest bull market status was due to concerns around economic growth and more importantly the Federal Reserve. The Fed has since backed off its desire to hike rates further. Also, valuations have come down from the start of last year and there is more potential for upside surprises. A trade deal with China is a good example. With all the worries in the market, there is not a lot of excessive risk taking that we saw in the early 2000s in the technology sector or in the mid-2000s in the housing sector. The next recession is not likely going to be a deep recession like the Great Recession. In addition, the average market decline during the 12 bear markets since World War II is 32%. If you exclude the previous two bear markets, which were historical anomalies, the average market drawdown is 28%. We came close to that in the fourth quarter of last year already. In conclusion, risks are mounting, but there are also some positive catalysts remaining. A bear market is inevitable but trying to time it can be costly as many have already gotten it wrong over the past ten years. Sticking to long-term risk and return objectives and diversifying among assets classes like equity and bonds is perhaps even more important now. High quality bonds have been out of favor for a while, but now offer higher yields. For investors that have shunned high quality bonds for substitutes or proxies, it may be a prudent time to reevaluate portfolios.
This report is created by Cetera Investment Management LLC
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