The second quarter started in somewhat choppy fashion as small cap and other high flying momentum stocks continued to face pressure as investors decided to shed stocks with swollen valuation multiples. The major averages fared better than their risky counterparts, and after a brief dip stocks began their ascent towards record breaking highs on the back on improving economic data, decent earnings growth, and continuing liquidity support from global central banks.
Meanwhile commodity markets appeared to work off some of their overbought readings from earlier in the year as they treaded mostly sideways during the quarter. Within fixed income, the bond market also fared well as investors continued to flock towards anything with a yield, foreign bond markets bubbled, and a number of technical factors came together to keep bond investors satisfied despite meager nominal yields.
One thing seems clear to us, and that is that the current bull market is heading into its late stages, which means we must keep watch for an emerging bear market.
Market Cycle is Mature
One way to evaluate how deep we are into the market cycle is to compare the current bull market to prior bull runs throughout history. Ned Davis Research (NDR) has done a study of 35 cyclical bull markets, where the median bull market gain is approximately 73%, and the median duration is 655 days. Using the Dow Jones Industrial Average, the current bull market that started in 2009 has generated a return of about 200%, with a duration of over 1,960 days.
While certainly in excess of the typical medians on both measures, the current bull market is not the longest of all time. There were two periods in the NDR study that had larger gains and lasted for longer periods of time, and we canâ€™t claim to know whether or not this cycle will end up eclipsing its predecessors. However, what we can infer from this study is that the current cyclical bull market is likely moving towards the later innings.
Economic Cycle is Mature
The economic expansion in the U.S. also appears to be aging. The National Bureau of Economic Research Business Cycle Dating Committee keeps track of official business cycle statistics, and they track average cycle data on their website. In the post-World War II period there have been 11 business cycles, where the average expansion is just over 58 months. If one looks at all cycles back to 1854 (33 cycles), the average duration of an expansion is shallower at 38.7 months. The start of the current expansion was June 2009, putting us 73 months into the current business cycle expansion.
Once again, the surface message from the numbers would imply that weâ€™re closer to the end of the current expansion than the beginning.
Valuation Prospects are Poor
The duration of both cycles and the magnitude of the current bull run are compelling facts, and valuation seems to confirm their message. As we have been writing for several quarters, valuation has clearly been turning in a direction that appears to be a headwind for future long-term returns.
Our internal model evaluates 16 different measures of market valuation, including several price-to-earnings ratios, intrinsic value estimates, yield-based comparisons, and non-earnings measures. Currently the weight of the evidence suggests that market valuation is clearly in expensive territory, where future long-term returns are projected to be meager over a five-year period. The simple message from valuation is that the margin of safety in stocks is razor thin right now.
Ceiling on Risk
Given the duration and magnitude of the current cycle, and knowing that valuation has deteriorated in the market, one might question why we continue to position portfolios with neutral levels of volatility. Despite some of the daunting facts presented above, we donâ€™t think itâ€™s time to pull the ripcord and de-risk portfolios just yet. A mature cycle and high valuation do impact our investment decisions by effectively establishing a limit, or ceiling, on how much market risk we are willing to accept. However, valuation is also a notoriously poor timing indicator â€“ overvalued markets can grow even more overvalued before turning lower. Therefore, in order to determine when to begin to exit this bull market, weâ€™ll rely more on the weight of the cyclical evidence that we routinely follow.
U.S. Cycle is Improving
The first positive on the cyclical front comes from the U.S. economy. While long in the tooth by historical standards, the business cycle has been so muted during this recovery that we believe it has further room to run. Currently we are encouraged by strength in leading economic indicators, improving confidence, and firming in the labor markets. We expect a big bounce back in second quarter GDP growth, and improving momentum to carry into the third quarter.
Ironically, if the economy gains too much traction it could prompt the Federal Reserve to start posturing for a withdrawal of its zero percent rate policy sooner than expected, which would likely produce temporary market turbulence. But any turbulence from an improving economy would likely be short lived. In the end a better economy should support revenue and earnings, which would likely extend the life of the current bull market.
Technical Conditions Say Bull Intact
On the technical front, the vast majority of global markets continue to be in healthy uptrends. We continue to watch closely for divergences to develop that would typically warn that a bull market is on its last legs. While the recent underperformance of small caps stocks does represent one potential warning flag, the broad message from measures of market breadth continue to signal that on balance there is still healthy participation in the current bull market. This doesnâ€™t rule out a correction, and signs of complacency imply that a healthy shakeout could occur at any time. In bull markets, short-term shakeouts are healthy and typically represent opportunities to find bargains in the market.
Though the technical environment must be monitored closely since it can change quickly, the weight of the technical evidence is that the bull market is still very much intact.
Quantitative Models are Perking Up
A variety of quantitative models that are designed to predict shorter-term market movements are holding up quite well, and have actually turned increasingly bullish over the past quarter. Our proprietary model aims to lead the S&P 500 Index by 6 months, and itâ€™s risen to the most bullish level in several years. In addition to its high score, the number of factors registering bullish signals gives us a secondary confirmation that the signal appears to be more than short-term noise. Pinnacleâ€™s model also aligns with a number of independent models, reinforcing to us the fact that unemotional quantitative measures are saying itâ€™s too early to give up on the bull market just yet.
Independent Analysts are Holding On
Lastly, the message of most of the independent analysts we follow is still constructive. While weâ€™ll never see the analysts we read agreeing with each other, the tone of the group could still be categorized as cautiously optimistic, and not yet ready to embrace a turn in the market cycle. We are aware there are many media pundits that are gloomy, and most of them have compelling stories about why the bear is right around the corner. Weâ€™d be arrogant to completely cast aside any cautious views at this point in the cycle, but we also realize that many of these pundits have been very wrong during much of the current bull market. At some point the bears will be correct, and our job will be to align with them when the evidence tells us itâ€™s the appropriate time to do so. That time may be approaching, but it isnâ€™t here yet.
Currently the market cycle is mature and levels of complacency suggest a shakeout could occur at any time. Elevated valuation indicators also imply that long-term returns are likely to be meager from current market levels. To juxtapose these headwinds, the cyclical evidence continues to improve from a U.S. economic perspective, and other cyclical measures are signaling that itâ€™s too early to bail on the bull market.
Pinnacle portfolios continue to run at neutral levels of volatility, and given a brightening U.S. economic outlook, we are tilted to cyclical domestic equity holdings that are levered to a pickup in business spending. Internationally we are positioned slightly defensive in nature, with overweights in Europe and Switzerland, and a large underweight in Japan. Commodity exposure is currently benchmark neutral given a lack of conviction in the asset class. In fixed income, we continue to carry underweight levels of interest rate sensitivity in our fixed portfolios, with an overweight to spread products that should fare better than safer bonds as long as corporate America stays healthy and defaults stay low.
We are growing more concerned that this cycle is getting closer to the end than the beginning, and that means weâ€™ll have to be even more vigilant in looking for signals that a bear market is imminent. For now we think the cyclical signals argue for staying invested at neutral levels of volatility, but when the evidence for a change in cycle materializes, weâ€™ll be ready to pull the ripcord and get more defensive.