With financial markets so overvalued, and with so many ticking time bombs around, we remain on high alert for a deterioration in market performance that could presage a bear market in equities and other risk assets.
What is interesting about looking back at past bubbles is that it seems obvious in hindsight that valuations were in bubble territory and that future cash flows would simply not justify the price paid by investors at the peak. It is also possible to identify, with hindsight, market peaks and troughs by simply plotting a chart of prices (see second chart below). Sometimes, it is possible to piece together the news flow that can be “blamed” for causing the start of bear markets. All that said, identifying turning points in real time is the devil's own job.
At the risk of repeating previous comments, we highlight below a chart from John Hussman that shows the market cap of non financial US stocks relative to GDP (blue line which is inverted) overlayed with the subsequent 10 year annualised nominal total return. The message is clear. Holding equities for the next 10 years from today’s price level will generate hardly any return on capital and will expose that capital to some wild swings in value. Said another way, risk adjusted returns for the next 10 years will be amongst the worst in history. (see above graph)
Assuming that this analysis is correct (and the r-squared correlation of market cap/GDP to 10 year annualised returns is approximately 90%), how can we spot a turning point in real time? Momentum models will help confirm a market turn but with a delay. However, losses will already be mounting by the time the sell signal is given. The chart below shows the S&P 500 on a monthly basis and also the 10 month (or approximately 200 day) moving average. A very simply model can be used that tells us to be long when the moving average is rising and either flat or short when the average is falling. In hindsight, it seems that using a simple moving average can help identify bull and bear market phases, although there will inevitably be noise as indicated by the red oval highlighting the period in 2011 when the market seemed to be entering a bear market, only to be re-energised by more QE.
Despite extremely rich valuations, the S&P is above its own 10 month moving average and the average itself is rising, and so on this basis the US equity market is still in a bull market phase.
Drilling down to the short term, we have been highlighting a loss of momentum in US equities in recent months which has been accompanied by deteriorating conditions in high yield bonds, high levels of share buy backs and M&A activity and complacency based the fact that the Fed will have investors back. This may well continue, however, when high flying markets begin to wobble (such as European equities down 3.7% on the week and Chinese futures down 6% on Friday), the potential for a clear deterioration in risky assets rises very quickly.
The declines in European and Chinese shares will be blamed on outstanding threats from a Grexit and macro prudential controls. However, they happened when policymakers are in ultra easy monetary policy mode and could well be the canaries in the coal mine. Biotech stock in the US also fared poorly towards the end of the week, and may also be another warning sign.
Despite all these canaries and ticking time bombs, US stocks will not be in a downtrend until recent lows are broken. We have highlighted two support zones around 2040 and 1970 in the chart below. These support levels are about 2% and 5% below the closing level of the S&P 500 last week, and in particular, we would view a break below 1970 points as a very bearish development.
One final point (and chart) on whether the Fed will support the market like it has done since the end of the crisis in 2009. This question can be put another way. Should investors ever fight the Fed, and the answer is YES. The chart below shows the S&P 500 (orange line) between 1999 and 2009 overlayed with the Fed Funds rate (or base rate) in white. As can be seen, both bear markets in the 21st century were accompanied by aggressive Fed easing, i.e. it was right to fight the Fed during bear market phases. The message here is that fighting the Fed makes sense when the market is trending lower.
To conclude, with market valuations in bubble territory, and evidence that some ticking time bombs are potentially exploding, the risks of a bear market are escalating. We believe a break below 1970 points on the S&P 500 will pretty much seal the deal. US equities have lost momentum and many other indicators such as margin debt, junk bond performance, stock buy backs and M&A (to name a few) are flashing warning signals. Markets where QE is still ongoing should do better, but there are no guarantees especially in bear markets. Investors are simply unlikely to be rewarded by staying in US equity markets for the next 7 to 10 years and should be shifting to cash aggressively. Traders who are allowed to be short US equity markets need to be getting ready for action.