Where Are We In The Market Cycle?
Before you can determine where you are going, you first have to know where you are now. Seems like a simple concept. A similar approach is taken when we are developing the investment strategy for our client portfolios. The question more specifically that we are trying to answer is “where are we at in the market cycle?” Is there more upside
Before you can determine where you are going, you first have to know where you are now. Seems like a simple concept. A similar approach is taken when we are developing the investment strategy for our client portfolios. The question more specifically that we are trying to answer is “where are we at in the market cycle?” Is there more upside to the market? Is there a downturn coming? No one knows for sure and there is no single market indicator that has proven to be an accurate predicator of future market trends. Instead, we have to collect data on multiple macroeconomic indicators and attempt to plot where we are in the current market cycle. Here is a snapshot of where we are at now:
The length of the current bull market is starting to worry some investors. Living through the tech bubble and the 2008 recession, those were healthy reminders that markets do not always go up. We are currently in the 87th month of the expansion which is the 4th longest on record. Since 1900, the average economic expansion has lasted 46 months. This leaves many investors questioning, “is the bull market rally about to end?” We are actually less concerned about the “duration” of the expansion. We prefer to look at the “magnitude” of the expansion. This recovery has been different. In most economic recoveries the market grows rapidly following a recession. If you look at the magnitude of this expansion that started in the 4th quarter of 2007 versus previous expansions, it has been lackluster at best. See the chart on the next page. This may lead investors to conclude that there is more to the current economic expansion.
Next up, employment. Over the past 50 years, the unemployment rate has averaged 6.2%. We are currently sitting at an unemployment rate of 5.0%. Based on that number it may be reasonable to conclude that we are close to full employment. Once you get close to full employment you begin to lose that surge in growth that the economy receives from adding 250,000+ jobs per month. It may also imply that we are getting closer to the end of this market cycle.
Now let’s look at the valuation levels in the stock market. In other words, in general are the stocks in the S&P 500 Index cheap to buy, fairly valued, or expensive to buy at this point? We measure this by the forward price to earning ratio (P/E) of the S&P 500 index. The average P/E of the S&P 500 over the last 25 years is 15.9. Back in 2008, the P/E of the S&P 500 was around 9.0. From a valuation standpoint, back in 2008, stocks were very cheap to buy. When stocks are cheap, investors tend to hold them regardless of what’s happening in the global economy with the hopes that they will at least become “fairly valued” at some point in the future. Right now the P/E Ratio of the S&P 500 Index is about 16.8 which is above the 15.9 historic average. This may indicate that stock are starting to become “expensive” from a valuation standpoint and investors may be tempted to sell positions during periods of volatility.
Even though stocks may be perceived as “overvalued” that does not necessarily mean they are not going to become more overvalued from here. In fact, often times after long bull rallies “the plane will overshoot the runway”. However, it does typically mean that big gains are harder to come by since a large amount of the future earnings expectations of the S&P 500 companies are already baked into the stock price. It leaves the door open for more quarterly earning disappointments which could rise to higher levels of volatility in the markets.
The most popular question of the year goes to: “Trump or Hillary? And how will the outcome impact the stock market?” I try not to get too deep in the weeds of politics mainly because history has shown us that there is no clear evidence whether the economy fares better under a Republican president or a Democratic president. However, here is the key point. Markets do not like uncertainty and one of the candidates that is running (I will let you guess which one) represents a tremendous amount of uncertainty regarding the actions that they may take if elected president of the United States. Still, under these circumstances, it is very difficult to develop a sound investment strategy centered around political outcomes that may or may not happen. We really have to “wait and see” in this case.
Let’s travel over the Atlantic. Brexit was a shock to the stock market over the summer but the long term ramifications of the United Kingdom’s exit from the European Union is yet to be known. The exit process will most likely take a number of years as the EU and the UK negotiate terms. In our view, this does not pose an immediate threat to the global economy but it will represent an ongoing element of uncertainty as the EU continues to restart sustainable economic growth in the region.
The chart below is one of the most important illustrations that allows us to gauge the overall level of risk that exists in the global economy. When a country wants to jump start its economy it will often lower the reserve rate (similar to our Fed Funds Rate) in an effort to encourage lending. An increase in borrowing hopefully leads to an increase in consumer spending and economic growth. Unfortunately, countries around the globed have taken this concept to an extreme level and have implemented “negative rates”. If you buy a 10 year government bond in Germany or Japan, you are guaranteed to lose money over that 10 year period. If you have a checking account at a bank in Japan, instead of receiving interest from the bank, the bank may charge you a fee to hold onto your own money. Crazy right? It’s happening. In fact, 33% of the countries around the world have a negative yield on their 10 year government bond. See the chart below. When you look around the globe 71% of the countries have a 10 year government bond yield below 1%. The U.S. 10 Year Treasury sits just above that at 1.7%.
So, what does that mean for the global economy? Basically, countries around the world are starving for economic growth and everyone is trying to jump start their economy at the same time. Possible outcomes? On the positive side, the stage is set for growth. There is “cheap money” and favorable interest rates at levels that we have never seen before in history. Meaning a little growth could go a long ways.
On the negative side, these central banks around the global are pretty much out of ammunition. They have fired every arrow that they have at this point to prevent their economy from contracting. If they cannot get their economy to grow and begin to normalize rates in the near future, when they get hit by the next recession they will have nothing to combat it with. It’s like the fire department showing up to a house fire with no water in the truck. The U.S. is not immune to this situation. Everyone wants the Fed to either not raise rates or raise rates slowly for the fear of the negative impact that it may have on the stock market or the value of the dollar. But would you rather take a little pain now or wait for the next recession to hit and have no way to stop the economy from contracting? It seems like a risky game.
When we look at all of these economic factors as a whole it suggests to us that the U.S. economy is continuing to grow but at a slower pace than a year ago. The data leads us to believe that we may be entering the later stages of the recent bull market rally and that now is a prudent time to revisit the level of exposure to risk assets in our client portfolios. At this point we are more concerned about entering a period of long term stagnation as opposed to a recession. With the rate of economic growth slowing here in the U.S. and the rich valuations already baked into the stock market, we could be entering a period of muted returns from both the stock and bond market. It is important that investors establish a realistic view of where we are in the economic cycle and adjust their return expectations accordingly.
As always, please feel free to contact me if you’d like to discuss your portfolio or our outlook for the economy.
About Michael……...
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.
Market Alert - UK Votes To Exit EU
We have been working through the night to monitor the UK exit vote in Europe and wanted to get this information out as soon as possible.Today is a historic day. Last night the UK voted whether or not to leave the European Union. The polls closed at 10 p.m. last night, the votes were counted, and at 2 a.m. this morning it was announced that the UK had
We have been working through the night to monitor the UK exit vote in Europe and wanted to get this information out as soon as possible.Today is a historic day. Last night the UK voted whether or not to leave the European Union. The polls closed at 10 p.m. last night, the votes were counted, and at 2 a.m. this morning it was announced that the UK had voted 51.9% in favor of leaving the EU. To put this situation in context, this would be similar to New York deciding to leave the United States to form its own country.
This was not the expected outcome and is largely an unprecedented event. Going into the vote yesterday most polls expected the UK “stay” vote to prevail given the economic headwinds that the UK would face if the “leave” vote were to win. David Cameron, the prime minister of the UK, was largely in favor of the UK staying in the EU. Today at 3:30 a.m., Cameron announced that he would step down as the prime minister since new leadership, that is in favor of the exit, should be in place to negotiate Britain’s exit from the EU.
The European Union (EU) is made up of 28 countries. It was originally formed back in 1957 with the goal of preventing wars and strengthening the economic bond between the European countries in its membership. The UK joined the EU in 1973. Members of the EU benefit from:
Freedom of movement between countries
Freedom of trade for goods, services, and capital
EU human rights protection
Euro currency (the UK does not participate in the euro currency)
The Argument To Stay In The EU
Supporters of the UK to stay in the EU believe that the Union is better for the British economy and that concerns about migration and other issues stemming from EU membership are not important enough to outweigh the economic consequences of leaving. Many economists agree with this claim. Europe is Britain’s most important export market and its greatest source of foreign direct investment. An exit of the EU could jeopardize its financial status in the world and the high paying jobs that come with that status.
Those who voted to stay were not necessarily defending the EU but were basically arguing that the UK is stronger with the EU than without.
Argument To Leave The EU
Those in favor of the UK leaving the EU believe that leaving the European Union is necessary for the UK to restore the country’s identity. Immigration has been one of the largest issue on the agenda with refugees entering the UK under the EU’s permission and “taking jobs” in the place of UK citizens. Voters in the middle to lower income classes are viewed as more likely to support leaving the Union due to a feeling of being “abandoned by their country” in lieu of the EU policies.
In a way Britain feels like they used to matter to the world as an independent country but over the years have lost their identity now that they are lumped into the EU. This group of individuals wants to be able to have full control over the country’s economic policy, culture, political system, and judicial system.
What Happens Next?
Now that the UK has voted to leave the EU, it has become clear that there needs to be new leadership in government that supports the UK exit since most of the current leaders, including the prime minister, were in favor of the UK staying in the EU. We would expect this to happen in a fairly short period of time.
Once the new leadership is in place, the negotiation will begin between the UK and the EU for the exit. There is not a precedence for this process which leaves a lot of unknowns. Immediately, nothing changes. Most likely while the negotiations are taking place over the course of next few months, or more likely years since the UK is still technically an EU member, UK citizens will still be able to move about the Eurozone countries freely, trade will continue, etc.
However, there will most likely be an immediate negative impact on the UK economy given the expectation of the exit. The British pound (currency) will most likely drop significantly. The profitability of the multinational companies and banks that are headquartered in the UK will come into question since they will eventually lose the benefits of free trade and capital movements with other EU countries.
Overall we are entering a period of increased uncertainty. Unfortunately, in our view, there is a larger issue at hand. Yes, the UK exiting the EU is a significant event but the larger issue is for the first time they are laying the ground work that will allow a country to exit the EU. There are other countries in the EU that may take up similar votes to leave the European Union since a precedence is now being set for the UK to exit. If the entire EU were to further destabilize it would most likely cause further disruption across the global economy.
Michael Ruger
About Michael……...
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.
