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Whether examining market runs, valuations, unemployment, consumer confidence, or the ISM (Institute of Supply Management) survey, one thing will become abundantly clear: we are at record highs nearly everywhere you turn. This bull market could last another six months, year, two years, or even five. However, with multiple indicators signaling an imminent economic downturn, I would recommend that investors remain conservative and hedge themselves against downside risk.
1. This is the longest bull market in history
Our current bull market began on March 9, 2009, when the S&P 500 catapulted from 672.9 to its current level of 2,901.5. That means this bull market is still going strong at nine years and six months. The average bull market, or period of uninterrupted gains before a 15 percent drop in the prices of major indexes such as the Dow and S&P, has lasted exactly 5.2 years when considering all bull markets since World War II.
The second longest bull market in history occurred from 1990 to 2000. It lasted 114 months and saw 418% returns on the S&P 500. Federal Reserve Chairman Alan Greenspan's easy money policies of low interest rates and liquidity injections during his tenure from 1987 to 2006 led to what was until now the longest bull market in history followed by back-to-back recessions in 2000 and 2008. Ben Bernanke ran the same plays from the Greenspan playbook during the crisis of 2008, leading to our current bull market. The lesson in all this? Loose monetary policy leads to extended bull markets. However, if the lessons of the 2000s are any indication, they also lead to more severe recessions.
2. This is one of the most overvalued markets in history
The Shiller P/E ratio, or Cyclically Adjusted Price to Earnings (CAPE) ratio, measures the real price of a stock or index divided by the 10-year average of real earnings. While a normal P/E ratio uses one-year earnings, the CAPE ratio accounts for the business cycle by using the 10-year average and serves as a better measure for valuation. The average CAPE ratio is 16.9. The ratio at the peak of the 2000s' bubble was 44.2, and 32.6 just before the Great Depression. Where does this market hold up? 33.3. According to this indicator, this is the second most expensive market in the stock market's history.
Other indicators tell a similar story. Market cap to GDP, also called the Buffett Indicator, measures the total value of all stocks over the country's GDP. According to this metric, this is the most overvalued market in history with the market cap of the Wilshire 5000 at 137.9% of GDP compared to 136.9% before the 2000 peak.
(Source: Advisor Perspectives)
3. Tightening financial conditions
In the short term, economies rise and fall based on the availability of credit. In order to spur borrowing and lending in the midst of the Great Recession, the Federal Reserve kept interest rates at near zero from 2008 to late 2015. What happens as the Fed raises interest rates? Companies and individuals who got drunk on excess credit now cannot meet their debt service obligations. Also note that interest rates peak at lower and lower levels from previous recessions, with rates in 2008 peaking at 5%. The Federal Funds rate currently stands at 2% and continues to rise. At what point will high interest rates break the economy's back? 3%? 4%?
(Source: NY Times)
4. Wealth to GDP due for a mean reversion
This chart says it all. The divergence from the mean in U.S. household net worth to GDP has reached nosebleed levels. While the middle and lower classes curtailed spending in the wake of the 2008 recession, the wealthy took advantage of near-zero interest rates and poured leveraged money into risk assets. However, a continuation of this trend is unsustainable. The only way for a meaningful mean reversion to occur in this metric is through a deflation in the price of risk assets.
5. Hindenburg Omens
Mathematician Jim Miekka created the Hindenburg Omen as a technical indicator of an imminent stock market crash. It signifies when there are both new 52-week highs and lows made on a particular index. Additionally, the 10-week moving average must be positive, and the McClellan oscillator, the difference between the numbers of advancing and declining stocks, must be negative. It indicates a general weakness in an uptrend. While an index may be increasing, more and more individual stocks hit new lows. One or two omens remains insignificant, but five to eight usually signals an imminent downturn. The NASDAQ composite currently has five. Keep an eye on this indicator. When it reaches eight, look out below.
(Source: The Felder Report)
6. Unemployment hits record lows
Unemployment for July 2018 reached 3.9%. Before the crash of 2000, the unemployment rate hit a low of 3.8% and 4.5% before 2008. While the economy can muddle through with low unemployment rates for years (see 1951-1953 or 1965-1969), rates this low simply do not last. They indicate an economy working at capacity, with minimal room for continued growth.
7. Corporate debt to GDP at record highs
Another indicator surpassing 2008 levels that cannot last in a rising interest rate environment. Corporations took on excessive debt amidst years of near-zero interest rates. As interest rates rise, many companies that survived on accommodative monetary policy will not have more room to run.
(Source: The Gold Telegraph)
8. Elliott Wave Analysis
In the 1920s, Ralph Nelson Elliott noted that stock markets moved in repetitive cycles comprised of eight waves. An uptrend will generally see two corrections before it reaches a top, and a downtrend will generally see one false rally before it reaches a bottom. Technical indicators such as this one are less concrete due to the differing perspectives of the chartists. However, if my analysis is correct, the S&P 500 is currently finishing the last wave of an uptrend.
(Source: Author; Tradingview.com)
9. The ISM
The Institute of Supply Management Manufacturing Index monitors employment, production, inventories, supply deliveries, and serves as a general gauge for the state of the economy and where the economy stands in the business cycle. Created from surveys of over 300 manufacturing firms, the index naturally rises when production is high and inventories low, then falls with the inverse. Generally, the ISM crossing below the 50 mark indicates a high chance of recession. The ISM is still high due to low unemployment, high production, high supply deliveries, etc. Yet take a look at the eeriness in the two charts that follow. The first chart shows the ISM from 2012 to today. The second chart shows the ISM from 1996 to 2000, just before the stock market crashed by 49%.
These two bull markets share many similar characteristics from a qualitative standpoint. Both involve debt-fueled spending spurned by easy money policies of the Federal Reserve as a reaction to a recession (1987 and 2008). Eight years after the crash of 2000, the ISM had its last downturn and attempted rally before the crash. Eight years after 2008, we see another downturn in the ISM and a subsequent rally. Seeing as the current business cycles share many similar characteristics with the 1990s' rally, it makes sense that the two would share similar chart patterns.
10. Your favorite investors are preparing for the worst
Perhaps the most compelling reason for the retail investor. Value investors say that cash is king during the late stage of the economic cycle. It allows investors to purchase their favorite stocks at incredible bargains once a recession occurs. Warren Buffett has $116 billion, or 33% of his entire portfolio, in cash. Seth Klarman, another famed value investor, has 42% of his portfolio in cash. A simple piece of advice when it comes to investing is to follow the experts. Currently, the experts are preparing themselves for a recession.
How to prepare
Markets are difficult, if not impossible, to time. Despite this, investors should understand where the U.S. stock market stands in the current economic cycle and position themselves accordingly. Here are a few steps I would recommend investors take given these indicators: 1) Build cash now. Simply stated, have cash on hand in order to buy your favorite companies at lower prices and build long-term wealth. 2) Stop indexing and enjoy the ride. Returns are a function of what you pay for, and if you buy stocks at these valuations, you guarantee a worse return than if you simply waited and deployed that cash when the market cooled off. 3) Diversify away from U.S. equities. Short-dated Treasury bills currently yield above 2%, commodities are still relatively cheap, and recent implosions in emerging markets and precious metals provide opportunities for the brave investor. 4) Consider protecting your capital with stop losses. I always recommend a 25% stop loss. This allows you to continue investing in the event of a correction or panic, but protects your capital from the ever-feared 40% or 50% crash such as 2000 or 2008.
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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.