An extended cycle?

The bulls may be justified in their optimism, but a sharp global correction is on the cards in 2018

We are now in the ninth year of the bull market in equities, specifically, and financial assets more broadly. The bull phase began in the US, with the S&P 500 bottoming in March 2009 at 667. The equity bull run has now extended more broadly with Europe, Japan, and emerging markets (EMs) also joining the party. Since hitting the bottom in 2009, US equities are up about four times, with the other regions rising by between two and two-and-a-half times. This year has been exceptional in that all regions and markets are up across all asset classes. Given the magnitude and duration of the rise, combined with extreme complacency and robust valuations, many investors are very worried about 2018. We also have the beginnings of monetary policy normalisation in 2018, an uncharted territory, with possibly serious implications for financial assets.

It does not help that most seasoned investors with good long-term track records are also extremely sceptical. It seems that a day cannot pass without some financial guru calling for a top and caution. The concentration of financial wealth in the FAANG (Facebook, Amazon, Apple, Netflix, and Google) stocks, and technology more broadly, also troubles many. It has become almost impossible to outperform the market unless you are fully positioned in the FAANG stocks and Alibaba or Tencent. Many people are drawing parallels between the FAANG and the Dotcom bubble of 2000 or the Nifty-Fifty stocks of the late 1960s. Technology has once again come to dominate the market indices. Regulatory risk for the tech behemoths is rising but no one seems to care. Any adverse regulatory fallout affecting the growth and profitability dynamics of the FAANG stocks could bring the entire market down. Just when stocks are seen as invincible, we should worry.

Given all the scepticism and the recent wobble in equities it may be useful to consider the bull case outlined by the optimists. There are people out there who feel that we are still only mid-cycle in this bull run. This is a structural bull market. In fact, they draw parallels between today and the great structural US bull market of 1982-2000. The market rally from March 2009 very closely resembles the first eight years of the 1982-2000 bull run. In fact, they are almost identical. The bulls are convinced it would be premature to sell. Their optimism is based on a continuation of the current Goldilocks economic environment.

The bull case basically rests on two pillars. First, there is a synchronous global economic recovery. All countries in the Organisation for Economic Cooperation and Development and major EM’s are growing strongly without a threat to financial stability. This growth will not fade quickly. 

Secondly, due to fears around deflationary forces (technological innovation, slack labor markets and excess capacity), central banks will remain consciously behind the curve. All the major central banks are more worried about deflation today than inflation. They will be very quick to cut rates or pause at the first signs of any return to the deflationary environment of the last few years. Monetary policy will slowly get normalised in the US, but remain highly accommodative for the foreseeable future in the EU and Japan. Despite the Fed tapering, central banks will remain net purchasers of financial assets through 2018.

Illustration by Ajay Mohanty

Combined with the above, earnings have been strong. Companies continue to deliver. 

Margins have held up far better than most expected. The whole regression to mean thesis of margin normalisation has not happened.

The bulls also argue that the EU and Japan are following the US roadmap of extraordinary and unconventional monetary policy, with a four year time lag for Japan and six years for the EU. These two regions have a period of above normal growth and profits still ahead of them.

The US has also shown that a well telegraphed, gradual removal of extraordinary monetary stimulus need not crater financial markets. US equities have posted very strong gains even after the end of QE, and despite the Fed actually beginning to hike rates.

The bulls also argue that a Euro breakup or a Chinese implosion, the two issues seen as most likely to cause an economic meltdown globally, both seem to be off the table today. Markets have obsessed about the downside risks of both scenarios incessantly over the past few years. Neither poses a threat in 2018 at least.

A relevant concern could be as to whether markets have fully discounted all the above positive news and is more than fully valuing the current benign environment. 

The bears point to the Shiller cyclically adjusted PE (price earnings) ratio, which shows markets as being highly overvalued, similar to the levels of 1929. The bulls point out that the Shiller PE has been a horrendous market timing tool, showing the market to be overvalued ninety percent of the time since 1988. The ratio also does not adjust for the current abnormally low interest rate environment. Adjusted for the low rates, even the Shiller cyclically adjusted PE shows the markets at only average valuations.

I remain in the more sceptical camp. At the minimum we should get a reasonable correction to jolt us out of our complacency. Making money can never seem so simple and easy. There has to be some fear and self doubt. Globally, fear does seem to be lacking at the moment. The bulls may be right in that it is premature to call for a full-fledged bear market, but a sharp correction is surely on the cards in 2018. 
 

The writer is with Amansa Capital