"The stock market has recovered so sharply for so long, you have to assume somewhere along the line we will get a significant correction. Where that is, I do not know." - Alan Greenspan, July 30, 2014
With all the volatility we've seen over the past few weeks and the possibility that we're nearing an inflection point, the bulls and bears are out in full force debating - and to some extent influencing - the future of the US stock market. Judging from the evidence being used to defend either side, the bears currently have a clear upper hand. Over the next five years, it is extremely unlikely that we will experience a bull market similar to the one we've just witnessed (from August 2009 to present). Based upon an examination of underlying economic conditions, trends and political realities, we can expect a significant market correction or full-on downturn in the years to come.
Let's start with the view from 40,000 feet. The graph below shows the performance of the S&P 500 (NYSEARCA:SPY), the Dow Jones Industrial Average (NYSEARCA:DIA), and the NASDAQ (NASDAQ:QQQ) over the past 5 years to date. For comparison, I've included a graph showing the previous five-year rally in US markets (using the same August-to-August timeframe), which took place from 2002-2007.
Major US Indices, August 2009-2014
Major US Indices, August 2002-2007
Despite the fact that the 2002-2007 rally (detailed in the second graph) conveniently begins at the end of the dot-com bubble and cuts off right before the Great Recession, the market rally we've witnessed over the past 5 years to date beats the previous rally by a pretty significant margin, for every index.
This comparison in no way proves that a bear market or market correction is coming. But it should make you wonder: have economic conditions over the past five years improved enough to justify such serious growth in asset prices? Where we are now, is the US positioned for the kind of economic growth that would sustain another five-year rally in the stock market?
Looking at the data, the answer is a resounding "No."
At any given time, there will be data that can used to support both bull and bear market hypotheses. Often times as we'll see, the exact same data point will be construed as positive AND negative, based on who's offering the analysis and what their overall thesis is. I've tried to compile what I consider to be some of the more salient points on either side of the argument:
- Aside from the volatility over the past few weeks, US markets have been demonstrating clear positive momentum. The NASDAQ, Dow Jones Industrial Average and S&P 500 indices each hit all-time highs in July 2014, well above the highs each had reached in 2007 prior to the recession.
- Overall, recent economic news in the US has been mostly positive. The US has been adding jobs lately, and although the 209,000 jobs added in July fell short of the projected 230,000 jobs expected, this represents the longest streak of 200,000+ jobs added since 1997. Job gains for May and June were revised upwards by a total of 15,000, to 229,000 and 298,000 respectively. Also positive was that most of July's job gains went to full-time workers, "partly reversing huge advances by part-time workers at the expense of full-time employees in June"
- Rapid employment gains have boosted consumer confidence, which hit a seven-year high in July
- The employment outlook therefore looks to be one of further robust job creation in the coming months, but with some moderation in the rate of job creation compared to the first half of the year. - Chris Williamson, chief economist at Markit
- Demand for commercial real estate loans is up, and net debt issuance of US non-financial sector has been climbing, hitting its highest level since its 2007 peak.
The aforementioned statistics are relatively short-term in nature. This short-term perspective was a common characteristic among the most compelling and fact-rich bullish analyses I've been able to find. Of those facts and analyses that are longer term in nature - such as those looking at the stock market's historical performance - it seems that many of these are actually more compelling evidence to the contrary (i.e. markets have hit all-time highs, thus the chance of recession is low), or are attempting to distract from examination of current market realities by discussing investment philosophy.
Some examples of the latter that stood out to me: "Timing the market is a fool's errand" (article I Told you So!), and "studies have shown that the more frequent an investor checks their account balances, the more over time they dramatically underperform nearly every single part of the investable landscape" (in article The Greatest Mistake Investors Make). Talking about the shortcomings of active management - a legitimate idea with plenty of facts to defend it - is a pretty weak argument upon which to claim that a bear market is unlikely to occur.
It also stands out to me that, of the "Editor's pick" articles chosen in the past few weeks, the vast majority of those examining market outlook have either taken a bearish or cautious/neutral stance. This hardly constitutes evidence that the bears are right. But considering how articles that win this designation tend to be heavy on facts and references, specific knowledge, and novel but reasonable analysis, the fact that there weren't many market-bullish articles on this list over the past few weeks did seem to imply that there may have been a lack of such articles with strong factual analysis to back them up.
That being said, the legitimate case for a bear market comes not from weaknesses in the opponents' arguments, but from quality analysis of what we consider to be the most important facts. I believe a bear market is on the horizon for several reasons:
Major economies are showing signs of a slowdown:
- The Baltic Dry Index, often considered a leading indicator of future economic growth or contraction, has fallen 60% since the beginning of 2004; it currently sits at its lowest level of the year.
- Germany and Great Britain have seen industrial production and manufacturing (respectively) decline by 1.8% and 1.3% in May. In 2014, "the Chinese economy will grow at its slowest pace in years"
- The Bank of Japan (Japan's equivalent of the US Federal Reserve) has been buying its own market ETF to "boost the impact of its unprecedented easing" ("Bank of Japan Seen Buying Nikkei 400 ETF," Financial Post, July 10, 2014)
- Despite 88 companies being listed on the stock market in Q2 2014, the US contracted 2.9% in Q1 2014.
Stagnating wages and chronic unemployment threaten the US economy:
- Despite the increase in new jobs over the past few years, unemployment rose to 6.2% from 6.1% over the past quarter. The so-called under-employment rate (which includes discouraged workers who have given up looking for jobs, and part-time employees who prefer full time work as well as the unemployed) ticked up to 12.2% from 12.1%.
- Since the Great Recession, participation in the labor force has steadily declined, and despite recent economic growth, has actually reached new lows:
Inequality is Reaching its Highest Levels since 1928
- In 1982, the highest-earning 1% of families received 10.8% of all pretax income, while the bottom 90% received 64.7%
- In 2012, the top 1% received 22.5% of all pretax income, while the share going to the bottom 90% dropped to 49.6% (source)
- Since 2009, 95% of income gains went to the top 1% of earners
- The richest 20% of Americans held 88.9% of the nation's wealth
- Top 1% wealthiest American households owned 35.4% of all U.S. Wealth (source)
- Richest 400 Americans together have more wealth than the poorest half of Americans combined (source)
- Before taxes and government transfers, America ranks 10th in the world in terms of income inequality. After taxes, it ranks 2nd in the world in income inequality. (source)
Uncertainty Regarding Geopolitical Crises Creates Potential Threats to Global Economy:
- Russia and Ukraine
- Israel and Gaza
- ISIS in Iraq
- Instability in Syria
US Tax Policy:
- Stopping corporate inversions "will make the US economy weaker," imposes big costs by discouraging investment (The Economist)
- America's corporate tax rate, at 35%, is the highest among the 34 members of OECD
Fed's Monetary Expansion:
- Since 2007, quantitative easing (printing money to buy bonds in order to keep interest rates low, with the goal of having cheap credit and stimulating demand and rising asset prices) has benefited Wall Street and the richest Americans disproportionately.
- "Motor force of Keynesian expansion is gone" (by which cheap credit and big interest rate cuts stimulate buying and spending, thus spurring overall economic growth). The expansion of US household debt - which is at 103% of household income - has come as a result primarily from massive student loan debts. As baby boomers retire, and start spending money rather than borrowing, this driver of Keynesian growth has nowhere to go but down. ("Don't Buy This Dip: The Fed is Not Your Friend")
- Same effect has been examined in England, where post-Recession QE has led to stock market gains, but benefiting disproportionately the rich, thus leading to rising levels of inequality ("Trickle-Up Monetary Policy?")
- "Factoring out the Fed's massive balance sheet expansion since its first big rate cut in August 2007 - that is, from $800 billion to $400 trillion - [US] real final sales have grown at less than 1% CAGR since then" ("Don't Buy This Dip: The Fed is Not Your Friend")
Shiller Cyclically-Adjusted P/E Ratio is Creeping back up to Concerning Levels:
Given the massive growth in US Federal debt, and the slowdown in US and global economic growth, valuations should be going lower, not higher.
Overall, examination of big underlying problems - from the short-term indicators (like monthly jobs and production figures) to the longer-term trends (such as slowing growth and growing inequality) - there are several reasons why the US is likely to experience a bear market in the years to come. Not only does it seem as if the big stock market gains achieved over the past five years (and the resulting current valuations) may not be justified; many of the underlying problems are difficult to address, and currently show little or no sign of improving on their own (specifically, US inequality).
Although trying to time when this will happen is indeed a difficult task, we can prepare ourselves by moving assets out of equities and into assets that historically have a low correlation with the stock market (such as gold), and focusing on the sectors with the most reasonable valuations and long-term growth prospects. Here is an article that has some interesting examinations of the correlation between different asset classes (long-term Treasuries, Gold, Cash, High yield, and equity securities) during key times of market activity.
As an investment advisor personally, I am currently shifting assets away from equities, towards alternative investment opportunities in my hometown of Seattle, and in Austin, Texas. Working with people you know, and becoming intimately familiar with specific projects, allows for greater control and a higher level of confidence than, say, betting on the US real estate market as a whole. Looking at the fastest-growing US cities in search of such alternative investment opportunities, Seattle, WA, Austin, TX and Washington, D.C. are on my radar.
Since 1929, looking at average monthly returns in the stock market, we see that September is by far the worst-performing month of the year, with an average monthly return of -1.1%. This doesn't mean there will be a for sure pullback in September, but should get you thinking about what you might do if the market began showing signs of a correction, or full-on economic downturn. In times like these, it is so hard to predict when a bear market or market correction will take place, precisely because it's so hard to distinguish between human effects and market effects in terms of changes in stock prices. If everyone - from Wall Street to average Joe and everyone else in the world - decided to keep on buying stocks with confidence, and ignore reality, prices would rise indefinitely.
The bulls have one thing right: timing the market is notoriously difficult, and is usually only done successfully by those who have their finger on the pulse and have taken the time to understand the underlying economic realities. But it is far from impossible, especially when so many signs point to an impending bear market. Timing and shorting the market is different, it's more difficult than simply preparing for a bear market mentally, and from an investment standpoint logically. Far worse than trying to time the market and failing, is to ignore the economic realities and pretend like everything is OK and stocks have nowhere to go but up.
Disclosure: The author is short SPY, RSP. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Since July 2014 author holds net-short positions on certain market indices (SPY, RSP) using ETF-options spread positions (typically characterized by an equal ratio of "long" to "short" options positions) and through the use of similar futures options spreads. Author holds long positions on wide variety of individual stocks and sector ETFs.