- Cyclical bear markets are a function of the economic cycle, while structural bear markets are triggered by imbalances and financial bubbles.
- Sentiment is anything but exuberant; vast swaths of the public remain deeply skeptical and investors seem bored and complacent.
Are we near the end of the long bull market?
It's a good question because the current bull run is now 9 years old, the second-longest in recent financial history.
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Astute investors have started to concentrate on whether there are any signs that a bear market might be beginning. A bear market is when there are declines of 20 percent or more in the markets.
That is a hard question to answer, but not impossible.
Why concentrate on the signs of a bear market? Because almost all bull markets have brief corrections (declines of roughly 10 percent) that don't last long. They can often send "false signals" about a more serious decline.
Bear markets are more serious and have many causes, but Goldman Sachs has noted that they tend to fall into three broad categories:
1) Cyclical bear markets are a function of the economic cycle, typically caused by some combination of rapidly rising interest rates, impending recessions, rising unemployment and decline in profits.
2) Structural bear markets are triggered by imbalances and financial bubbles. The most recent examples are the dot-com bust of 2000 (technology bubble) and the financial crisis of 2008 (real estate bubble).
3) Event-driven bear markets are triggered by some significant macro or geopolitical event such as a war or an oil shock. They are "one-off" events that usually do not lead to a recession. Investors simply remove exposure to the markets and are not typically concerned with earnings or valuations. Examples include the 1973 oil crisis, the October 1987 market crash, the Russian debt default of 1998 and the 2011 European debt crisis.
Goldman researchers say that of 12 bear markets they have studied since 1960, five have been event-driven, three have been structural and four cyclical.
What are the chances we are heading for any of these bear markets? Let's leave out event-driven bear markets because they are, by definition, difficult to see in advance (though North Korea, should it ever come to a head, would certainly qualify).
Let's look at the chances of a structural and cyclical bear market.
Structural bear markets are driven by bubbles and investor exuberance.
Alan Greenspan's warning of "irrational exuberance" at the end of 1996 correctly presaged the dot-com bubble. Everyone was all-in on tech stocks; volume and volatility were huge and no bears were to be found. With a bull market peak, a lot of money gets in late and gets burned when the market turns.
But we don't have that today. Investor sentiment is anything but exuberant. Vast swaths of the investing public remain deeply skeptical. And volume and volatility? I've noted often that investors, while happy with the returns this year, seem bored and complacent.
But low volume and low volatility are not classic signs of a market peak, and other internals, such as the advance/decline line, remain healthy. Lowry, the nation's oldest technical analysis service (founded 1938), reviews market internals in great detail and recently told clients that all the indicators "suggest a bull market still in a healthy primary uptrend with the likelihood of further gains in the months ahead."
Are there bubbles in asset prices? Opinions may differ, but Goldman Sachs noted "the post financial crisis era has [brought] with it a raft of regulation that has led to lower leverage in the financial sector and in the corporate sector. The lack of imbalances also makes a structural bear market less likely."
As for cyclical bear markets, Goldman looked at a combination of factors that were important cyclical indicators of a bear market in the past, including recessions, rate hikes, inflation, unemployment, yield curves and valuations. It concluded that while the risks were elevated, "we think the outlook for equity markets over the next 12 months is likely to be very low returns rather than a sharp decline."
1. Recessions. The relationship between stocks and recessions is very well-studied, but unfortunately, the relationship is very tenuous. All recessions since World War II have been preceded by a decline in stocks of at least 10 percent. But many recessions never saw stocks drop into bear market territory — declines of 20 percent or more. The recessions of 1953, 1960 and 1980 were preceded by S&P 500 declines of 15 percent, 14 percent and 10 percent, respectively, according to my old friend Sam Stovall, chief investment strategist at CFRA.
The reverse is also true: You can have bear markets without recessions. This happened in 1961, 1966 and 1987.
"Bull markets often don't die of old age, they die of fright," Stovall told me. "In 1987 everyone was convinced there would be a recession [after the October market crash], but there wasn't one."
Right now, all we can say is that we have not had a 10 percent decline in a long time, so even this tenuous indicator is not sending a warning signal about a recession.
2. Aggressive rate hikes. The Fed raising rates aggressively were a factor in bear markets in 1966 and 1968-1970, among others, but Goldman thinks the chances of really aggressive rate hikes is low: "Without monetary policy tightening much, concerns about a looming recession — and therefore risks of a 'cyclical' bear market — are lower."
3. Rising inflation, along with the Vietnam War, was a factor in the 1968-1970 bear market, and again in bear markets in 1976-1978 and 1980-82. Goldman noted that "confidence in the low future path for inflation is leading to similar confidence that low interest rates today are not likely to spike sufficiently to generate a recession."
4. Profit declines or high valuations. Profits are still rising. Its true valuations are high: The forward P/E ratio (earnings estimates for the next four quarters) for the S&P 500 are at roughly 18.0, which is in the top 89 percent of where it has been since 1976, according to Goldman.
But that is not predictive of anything: While high valuations are a feature preceding most bear markets, you can have high valuations for very long periods. As Goldman noted: "Valuation in isolation is unlikely to be the trigger for a bear market." It notes that the rise in valuation is largely a function of very low inflation, bond yields and the impact of quantitative easing.
The bottom line on a bear market risk: The combination of low inflation, low risk of sharp monetary tightening and low risk of recession is what has led Goldman to tell clients that very low returns are more likely than a sharp decline.
Stovall agrees. "People are working themselves into a bit of a frenzy, but the risks [of a bear market] are low right now," he told me. "So many are waiting for a decline in prices that it offers fuel for the market to go higher. And I think the chances of a tax cut are high, which will add to earnings."
His assessment: "The risks are to the upside, not to the downside," for the markets.
There is one risk that keeps him up at night: geopolitical. "How do you put logic onto an irrational despot" like North Korea's Kim Jong Un, he asks. "That is scary and impossible to model."