A Wall Street sign is pictured in the rain outside the New York Stock Exchange
Light a couple of candles and sing for the “relentless rally,” the tireless gain-without-much-pain phase of this bull market, which has added $8 trillion worth of U.S. stock-market value since it began two years ago.
Sure, this bull market dates back five and a half years to the March 2009 climax of the financial crisis. But it was in mid-November of 2012, just after the election, when the character of the advance changed.
Investors at that point stopped expecting a crisis relapse with every sunrise, the economy moved out of intensive care and into recovery mode, Washington was stalemated to the point of irrelevance and central banks continued delivering easy-money medicine to an economy that decreasingly needed it.
As a result, markets re-embraced risk, stock prices started rising faster than corporate profits and companies turned toward aggressive deal making. This, I’ve called the “liftoff phase.”
At yet another set of new highs this week, the Standard & Poor’s 500 index is up 52% in this two-year span, without having undergone as much as a 10% pullback along the way.
The market barometer's price-to-earnings multiple on the past 12 months’ profits is 19.5, up from 16.1 two years ago; the multiple on forecast earnings for the next year has climbed to 17.5 from 12.2. The ratio of bullish to bearish investment advisors in the weekly Investors Intelligence survey has ramped to 3.75 from 1.5, and the proportion of Americans’ household net worth allocated to stocks is near an all-time high.
All of which is to say, stocks are fairly expensive and the public increasingly enamored of them, implying that the bull market needs a new, persuasive “story” if it is to carry much higher from here in 2015.
Goldman Sachs, in its just-released 2015 outlook, says that the P/E “multiple expansion” phase is probably over, meaning that additional appreciation will be reliant on underlying growth.
This is arguable, of course. The past couple of bull markets got a bit more expensive than this one before expiring, with trailing P/E ratios above 20. But even so it’s a bit uncomfortable to bet on this being a big driver of further gains form here.
The main elements of the market’s run to the current heights are low yields and plentiful liquidity, spurring investors to re-price stocks higher based on their dividend and cash-flow yields relative to bonds.
Strong credit markets and corporate stock buybacks have been the key instruments here, and low rates and depressed wages have helped big companies maintain lofty profit margins to support equity values.
With the Federal Reserve at least outwardly eyeing a chance to lift short-term interest rates next year as economic data continue to impress, and profit margins sitting far higher than average, these dynamics appear largely played out.
As noted here, stocks have only made much headway in recent years when their cash-flow yield has exceeded junk bond yields. That’s not the case today.
Tailwinds pick up behind the U.S. consumer
Healthcare and industrial stocks have been the quintessential cash flow, buyback and profit margin plays the past two years and each has vastly outperformed the broad market. They’ll probably need help from here. It’s worth noting that the buyback theme has tired, with the Powershares Buyback Achievers ETF (PKW) lagging the S&P 500 year to date.
Wall Street is already indicating that the next “story” to be embraced is a domestic consumption resurgence. Brisk increases in payrolls, low personal debt-service costs, crashing petroleum prices, an uptick in housing activity and a stronger dollar making imported goods more affordable are all lining up behind this tale.
Retail stocks and home-construction names have both led the market in the month since the October global-growth scare market shakeout, hinting that the market is rotating in favor of this domestic revival idea.
Meantime, if the capital markets maintain their current calm, count on big companies to continue indulging their quest for domination through deals. We’ve seen some $3 trillion in global mergers and acquisitions this year, and mature bull markets like this one are the venue for bigger and more audacious deals.
If we are due for a stretch when obvious good news is truly good for stocks – a transition from a suspect, grinding rally to a “belief phase” - then consumer buoyancy (perhaps finally accompanied by some wage growth) and gaudy takeover headlines will likely be prominently featured.
It should be said that these market “stories” don’t always need to play out as expected to provide the excuse for “more buyers than sellers” pushing stocks up.
The prevailing “story” heading into 2013 was an anticipated “great rotation” of investor cash from bonds into stocks. It never really happened; stocks surged and lifted investors’ total allocation to stocks, but no big, willful shift of cash occurred.
Heading into this year, the consensus call was for U.S. growth to reach “escape velocity” as interest rates rose and pent-up capital spending accelerated. Didn't really happen, with rates anchored and growth slow in the first half of the year. But liquidity stayed plentiful and profit growth was decent enough to help large-cap stocks on their way to another nice return.
So even if the new story become U.S. consumer vigor, it would be just like Mr. Market to have, say, cheap Euorpean stocks outperform the lofty domestic indexes.
As ever, nothing is guaranteed in life or markets. When stocks get as pricey as they are now, not only do long-term future returns tend to be weaker but accidents tend to happen more frequently.
The violent 9% drop in four weeks through mid-October was on relatively tame news – hints of wavering global growth, fear that central banks would not step up in support and a fouling of some popular trades across debt, commodities and currencies.
This shows that markets seem dependent on a fairly fragile equilibrium of slow but positive growth and generous central banks. With various world regions seeing radically different growth rates and disparate monetary policy paths, disturbances to this arrangement are likely to come from multiple directions.
So maybe the common notion that markets will undergo more frequent bouts of volatility will bear out and the rally will become less relentless. The bull market is still innocent until proven guilty, but it’s time to start gathering evidence and making sure it can tell a believable story to the judge and jury.