As we all know, the stock market has been in a bull run for a very long time. As of August 22, 2018, it became the longest bull market on record.
From the time of the previous bear market (February 2009) to that record day, August 22, 2018, the S&P 500 Index had increased by around 300%. That equaled an average compounded annual growth rate of over 15%. Add in an annual dividend yield of around 2%, and the decade was very good for stock investors.
In August, the environment seemed favorable to a continued boom in the stock market. Corporate earnings and GDP growth were strong; while unemployment and inflation were both very low. Although some global growth indicators were beginning to hint at a slowdown in growth, it remained pretty much a Goldilocks economy – not too hot, not too cold, just right.
Even so, we knew that every economic expansion, and its associated bull market, would eventually come to an end. Looking in hindsight, it is usually easy to see what the cause of the reversal was. Looking in real time, however, it almost never is – each new bear market seems to come out of the blue.
We don’t know what the cause will be this time, whether tariffs, a trade war, a shooting war, the short-term stimulus coming from the corporate tax cuts running out of steam or, equally likely, something that is just not on the radar at all right now. But one day the bull market will certainly end. While it’s unlikely we’ll know why or exactly when, we can keep an eye out for warning signs of an ending bull market and impending bull market on the horizon.
Warning Signs That a Bull Market May Be Ending
Three possibly worrisome early-warning signs of a coming bear market:
The Yield Curve
The yield curve is the relationship between the interest rates on short-term debt and the rates on long-term debt. The normal relationship is that for a given borrower (and the U.S. Treasury is usually used as the benchmark borrower), debt that matures sooner should have lower rates than debt that matures farther in the future. This is to compensate the buyers of long-term bonds for their increased risks, chiefly that of inflation. The farther out in time the date is when an investor will recover his or her principle, the more the compounding of inflation reduces the purchasing power of that principle in the interim.
A normal yield curve is favorable for lenders (banks), whose business is borrowing short term and lending long term.
In rare situations, when long term interest rates are stubbornly low, the relationships get upset. The long-term rates are not as closely under the control of the monetary authorities (which in the U.S. is the Federal Reserve) as short term rates are. Low long-term yields are a sign that global bond investors are skeptical of long term growth prospects and are willing to accept low yields for the relative safety of long-term bonds. Meanwhile, the central bank may feel the need to raise short term rates, as the Fed has been doing since late 2015. If the short term rates rise above long-term rates, then the yield curve is said to be inverted.
In August 2018, the yield curve was not quite inverted but it was very flat and headed toward an inversion, which could happen after one or two more Fed increases in short-term rates. This remains true today (February 2019).
An inverted yield curve has historically been followed by a recession, after a lag of 6 to 24 months. It is not known what the exact mechanism is that underlies this phenomenon, which means it could conceivably be a coincidence. Or it could have something to do with the fact that banks are less able and willing to lend when their margins are negative. In any case, it is undeniably true that every recession since World War II has followed an inverted yield curve; and that in that time period there has only been one false positive – an inverted yield curve (in the mid 1960’s) that was not followed by a recession. In that one case, there was a significant slowdown that didn’t quite meet the definition of a recession. So, as an indicator of a market slowdown and end to a bull market, an inverted yield curve is not a sign to treat lightly.
The Average Price/Earnings Ratio
The price-earnings ratio is the ratio of a stock’s price per share to its latest annual earnings per share. For example, if a company earns $5 billion in a year and has one billion shares outstanding, it has earned $5 billion / 1 billion shares = $5 per share. If that company’s stock is trading at $100 per share, then its price-earnings ratio is $100 / $5 = 20 to 1.
The average P/E ratio for a basket of stocks can be calculated by averaging their individual P/E ratios. The average P/E ratio for the S&P 500 is often watched as an indication of the cheapness or expensiveness of stock prices in relation to their earnings.
At this time, the S&P 500 average P/E is a little over 21, down from 25 a few months ago. This compares with a long-term average of about 16. In its history, the S&P 500 average P/E has reached the level of 25 or higher only three times before: once before the crash of 2008, once before the crash pf 2000, and once before the panic of 1897. So, at 25 to 1, stock prices were extraordinarily high, and now are a little less so.
Recent Market Behavior
In August 2018, the earnings season for businesses to report earnings for the second quarter of 2018 was just about wrapped up. Earnings came in at all-time highs, with 4 out of 5 companies reporting earnings that were better than forecasts. Even with these blowout earnings, the S&P 500 index was slow to crack the highs that it had reached in January 2018. This relative lack of strength was a possible warning of the end to the bull market.
In September 2018, the market did in fact make new all-time record highs. The S&P 500 topped out at an intraday high of 2941 on September 21. But then investors got lots of coal in their stockings for the Christmas season. The S&P dropped by 20%, which partially fulfills the definition of a bear market. Markets bottomed out on Christmas Eve at 2346, almost exactly 20% off their highs.
At this writing, the equity markets have been coming back strongly – but there is a new warning sign that the bear might not be finished yet. The chart below shows the new high made in September, the later drop, and the recent partial recovery.
Note the Relative Strength Indicator (RSI) in the subgraph below the main graph. This indicator made a much lower high in September than the earlier high in January 2018. When prices make a higher high, while a momentum indicator (which the RSI is) makes a lower high, that is said to be a bearish divergence. These can be signs that the tide has turned.
Finally, note the extended range of the last two red candles in the price chart. Long down candles and relatively shorter up candles are another sign that the impulse direction of the market has changed from up to down.
How to Prepare for the End of a Bull Market
So, what can we do as investors when the party ends, whenever that might be? And how can we prepare for it?
That is a long story. The broad outlines are:
- No one should have so much of their wealth tied up in the stock market (or any one asset type) that a 50% drop in that asset would wipe them out. If you are too exposed to the stock market, consider taking some profits and moving money to less volatile assets.
- Have a clear exit plan and stop losses on your market positions.
- Consider the use of options as protection.