Can Aging Bull Market Regain Blush of Youth?
The scenario for stocks in 2013 hinges on whether an already mature bull market can find the right combination of supplements and psychology to age gracefully for another year.
In two months, this bull run will turn four years old, having more than doubled since it began on March 9, 2009, with the S&P 500 index (^GSPC) lifting off from a 13-year low of 676. The average duration of all prior bull markets since 1929 is 3.8 years, and the median just 3.6 years. The major indexes have also risen more than the average, albeit from the wreckage of a particularly devastating decline.
Aside from this simple tale of the tape, some seasoned observers are spying wrinkles on the bull. Technical market analyst Mary Ann Bartels of Bank of America Merrill Lynch views fewer and larger stocks leading the tape higher, with unimpressive momentum, as evidence of an aging advance that could culminate sometime this year. Investment firm Leuthold Group also backed off its previous optimistic stock views because of the hazards of mature uptrends.
More fundamentally, much of the benefit from soaring corporate profits and sharply lower interest rates has been realized, this fuel largely spent in propelling stocks to their current levels. Corporate profit margins are near 50-year highs and borrowing rates around half-century lows. There are plausible arguments for why both can remain benignly steady but neither is likely to provide incremental oomph for share prices.
Yet a few factors mitigate the effects of the years on this stock market phase. For one, all prior bull markets at least matched their former all-time high, which now would mean gaining at least another 10%.
Then there is the fact that this bull is uncommonly battle-tested. It has been shadowed by the constant fear that the global economic recovery was faltering, and rattled by the periodic loss of faith in sovereign finances. It has weathered a double-digit percentage decline in each of its three full calendar years, only to prove resilient (with the copious help of central banks' free money acting as "liquid courage," naturally).
Because of this pattern, few of the excesses that typically build up and eventually doom a rising market are apparent. The public has not gotten excited about the market and therefore hasn't driven much speculative froth. Valuations – while not cheap compared to profits – are within roughly the normal band of historical readings, and would not impede a run to new highs should recent signs of economic momentum persist.
Stocks, too, are being flattered by the company they're keeping. The U.S. economy, though it's been growing for more than three years, is still operating well below its potential, with lots of slack productive capacity and idle workers. These are early-stage-recovery traits, and as such are being treated with intense post-recession medicine by a Fed that still views this as a fragile, halting expansion. While the release of minutes from the December Fed meeting showed some policy committee members preferring to end the bond-buying program later this year, the Fed will almost certainly continue to err on the side of easy money and keep rates near zero.
This same Fed suppression of risk-free rates is dragging down yields on all other assets, from mortgage debt to corporate bonds. Set against these alternatives, stocks' valuations are not anomalous at all, even if, in the abstract, shares are not demonstrably cheap.
There are at least two themes to watch in 2013 that should determine whether this bull can keep marching higher: The potential receding of macro/policy influences and the appetite for corporate deal-making and other risk-seeking behavior.
There's a good chance we are now witnessing the peak of partisan polarization and the fiscal frictions driving domestic economic policy anxieties.
Before laughing too hard, consider that, a year ago, the dominant sentiment was that central bankers were at serious risk of losing control of the capital markets, the European Central Bank was not up to the task of holding the euro zone together and a Lehman-like incident was a real risk.
In fact, we saw central banks in 2012 resolutely deploy irresistible monetary firepower to pacify markets and suppress volatility, to the point that today it is broadly taken for granted that they have duly muted the "tail risk" of terrible financial disruptions.
Now that the full "fiscal cliff" has been averted, investors broadly assume the coming debt-ceiling/spending cut debate will prove just as maddening and market-rattling, or even worse. Yet the latest deal took tax rates off the battlefield. And President Obama can use his State of the Union address to invite a broad, legacy-defining fiscal arrangement, becoming flexible to Republican priorities now that his campaign promise on taxes is met.
This should put both monetary and fiscal policy tentatively in the "settled" column, after nearly half a decade in which systemic, macroeconomic and policy threats caused markets to dart and shudder. In a best-case scenario, this would return markets to the boring old elements of gauging the economic cycle and sorting the corporate winners from the losers.
The most bullish handicappers, such as Jim Paulsen of Wells Capital Management, assert that such a policy-risk ebb tide should allow confidence to build among investors and CEOs, extending their time horizons, lifting asset valuations and emboldening hiring and capital spending. Could happen. There's a chance that, even if easy money and a self-sustaining economic recovery can't in themselves inflate stock prices, a spreading sense that the Fed has successfully stretched out the slow-and-steady economic trajectory could be enough to loosen investor and company purse strings.
Either way, the caging of macro/policy monsters could make the market safe again for picking and panning individual stocks and asset classes. The pendulum is overdue to swing back in favor of security selectors, long-short managers and hunters of idiosyncratically mispriced assets. That could mean betting heavily on the auto rebound, loading up on cheap "old tech" stocks or playing possible downside in expensive slow-growth staples stocks.
The second key is deal activity. Mergers and acquisitions volume as a proportion of total stock-market value in 2012 was 20% below the 10-year average. It almost has to accelerate if this market is to resist gravity much longer. This is not just because buyouts enrich the shareholders of the acquired companies. It's because this is the point in the corporate-profit and bull-market cycle when "financial engineering" takes over as a driving theme.
Here, corporate productivity is already high, the rapid demand surge after a recession is past and profit margins near peak levels, while financing is cheap and cash piled high at companies and private-equity funds. Transactional ferment raises the corporate metabolism, enforcing discipline on the active use of capital, leading to purchases, sales, aggressive buybacks, spinoffs and initial offerings – tipping, eventually, toward recklessness.
If such a phase doesn't soon emerge, it will likely mean the post-crisis risk aversion fog refuses to lift, growth globally has sputtered or capital markets have had another unnerving financial accident. Under these circumstances, it would be hard to envision the broad market defying Father Time much longer.
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