Say goodbye, and thank you, to what is likely to go down as the easiest year of this bull market.
Since lifting off exactly 12 months ago, the benchmark Standard & Poor’s 500 index has climbed 30% in a quite-gentle fashion, reaching a new record that few foresaw when the rally began, with most setbacks fleeting and shallow -- the worst drop measured less than 6% in the spring.
As a result, stock valuations, investor attitudes and the advancing age of this bull market probably mean things will become less easy before too long. There aren’t many signs that stocks have topped out. The prevailing winds still favor the upside for now, perhaps after the current little retreat from overbought conditions.
But we’re near a stage where the market typically becomes a bit less smooth and somewhat more … eventful.
A quiet start
The relentless rally began unassumingly, amid general apprehension. As of Nov. 15, 2012, the market had lost more than 7% in less than a month, nearly half the 2012 gains to that point.
While the market was sufficiently oversold and investor sentiment gloomy enough for a reflex bounce to seem likely, what instead took hold, with the S&P 500 at 1353, was the liftoff of one of the sturdiest ascents in years. The index has spent all of the past year above its 200-day average, a rarity that illustrates an underlying resilience and absence of selling pressure.
The climb has carried through the “fiscal cliff” tug-of-war, the government-spending restrictions, various European political and financial scares, the Federal Reserve’s initial hints of paring back its liquidity injections, an emerging-markets capital flight and U.S. government shutdown.
Behind the move is a steadily broadening recognition that the macroeconomic aftershocks of the 2008 financial crisis had passed: The era of uncertainty was giving way to something resembling normalcy, while central banks would err on the side of easier money for longer.
The year hasn’t been easy in the sense that it’s been effortless to get into and stay in stocks. No, given still-slow growth, a defective political culture and the sense that easy money has somehow made the rise in asset prices untrustworthy, it’s been tempting for many to sit it out. However, risk appetites have grudgingly recovered. Only now are more investors warming to equities, if mainly in fear or disgust for alternatives such as bonds (which are vulnerable to further rate climbs) and gold (in a bear market as doomsday fears have gone unrealized).
The big question
The main question in front of investors approaching 2014, in which the bull market will turn five years old, is: Will the market ultimately reach the level of optimism and excess of prior strong bull markets?
Investors are certainly beginning to chase the good returns that were built up while they largely sat out. Jeff Kleintop, strategist for LPL Financial, says investors tend to rush into whichever asset class has done best over the preceding five years. Right now, stocks are up 15% annualized in the last five years versus 6% for bonds. Kleintop says if stocks and bonds were to be at this level on March 6, the spread would be 25% to 5.2%, thanks to the stock rally and the fact that the worst of the 2008-‘09 declines will have rolled off.
Recent money flows into stock funds, the largest in years, and record high levels of margin borrowing in brokerage accounts, show a more bullish consensus -- not a reckless frenzy, but greater acceptance of “better times” by the public. The risk is that the “wall of worry’ gets too low, and the market becomes vulnerable to many of those things – Fed policy shifts, D.C. noise, emerging-market indigestion – that folks assume can’t derail it because they haven’t yet.
All but about 5% of the 21% advance in the S&P in 2013 has reflected not corporate-profit growth, but a higher value being placed on each dollar of earnings – so-called multiple expansion. In the prior three years, profits grew faster than stocks rose, so this is in part a catch-up move. But at nearly 19 times the past year’s earnings and close to 16 times forecasts for 2014, stocks are now fully valued versus history, given how high profitability already is.
That means the aggressive bull case from here involves a market going from fully valued to some more fragile, overvalued condition. Tony Dwyer of Cannacord Genuity, who has been quite bullish, points out that this multiple expansion is tracking the trajectory of the prior two non-recession valuation cycles from the ‘80s and ‘90s. This would equate to where the market sat in mid-1986 and late-1996. In those cases, public excitement began to boil over, speculative excesses grew, and stocks became more volatile and vulnerable to big shocks (’87 crash, ’97 and ’98 financial panics).
One could easily argue that, with central banks still applying the kind of easy-money “cure” usually intended for en early-cycle recovery state, it would almost be perverse if we didn’t end in a bubbly place.
Watch that comfort level
This suggests that today’s aggressive buyers need to hope for a typical “overshoot” phase of the bull market to play out, with late-coming investors piling in, companies taking on more debt, doing more deals and chasing hot stories.
It could happen, of course. Doug Ramsey, of market-analysis and asset-management firm Leuthold Group, believes a long, topping process might soon get underway, with new highs being reached but in narrower fashion. He points to the “inflation-adjusted” peak for the S&P at around 2100, up another 20%, as a level of interest. “That’s well within the bounds of an overshoot,” he says.
But the reality is that this market doesn’t owe investors much, even as many are just becoming comfortable with it. Stocks are valued at levels that, in the past, have meant subpar long-term returns in the years to come.
Ray Dalio of hedge fund Bridgewater Associates articulated as much this week, noting that, as stock prices rise, future returns fall. He says expected future returns on equities now looks to be about 4% a year.
In a time of easy money, there are few, if any, easy trades.
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