No bull lasts forever. Good times eventually are followed by bad ones, as investor euphoria gives way to fear and despair. The performance history of the Standard & Poor’s 500 stock index drives home the point: The 12 bull markets since the 1930s have all been followed by bear markets, or downturns of 20% or more, according to S&P Dow Jones Indices. The average bear market decline is a sizable 40%. Then there’s the mega-bears like the 2007-2009 rout during the financial crisis that knocked the S&P 500 down 57% and the nearly 50% slide after the internet stock bubble burst in 2000.
The current bull run, the second-longest in history and one that's generated a fourth-best gain of 254%, will eventually tire out, hit one final peak and head lower like all the rest.
The only question is when?
James Stack, a market historian and president of money-management firm InvesTech Research, says there are seven warning flags that can signal trouble ahead. The more flags that are present at one time, the more danger there is. Only one of those warning signals is now flashing yellow, he says.
The other good news, he adds, is that bull markets don’t typically “end with a big bang.” Market tops are usually slower-moving events that play out over many weeks, which gives investors time to prepare.
Here are Stack's seven warning flags:
The more bullish, optimistic and confident the investing public is, the riskier the market becomes. “Bear markets bottom in doom and gloom," says Stack. "Bull markets peak when optimism is highest.”
So what are signs of “extreme optimism”?
Bullish headlines in the news, such as the recent Barron’s cover story, “Next Stop: Dow 30,000.” Hot IPOs, like Snap's 44% jump in its debut last week. A dearth of scared investors, measured by a closely followed "fear gauge," dubbed the VIX, which is now hovering near an all-time low. Skyrocketing consumer confidence measures, such as the Conference Board’s February survey, which registered its highest reading in 15 years. The Dow Jones industrial average’s recent run of 12 record highs in a row also fits the bill. Rising stock valuations are another red flag, and currently the market is trading at close to 20 times earnings, well above the historical average and double where it traded back in March 2009.
“We have exuberance now,” Stack says, noting this is the only yellow flag from the market so far.
The 8-year-old bull has been powered by zero interest rates for nearly a decade. But the Federal Reserve has hiked short-term rates twice in the past 15 months to 0.75%. Fed chair Janet Yellen warns that three more hikes of a quarter percentage point apiece could come this year, with the next hike possibly coming at the Fed's meeting next week. Future markets place nearly 90% odds of a rate increase on March 15, according to CME Group.
In the past, stock market uptrends have been derailed by the Fed hiking rates faster and more aggressively than expected. Higher rates slow down the economy, which hurts the profitability of U.S. companies, a key propellant of stock prices. Higher rates also make it harder for borrowers to keep up with their debt payments, which could dent consumer spending and undermine the health of businesses with high debt loads.
“Fed policy," Stack says, "is a very important wildcard.”
“Bear markets and recessions go hand in hand,” Stack says. Seven of the past eight bull markets were undone by economic contractions, RBC Capital Markets data show. Recessions cause job losses, crimp consumer spending and squeeze corporate profits. Signs of trouble include weaker-than-expected incoming economic data, especially the Conference Board’s Leading Economic Index, which consists of 10 data points that predict future economic performance. If quarterly GDP, or economic growth, starts to slow, that’s another red flag, Stack warns. Any signs that the manufacturing or services segments of the economy are turning down is also a bad sign. The latest reading on fourth-quarter 2016 GDP, however, was 1.9%, down from 3.5% in the third quarter, but far from the recessionary danger zone. First-quarter 2017 economic growth is estimated at 1.9%, Barclays says.
American shoppers account for roughly two-thirds of U.S. economic activity. So any signs that consumers are not spending as much is cause for alarm. In February, the Conference Board's closely followed consumer confidence index hit 114.8, its highest level since July 2001. That’s a far better reading than when confidence plunged below 30 in 2008 during the financial crisis.
When stock market leaders, or bellwether stocks that are sensitive to changes in the economy, start to turn down after profitable advances, that's an early sign that investors are losing confidence in the market, Stack says. Stocks to watch: ones that do best when times are good, such as banks, transportation companies and businesses that sell stuff to consumers that isn’t needed for daily survival.
A rising market driven by fewer and fewer stocks is a bearish sign. Clues include more stocks going down than up on a daily basis and more stocks hitting 52-week lows than highs. “It is one of the most reliable bear market warning flags,” says Stack.
When the number of stocks hitting their lowest price levels in a year starts to swell, and if the new low list grows day after day, it’s a sign that the "smart money," or professional investors, are bailing out of the market. “It means investors are becoming desperate to sell, even ... at a loss,” Stack says.
For now, most of these warning flags are not flashing yellow, says Stack. But the fact the bull market has lasted so long makes him “nervous and more watchful of these warning flags.”
Courtesy of USAToday