The current bull market (which began in 2009) will soon be entering its 9th year of expansion. That is quite a long time for a bull market to run without interruption, actually one of the longest on record. This has some investors worrying that we are getting into the late innings of this business cycle, and the time to cash in some chips and focus on playing defense is at hand.
Normally at this juncture in the cycle, one would be looking for areas of excess in the economy and financial markets and pointing them out as worrisome. This would include things like the economy overheating, inflation rates picking up, and interest rates rising in conjunction. But one of the conundrums this time around is that inflation has remained low, interest rates are near record lows, and economic growth remains subpar.
Economic backdrop: The backdrop for the US economy offers a mixed picture. GDP growth has been fairly weak. As the graph below shows, GDP growth actually started to pick up in 2013-14, but has since peaked and started trending lower in a linear fashion. Job growth has also been below average compared with past economic recoveries, but strong enough to keep the unemployment rates moving lower. Jobless claims are at multi-decade lows. This has supported consumer spending, which is the biggest component of US GDP, and helped GDP growth stay in positive territory.
While this economic recovery has appeared steady, the growth rates of just about every economic sub-sector are below average when compared to past recoveries. This is the main reason that monetary policy has remained ultra-accommodative, with interest rates barely above levels reached at the height of the 2008 financial crisis. And while there continues to be a lot of chatter and debate about the Fed raising rates again this year, and possibly more into 2017, most other central banks around the globe are still easing monetary policy deeper into record territory.
Bull / Bear debate: There is always a healthy bull/bear debate in any cycle, but the uniqueness of this cycle seems to be allowing for an unusually high number of salient points on both sides of the debate. The bulls argue that although economic (GDP) growth has been weak, it is expected to rebound soon from current low levels and gradually improve. Coupled with a solid jobs market, this should help incomes rise and support a boost to consumer spending.
This is sort of the ‘optics’ argument, whereby since economic growth rates have been weak for so long, when the market starts to look at year-over-year comparisons growth will soon appear stronger (if only because the comparison periods from a year-ago were so weak). So upcoming GDP reports may look stronger when compared to weak figures from a year ago. This argument also applies to corporate profit growth, the fuel for stock market advances.
Earnings growth for the S&P 500 Index has been showing negative growth rates for the past six quarters. Analysts finally expect the earnings contraction to trough this quarter and for positive growth to resume. Bulls argue that the stock market held in pretty well during this ‘earnings recession’, and that with earnings growth set to resume and post solid growth figures, investors will likely cheer the change in trend and bid stocks higher.
The bears’ thesis starts with the position that it has solely been the Fed’s ultra-easy monetary policy and supportive quantitative easing measures that have been responsible for this 8-year old bull market. Without the support of central banks and their desire to help lift asset prices, this bull market would have ended years ago.
They continue that GDP growth has struggled to stay above 1% in this environment, and although it could see a bounce in the near-term, growth rates are likely to continue to trend lower. They point out that historically jobs growth is a lagging indicator and that we have likely seen the peak in jobs growth as well. That may be all that is needed to tip the scales and push this fragile economic expansion into contraction territory.
Outlook: As we have stated in previous missives, we came into 2016 wanting to take a more defensive posture in client portfolios. The Fed had just hiked interest rates for the first time in many years, earnings estimates had started to be revised downward in significant fashion, and economic growth was slowing. That defensive posture looked to be prescient as the year started out with a quick -11% correction (for the S&P 500) in just the first few weeks of the year.
But from there the market was able to bottom and put in a solid bounce. Despite some continued volatility, most notably around the Brexit vote, the market was able to shrug off all the uncertainty and make marginal new highs during the summer. While at times our cautious stance has looked overly conservative, the overall gains in equities thus far this year have been modest. We don’t feel that we have missed any significant upside in the market. And while we could see another relief rally post-election, our big picture concerns about the global economy have not gone away.
One of our biggest concerns remains the central bank policies in Europe and Japan that involve aggressive quantitative easing, and an economic “experiment” of cutting interest rates into negative territory. While quantitative easing has helped lift asset prices, it has not accomplished its goals of boosting economic growth in most parts of Europe and Asia. And the policy of pushing interest rates into negative territory does not seem to have accomplished any of its stated goals.
This has to leave the astute investor scratching their head and wondering, if ultra-aggressive monetary easing and negative interest rates can’t do more to boost economic growth, how will things look when central banks have to pull back from this strategy? The ECB’s quantitative easing program is set to expire in March 2017, and there haven’t been any comments or suggestions yet about extending the program. That would leave just the Bank of Japan to question the continued effectiveness of their asset purchase programs, as well as the ultimate cost of these policies.
As such, we continue to favor our approach of erring on the side of conservatism with respect to taking risk in investment portfolios. We do not see the current risk/reward tradeoff as sufficiently compelling to overweight stocks relative to fixed income and other more defensive investments. We prefer to focus on preserving the gains we have worked hard to accumulate in recent years, and to exercise patience with respect to the next buying opportunity.
Jordan L. Kahn, CFA
Chief Investment Officer
Sources: Stockcharts.com; BTIG research; Raymond James; Briefing.com; IBD; FT.com; Barron’s; Charles Schwab