2 Strikes Against Bull Market And Waiting For The Third

by: Sean Butson, CFA


Four of the five biggest S&P 500 stock market crashes since 1934 occurred when stock valuations were high or very high, the FED raised interest rates, and a recession ensued.

That’s two strikes against the bull market (expensive stocks and rising rates) and we are now waiting for the third.

With the S&P 500 bull market recently hitting its 8th anniversary (second longest ever) from the Great Recession low on March 9, 2009, we have been getting more frequent questions from clients about whether we expect stocks to materially fall in the near future. Accordingly, we think it's appropriate to devote our next few letters to the anatomy of corrections, bear markets, and bull markets. But before we do that, it's important to define what we mean by these terms. The financial media generally refers to a 10%+ investment decline as a correction, a 20%+ decline as a bear market, and rising prices in the absence of a bear market as a bull market. Declines of 30%+ are generally referred to as crashes. We don't spend a lot of time trying to predict short-term declines of 10% or 20%, and are often buying more stocks during such swoons. However, we do exert a significant amount of energy attempting to reduce risk ahead of major crashes of 40%+. The primary reasons for this are twofold: 1) through our research, we have found a number of leading indicators that flash warnings signs prior to such large crashes; and 2) while investors are generally able to remain invested through relatively small, short downturns, the same is not necessarily true during long, massive declines which take their psychological toll as the months (or years) drag on. This stress can manifest itself in a desire to "sell everything" at exactly the wrong time. As a result, at DCCM we are focused not only on producing solid returns over full market cycles, but also on limiting risk during market crashes.

In the chart below, we detail the magnitude, duration, and time to breakeven (i.e. the amount of time between all-time highs) of S&P 500 declines of 19%+ since 1934. Why 19% instead of 20%? Because there are a surprisingly large number of 19% drops and some of them were actually 20% declines using intraday prices (we use closing prices in our chart). A quick glance at the chart illustrates that 4 of the 5 biggest declines occurred when stock valuations were high or very high and coincided with a U.S. recession. These four crashes averaged a decline of 49%, a duration of 31 months, and a breakeven of 59 months. By contrast, the largest decline without a recession was 33% in 1987. While this crash was nothing to sneeze at, it only lasted two months (with the vast majority of the damage occurring in just one week) and the losses were made up in less than two years.

If stock valuations and recessions are important in predicting the size of stock market declines, where do we stand today? Unfortunately, based on a host of valuation metrics that analyze stock prices in relation to earnings, cashflows, sales, and net worth, we believe that stocks are currently expensive. Some naysayers will point to how changing accounting rules make long-term historical comparisons less effective. While there is some truth to that, we would point out that sales multiples (which are dramatically less affected by accounting changes) are near all-time highs and that the S&P 500 is significantly above its shorter-term 5, 10, 15, and 20 year earnings multiple averages. We have also heard numerous arguments that stocks are cheap relative to bonds because of the latter's low interest rates. There is even an acronym for this belief - TINA, as in "There Is No Alternative" (to stocks). While this thesis may sound appealing on the surface, it doesn't hold up to historical analytical scrutiny. The last time interest rates were this low at the same time that stock valuations were high was in the mid to late 1930s, coming out of the Great Depression. Such low rates were not able to prevent the 60% stock market crash in 1937 detailed in the chart above. Likewise, despite Japanese interest rates of less than 1%, the Nikkei stock market dropped more than 50% twice since 2000. Lastly, we often hear that stocks are "fairly valued" based on projected earnings per share. While it is true that such forward earnings multiples are closer to historical averages than many other valuation metrics, we would point out that they have not been an accurate predictor of future returns. For example, the S&P 500 projected earnings multiple was lower in 2007 than it is now, just before the last stock market crash. Conversely, the multiple was higher in 1991 than it is now, just before the biggest bull market ever. The problem with these projected earnings multiples is that stock analysts (who collectively produce the projected figures) almost always miss forecasting recessions due to their eternal optimism. I should know, I used to be one.

High valuations late in bull markets are usually associated with individual investor euphoria, as evidenced by the following: SNAP (NYSE:SNAP) (the parent company of Snapchat) went public at more than 70x 2016 sales, the recent popularity of the Real Estate Wealth Expo featuring Tony Robbins (the self-help guru) and Pitbull (the rapper), borrowing to buy stocks on margin is at all-time highs, and bullish investor sentiment is through the roof. Sound familiar? I've seen this movie twice in the last 17 years and know how it ends. It's just a matter of when and how badly. What's astounding is how short investors' memories are. It wasn't very long ago that Americans were lamenting the plummeting values of both their 401ks and their houses. To be clear, the euphoric conditions detailed above have historically not been enough to cause stock market crashes, but they often exacerbate them once a recession hits. Fortunately, we don't think a recession is imminent, but note that the Federal Reserve raising interest rates typically marks the beginning of the end of bull markets, although this phase can go on for an extended amount of time. We will explore this theme in depth in our next letter.

So what does all this mean for your money? It means that we have reduced our stock exposure somewhat over the last 15 months, but not dramatically so. Remember, valuations are excellent predictors of long-term stock market performance (i.e. 10+ years), but poor forecasters of short-term returns. Stocks were expensive in 1928, 1965, 1996, and 2004, but kept rising for year(s) anyway. Can stocks get significantly cheaper without a crash? Sure, but historically that hasn't happened. Rather, earnings tend to rise but prices increase even faster, making stocks even more expensive. Of course, anything can happen in the future, but history suggests that a 40%+crash likely won't occur until one of Newton's "unbalanced forces" hits. In the past, the most damaging such force has been a recession. And because we aren't seeing initial signs of one, we don't think the matador has entered the ring quite yet. Accordingly, we are not "selling everything", nor are we "letting it ride" as Richard Dreyfus does in his classic horse racing movie. In short, we are content to give up a portion of the final gains of an aging bull market if it means reducing declines in the next stock market crash, all the while focusing on producing strong risk-adjusted returns over full market cycles.

All comments in this letter are strictly the opinions of the writer and in no way should be construed as guaranteed. Opinions expressed are subject to change without notice and, due to the rapidly changing nature of capital markets, may quickly become outdated. The opinions and information presented do not constitute a solicitation for the purchase or sale of any securities or options on securities. Please contact DC Capital Management if there are any changes in your financial situation or investment objectives, or if you wish to impose, add or modify any restrictions to the management of your account. Our current disclosure statement is set forth on Part II of Form ADV and is available for your review upon request. Past performance is no guarantee of future results. All investing involves risk, including the potential for loss of principal. There is no guarantee that any investment plan or strategy will be successful.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.