Jean-Paul Rodrigue, a professor at Hofstra University, put together a slightly different chart than we've shown before of the stages of a bull market (via The Reformed Broker). Naturally, seeing a chart like this immediately prompts the desire to try to identify where to place the current market on it. That's easier said than done. But it seems we're likely somewhere in the mania phase, as the institutions have dominated most of the five-year bull market to this point, and have actually started lightening up on stocks (at least in some cases).
There's probably an argument to be made we're at the "media attention" stage, where the bull market starts to cross over from the Finance/Business pages and channels to more mainstream coverage, though that certainly hasn't happened in the huge way it did at the end of the 1990s. I could see an argument for anywhere in the "enthusiasm" to "greed" area as well. But there's no real scientific way to quantify this.
While trying to pin this down is a fool's errand, that doesn't mean we can't at least take a quick stab at it, right? As I see it, there are three main approaches we can take to do so. We can consider the market's valuation, the sentiment of investors, and the state of monetary policy. Let's briefly look at each.
Valuation. This one is all over the map, which is surprising, because at a glance one would think this would be the most quantifiable. The problem is there are so many ways to measure valuation! Barry Ritholtz had an article in this weekend's Washington Post that examined How to know whether stocks are cheap or pricey. After walking through the variables, he offers this synopsis on the U.S. market:
With that caveat, let’s look at the Standard & Poor’s 500-stock index, a broad benchmark for equity markets. It is currently trading at 16.7 times forward earnings estimates. In other words, investors are willing to pay $16.70 for every dollar of corporate profit. That’s more expensive than the average price over the past century, but it’s about a 5 percent discount to the average over the past 15 years. Let’s put this into broader context: In 1982, we were at the end of a 16-year bear market. Price-to-earnings multiples were under 10, and stocks, which were widely reviled, were cheap. Fast forward to 1999, the tail end of an 18-year bull market. Just before the dot-com bubble burst, the S&P 500 traded at an expensive 27 times forward earnings. Today, using the same measures, stocks are more or less fairly valued — not cheap but not terribly expensive.In his article, Ritholtz refers to a chart on his own site showing the current status of 15 of the most common valuation metrics. He also makes the point that the measure most bears are focused on is Robert Shiller’s cyclically adjusted price-to-earnings ratio (CAPE ratio). That measure does in fact indicate that stocks are overpriced right now, but he notes that over the past 20 years, this CAPE measure has had the overvalued label on U.S. stocks 85% of the time. Of course, not everyone agrees with the "roughly fairly valued" assessment. Jeremy Grantham, whose specialty is determining 7-year projections for various asset classes, and whose firm has done a great deal of research on historical asset bubbles, made some interesting comments in a Barron's interview the week before last:
How overvalued are U.S. stocks? They're 65% overpriced. If they go up another 30%, you would have a true bubble, at which point stocks would be close to twice their fair value. Similarly, in 2000, stocks were more than double their fair value. So they are quite capable of doing that. But my point is that with the professionals getting reinforced by the Fed going back to 1994, it will be very surprising if they don't keep on playing this game until the market at least hits a classic bubble definition. Bubbles don't usually stop until sensible investors, value investors, and prudent investors have been hung out to dry and kicked around the block. That hasn't happened yet, so that tells you there is probably quite a bit left in this rally.
So Grantham thinks stocks are 65% overvalued, and will have negative returns over the next seven years overall. Yet he thinks they are likely to go significantly higher before they go lower. Which, it might be noted, is perfectly consistent with our opening chart, if this market is somewhere around the middle of the "Mania Phase."
Sentiment. As with valuation measures, there are lots of sentiment indicators as well. The difference is that while the valuation measures are at least somewhat familiar to many "normal" investors, most have never heard of many of the sentiment indicators. So while simple tools like the AAII Sentiment Survey offer us some insight, it's better to take a wider view of a basket of these indicators. Without going into many of these unfamiliar measures, it's safe to say that, on balance, the sentiment indicators are flashing some warning signs. There are some conflicting signals between some of the individual-focused indicators and the professional-focused indicators, which perhaps is understandable as we're transitioning out of the institutional-dominated "awareness" phase of the chart and into the public-dominated "mania" phase of the chart. While sentiment isn't horrible overall, it isn't great either. But as Grantham noted in his Barron's interview:
There is a high level of enthusiasm from the financial professionals, hedge funds in particular. This time you have a very high level of confidence from the professionals—but not a very high level of confidence from the individual investors. The individuals are a bit more down to earth. They felt the pain of 2009 longer than the institutions did, and they have been slow to come back into stocks when you look at net buying of mutual funds. There has never been a bubble where individuals were not flooding into the market at the very end, though sometimes they are pretty late to the game. By the end of a real bubble, individuals are gung-ho, and they are not gung-ho yet. That says a lot.Monetary Policy. If you've been reading my "state of the markets" type posts over the past couple years, you probably know that this is where my attention has been focused for clues. I've been persuaded over the years by the argument that most bull markets don't end until monetary conditions tighten considerably. David Rosenberg wrote an excellent article last week summarizing how bull markets have reacted to Fed rate hikes historically. The whole thing is worth reading, but here's what he had to say about where bull markets typically stand at the point of the Fed's first rate hike:
A dive into the history books shows that at no time did a bull market end after the first rate hike. Typically, in terms of trough-to-peak moves in the S&P 500, we are only one-third of the way into the bull run on the eve of the first Fed tightening in rates. That is an average, but the median is almost identical and there was never a time when the cycle was more than halfway through at that point of the first rate increase.That's fairly remarkable, given that the Fed isn't anywhere close to raising interest rates yet. Last Wednesday, new Fed Chairwoman Janet Yellen spooked the markets by being unusually (and likely, unintentionally) candid about the probable timing of the Fed's first rate hike. When asked how long after the end of QE tapering the Fed would likely wait before beginning to raise interest rates, she responded "around six months." As MarketWatch explained the next day:
The taper of the Fed’s bond purchases is on course to end in October or November. Six months after that would be April or May. So Yellen said the first rate hike could come in April or May, depending on how the economy is doing. Before this Fed meeting, the market had been expecting the first rate hike to come toward the end of 2015, perhaps in October or December. The updated forecasts provided by the Fed’s “dot plot” would point to a first rate hike in September or October of 2015, just a little faster than the market had been expecting.
Combining the current pace of the QE taper, Yellen's comments about when rate hikes would be likely to follow that, and Rosenberg's article on how bull markets have typically responded to Fed rate hikes, it's not at all hard to build a case for this bull market continuing to run for quite some time — easily another year or more. Of course, that doesn't mean it will. But it's not like crazy stuff has to happen for that scenario to play out. In fact, it's probably fair to say that it's the path of least resistance from here, with one huge caveat — this assumes that the economy continues to recover and doesn't roll back over into recession. If that happens, stocks aren't likely to hold up well from today's valuation levels.
One final note on these factors. Bear markets tend to end in sharp, cataclysmic events: the proverbial "V-shaped" plunge that sets the final bear market bottom and begins the new bull market. Partly as a result of this, sentiment and valuation indicators are often pretty useful in calling bear market bottoms. When stocks hit certain extremes from a historical price level standpoint, and likewise, sentiment is swinging to negative extremes, it's usually not long (often just hours or days) before the bottom is in and a new bull market begins. Few have the stomach to believe it at the time, but it's true.
But bull market tops are different than bear market bottoms. Bull markets tend to top in a prolonged, rolling fashion. It's not unusual to look back at a chart of a bull market peak and see it as more of a several month process rather than a sharp event. At the end of the last bull market in 2007, the market was near its final highs throughout the summer, dropped a little in August before reaching its final high in October, but was still within 10% of that level seven months later in May of 2008. No sharp event there. The same was true in 2000: peak in March, but the S&P 500 was within 10 points of that level again on August 31. It basically took the first eight months of the year to establish that final top and start heading lower for good.
This rolling process makes it much harder to use valuation and sentiment as a short-term clues, because they can both "stay high" for so long without the market responding in a negative fashion. Valuation, sentiment, and monetary policy are always at work determining how attractive stocks are at any given point in time.
You don't hear a lot about these factors at SMI, because they are very difficult to interpret and use in a predictive way. As you know, the prediction game isn't SMI's thing anyway. We feel that our mechanical strategies are enough to handle the market's ups and downs, and if you stick with those strategies through both the bull and bear portions of the stock market cycle, you're going to do quite well over time. Nonetheless, it's helpful to have some idea of how this longer-term cycle typically plays out. Even if we can't precisely identify where in the cycle we are at any given point in time, it's good to know how the process roughly works.
Just remember that even if this bull market does have significant upside left in it, that doesn't mean we won't have some gut-churning corrections between now and its eventual end. We'll likely talk more about this over the next month, but the six month period leading up to the Congressional midterm elections are typically the most volatile of each four-year election cycle.
Craig Johnson of Piper Jaffray recently noted that since 1930, midterm election year corrections have averaged 17%. Given that we've only had three little pull backs of less than 10% each since 2011, we're overdue for something along those lines. So longer-term, there seems to be plenty of reason for optimism that stocks will be higher a year from now than they are today. But in the short-term, anything can happen, and a significant correction sometime this summer certainly wouldn't be out of character.
Above all though, if your investment plan is solid and founded on SMI's mechanical strategies, you can read this type of material for educational value only and not feel the need to make any adjustments to your portfolio.