As we travel around the great state of Virginia, savvy investors point out that the current bull market has just become the longest in history. (Others say it has another 18 months before we can truly say it is the longest.) Regardless, people are concerned that a bear market must be right around the corner. Let’s talk about why those concerns are misplaced.
I was privileged to attend Merrill Lynch’s Annual Institutional Briefing last week. Interestingly, they are hearing the same question and concern, so they addressed the subject in their typical very straight-forward, factually-based manner. Their clear and unqualified answer was no – a bear market is not right around the corner. Here are 3 reasons why they believe concerns are misplaced.
First, it’s true that bear markets are generally preceded by lengthy bull markets, in the same way that car accidents tend to be preceded by braking. However, just as braking does not cause the accident, a lengthy bull market does not cause a bear market.
Second, there has been much talk about the flattening yield curve. The yield curve is simply a graph of the interest rates for various maturities of CD’s or government treasuries, i.e. 1 year, 2 years, 3 years …. 20 years. A simpler / quicker version is to look at the difference in yields between the 10 year and 2 year treasuries. As that difference becomes smaller and smaller, it means the yield curve is flattening.
It’s true that the curve has been flattening. The difference between the 10 and 2 year treasuries was 123 basis points (or 1.23%) at 12/31/16. At last year-end it was 59. At the end of June it was 30 and at the end of July it was 29. However, a flattening yield curve is not a reliable determinant of a bear market. Further, the yield curve has demonstrated in the past that it can remain flat for a time – sometimes a long time – and then resume its curve.
The much more reliable indicator is an inverted yield curve, i.e. when the 10 year treasury rate actually falls below the 2 year rate. While we and the rest of the financial world will watch carefully for that, it hasn’t happened and we have no idea if or when it will happen.
Third, a common indicator of bear markets is overvaluation of equities. This is most commonly measured by the Price / Earnings (PE) ratio. PE ratios can be calculated in two ways. Trailing PE’s are based on the company’s actual earnings during the last 4 quarters. Forward PE’s are based on analysts’ estimates of the company’s earnings during the next 4 quarters. While the former is indisputable, the latter is what drives market prices.
Currently, the Forward PE of the S&P 500 stocks is estimated to be 16.1. This compares to a 25 year average of 16.1 – yes, exactly the 25 year average. This measure will not become worrisome until it crosses 19, 20 or 21.
Some people will point out that some popular tech stocks that are frequently seen in the headlines have PE’s substantially higher than 16. Some go as high as the 40’s, 70’s or even 90’s. Those are generally companies whose good fortune is to be growing (revenues and earnings) at 3, 5 or 10 times the pace of the S&P 500 stocks in general. Some argue, with possibly good reason that those highly inflated PE’s are justified. And they may be, provided they deliver the revenue and earnings growth upon which the ratios are predicated.
Long story short – Merrill Lynch (and others we read and listen to) do not believe a bear market is around the corner. If and when things change, we’ll try to alert you.