As regular SMI readers have likely figured out by now, we've gradually shifted over the past couple years from enjoying this bull market run in stocks to increasingly dreading its inevitable end. There's a place in every bull market where the focus has to shift away from maximizing profits through the duration of the upward slope of the cycle (however long that may last), toward an emphasis on capital preservation through the bear market that will eventually follow.
The trick, of course, is to not make that shift too early. At SMI, the "stakes" of that decision haven't tended to be real high, because most of our strategies operate independently of the market's cycle — they're going to do what they're going to do, and our readers, for the most part, are going to follow them and not try to guess what the market is going to do next.
That's important because it's super hard to predict where the market will go next, so taking preemptive action (by moving money out of the market) usually ends up being counter-productive. So if we're modifying our investment level in stocks at all (as DAA does), we're going to rely on a mechanical, objective, price-based signal triggered by what the market is actually doing to make any such adjustment — not how overvalued we think the market is, or any other "squishy" indicator that can keep getting ever more extreme for weeks/months/years longer.
This idea is summed up well in a quote from legendary investor Ben Graham, delivered in a talk more than 50 years ago:
The main need here is for the investor to select some rule which seems to be suitable for his point of view, one which will keep him out of mischief, and one, I insist, which will always maintain some interest in common stocks regardless of how high the market level goes.
For if you had followed one of these older formulas which took you out of common stocks entirely at some level of the market, your disappointment would have been so great because of the ensuing advance as probably to ruin you from the stand point of intelligent investing for the rest of your life.
In other words, historical indicators (P/E ratios, for example) can help us identify when markets are generally cheap or expensive, but they can always get even cheaper or even more expensive. Making investment decisions based on those type of "comparative" indicators is dangerous.
Again, we've detailed how this market's valuation is very expensive by historical measures, and how the lack of volatility seems to indicate a dangerous level of investor complacency. Those factors, coupled with the relatively new factor (within the past 18 months) of the Fed actively removing the monetary policy accommodation that most people attribute much of the credit for this bull market to, have us increasingly focused on the bear market to come — even as we maintain our stock allocations, waiting for the objective signals from our strategies to tell us to make any changes.
But today I wanted to look at the factors supporting the continued bull-market advance. There are several, among them:
- Political indecision: David Kotok of Cumberland Advisors makes the point that "The U.S. stock market prefers a divided government that cannot do damage to what is a slow-growth but steadily improving economy."
- Inflation remains muted. Simply put, unless inflation picks up, there's likely a natural cap on interest rates. Again, from the market's perspective, if there's no recession and no pick up in inflation, a slowly growing economy and slowly accelerating earnings are just fine.
- Earnings are picking up. With more than 90% of second quarter earnings now in, FactSet reports that earnings have grown more than 10% year over year, well above the 6.4% expectation.
It's this last point on earnings that requires a deeper dive though. Bank of America Merrill Lynch strategists pointed out last week that stocks of companies beating earnings and sales forecasts aren't outperforming the S&P 500 as they normally do. In fact, the last time this happened was in the second quarter of 2000, near the top of the dot-com bubble (how's that for an ominous sign?).
While there are some good reasons why that isn't necessarily a foreboding indicator, it does require some sort of explanation. Usually when earnings are growing and beating forecasts, that's good for stock prices. There must be a reason if that's not happening this time, and in fact, there is.
The best explanation I've seen comes from Wolf Richter, who explains that this earnings "growth" is largely a mirage. The reality is that S&P 500 earnings have recently "grown"...back to the levels they were in May 2014:
Yep. More than three years of earnings stagnation. No growth whatsoever, even for “adjusted” earnings. In fact, on a trailing 12-month basis, aggregate EPS of the S&P 500 companies are down about 5% from their peak in Q4 2014. And yet, over the same three-plus years of total earnings stagnation, the S&P 500 index has soared 34%.
This chart shows those “adjusted” earnings per share for the S&P 500 companies (black line) and the S&P 500 index (blue line). Chart via FactSet. I marked August 2012 as the point five years ago, and May 2014:
What happens when earnings stagnate but the market keeps moving higher? The market gets more expensive. The "P" (price) continues going higher, while the "E" (earnings) stays the same. Investors have been bidding prices up higher and higher. This multiple expansion happens during every bull market. But eventually, it ends and multiple contraction sets in during the next bear market.
Or as Wolf sums it up:
No one knows the date when this process kicks off in earnest, though everyone wants to know it so they can scurry out of the way beforehand. But when enough folks are trying to scurry out of the way, they’ll will precipitate the beginning of that process. That’s always how it happens.
As always, the frustrating thing is we can't look at any of this and draw any definitive conclusions about what it means for the immediate future of the market. It could be that no recession hits, slow growth continues, and the political climate continues to deliver just the right blend of conditions for the market to keep grinding ever higher. But like a rubber band stretching further and further, it sure seems like each passing day just brings us another step closer to an eventual market shift.
That's why our eyes are firmly planted on how to best survive the transition through the next bear. We suggest that you have that in mind as well at this stage in the market cycle. We'll continue to unpack exactly what that means in future articles.