By Jason Pearce
Anos de los Muertos
Every year at the end of October, Mexico has a three-day festival known as Dia de los Muertos. This Day of the Dead is a celebration where the people remember and honor those who have departed.
This year, you may want to prepare for Anos de los Muertos, which translates to Year of the Dead. It is not going to be a celebration, either. You see, the odds are higher-than-normal that the multi-year equities bull market could come to an end in 2017.
In this post, I am going to reveal a convergence of data that could be pointing to a major disruption, maybe even an abrupt end, to the current bull market. But let’s get one thing straight right up front: this is not a prediction of what will happen in 2017; it is an assessment of the most probable outcome of what will happen in 2017. We cannot know the future. We can only know the likelihood of what’s to come. There is an important difference.
Let’s go ahead and revise a prior statement to read “It’s not going to be a celebration for most people.” After all, some people –hopefully you are one of them! – will be well-prepared and positioned on the right side of the market if/when that time comes.
It Ain’t Cheap
The P/E ratio of the S&P 500 recently hit 27:1. Think about that for a second. If you bought the companies in the S&P 500 and wanted to pay it off from what those companies currently earn, it will take you one quarter of a century to get your initial investment back.
Just how patient are you?
Patience isn’t the main issue, either. Investors need to consider the size of the return their getting on their money. Warren Buffett has reminded investors time and time again that “the price you pay determines your rate of return.”
The historical average P/E ratio for the S&P 500 is 16:1. That means that the current P/E ratio of nearly 27:1 is 69% above the average. Based on Buffett’s logic, this historically high-priced market should lead to a period of historically low returns.
Looking at nearly 150 years of stock market history, there are only a handful of times when the P/E ratio hit 25:1 or higher: Around the Panic of 1893, the start of the Roaring Twenties, the Great Depression in the early 1930s, the end of the Dot Com bubble in 2000, and during the Great Financial Crisis of 2008-2009. As we all know, these were not optimal times to be invested in the stock market.
Furthermore, let’s remember that price was plunging during these bear markets, even though the P/E ratio soared. The reason for this was because earnings dropped at an even faster rate than the price! As a matter of fact, earnings were negative in Q4 of 2008 for the first time in history. This is why the P/E ratio rocketed into triple-digit territory for the first time ever.
Accounting for Inflation
Economist Robert Shiller decided that the P/E ratio can sometimes be misleading because it does not reflect where the market is in the business cycle. In response, he created a ratio that measures the current prices to average earnings over the past 10 years adjusted for inflation. His Cyclically Adjusted Price/Earnings (CAPE) ratio reveals a market that is even frothier that what the standard P/E ratio shows!
Currently, the CAPE ratio stands at a nosebleed level of 29:1. Going back to 1881, there are only two other times when the CAPE ratio was at 29:1 or higher: Right at the end of the Roaring Twenties in 1929 and right at the end of the Dot Com bubble in December 1999. I would not consider this to be a good omen for today’s stock market.
In light of the current P/E valuation, I think it’s an understatement to say that the stock market is certainly not a bargain for investors right now. One could even say it’s getting into overpriced territory.
It is important to remember, though, that the P/E ratio only tells us about the market’s value. It does not tell us anything about timing. We need to look elsewhere for that.
Dog Years and Bull Years
The equities bull market that began off the March 6, 2009 low celebrated its 8th birthday on Monday. Eight years may not sound like much, but in dog years the bull market would be a mature 56. It’s certainly not young anymore.
But we’re not talking about a dog here. We’re talking about a bull. And in bull market years this one is beyond old; it’s now ancient!
Over the last 130 years, there have been 15 different bull markets in the US. The average lifespan of these fifteen bull markets was 2 years and 11 months. Therefore, our eight-year-old bull market is nearly 175% longer than the average.
As a matter of fact, the current bull market is the third-longest in history. It will move up the ranks to being the second-longest bull market if it can last beyond St. Patrick’s Day on March 17.
As a note of interest, the current bull market duration ranked in the #2 spot ended in September of 1929. We all know that wasn’t exactly a gentle landing.
Maybe this current bull market is destined to match the nearly nine and a half year record bull market duration that peaked at the Dot Com bubble top of 2000. Heck, it could even set a new record. But knowing the typical lifespan of prior bull markets, you can see that the odds are against it.
Sizes Really Does Matter
In addition to the maturity of the bull market, we also need to consider how big it is. So far, this bull market has gained 260% from the lows. That’s an average annual return of roughly 18%!
When we examine those 15 US equity bull markets that have occurred since 1888, we discover that the average size of a bull market is 120%. Therefore, the current bull market is a little more than double the average size.
As far as rankings go, the 260% gain from the 2009 low is the fourth-largest in history. If the S&P 500 just adds another 46 points to the current record high of 2400.98, it will match the 267% gain of the 1949-1956 run that occurred during the Nifty Fifties. All it would take to make that happen is a favorable Tweet from the President!
The largest and second-largest bull markets in history were substantially bigger than the current one. The second-largest was the 427% advance off the 1990 low that ended when the Dot Com bubble burst.
The largest bull market in history was a mind-blowing 504% gain that ended with the 1929 stock market crash.
The takeaway from this study is a paradox of sorts. On the one hand, most bull markets don’t gain much more than our current one. Therefore, we should not be complacent or unrealistic in our expectations going forward. Average annual returns of 18% don’t last forever.
At the same time, we know that in the couple of instances when the current size of gains was trounced, it was done by a huge margin. Why? Because some bull markets experience a blow-off stage at the end where prices go parabolic.
You have to remember that the improbable is not the same as the impossible. The informed trader/investor needs to bet with the odds, yet not fight the trend.
Will the Honeymoon Be Over This Summer?
Another potential headwind for equities right now is where we are in relation to the Presidential Election Cycle.
The S&P 500 is up nearly 13% since the Friday before the election as Donald Trump is supposed to be the best thing since sliced bread for the US economy. Stocks have not been shy about pricing that in.
However, history indicates that the market could hit a rough patch in the second half of 2017.
Looking at the stock market since 1897, the typical year following the US Presidential election is bullish for the first half. But the second half of the year is where the trouble begins…
On average, the stock market peaked out in the summer after the Presidential election. It then declined sharply into November and wiped out several months’ worth of gains. After a bit of a recovery, the market was then locked into a choppy trading range for nearly a year. At best, it would stabilize and then tread water for nearly a year.
Using a shorter data set makes this pattern look even uglier.
If we start the data at 1928 instead of 1897, the summer peak and November bottom still show up. However, the final low does not hit until autumn of the following year.
If the data set begins with 1965, the stock market once again peaked in the summer and dropped into November. This time, however, the market hit new lows for the year before it finally bounced off a November low.
No matter how you cut it, the Presidential election cycle indicates that prices will peak this year when the temperatures peak. A bottom would not be expected until November at the earliest.
Not-So-Lucky “7”
An additional cycle that investors and traders need to be aware of is the Decennial Cycle. Everyone either remembers or has at least read stories about the Crash of 1987. But do you know what happened in many of the other “7” years? For some reason, the US stock market has a bad history with the “7” years. Consider the following list:
2007 – Although the financial crisis occurred in 2008, the market peaked in October of 2007. It dropped nearly 58% over the following eighteen months before all was said and done.
1997 – Although it was a short-lived event of just a few weeks, the stock market still experienced an “unlucky” 13% drop from the top during the Asian Contagion in October of 1997.
1987 – This infamous stock market crash racked up a 36% loss in just two months.
1977 – A modest 20% bear market was torturous, due to the fact that it stretched out for nearly a year and a half before it was finally over.
1957 – The stock market lost 20% over a three-month timeframe.
1937 – Stocks dropped a whopping 46%. The wipeout lasted for nine months.
1917 – After peaking in 1917, the bears dominated for thirteen months and knocked 40% off the stock market.
1907 – This was the start of a 45% price markdown that lasted for ten months.
Amazingly, this Decennial Cycle even had an influence in the 1800s! The stock market lost 50% after the peak of 1857 and it lost 53% from the 1807 top. These bear markets lasted nine months and thirteen months, respectively.
Despite how this year has started out, history indicates that 2017 could have some bad juju in store for investors. But if you prepare yourself ahead of time and know what to look for, you can sidestep disaster. If you play your cards right, you could even be in a position to profit from it! There’s certainly wisdom in the old saying, “One man’s misfortune is another man’s fortune.”
Synergy Effect
We are only days out from becoming the second-longest bull market in US history. The age factor alone suggests that it could be nearing the end of the line.
Furthermore, the size of this bull market also indicates that there may not be a whole lot of upside left. Add another 60 points or so to the current S&P 500 high and this will rank as the third-largest bull market in history. Although there were a couple of prior bull markets that were substantially larger than the current one, that’s precisely the point: Only two of them in history gained more than this!
In addition, the US Presidential cycle indicates that the “Trump rally” could reach its completion this summer. From there, sizable reversals tend to follow. This was corroborated by data with three different starting points.
Finally, the Decennial cycle is casting a dark shadow over the stock market this year. There are way too many “7” years that have experienced corrections, bear markets, and even crashes to ignore or dismiss as mere coincidence. In five of the last six decades, the “7” years handed out double-digit losses to investors. Don’t bet against this streak.
When you know the valuation history of a market, you can determine what levels are unsustainable because of being too expensive or too cheap.
When you have a metric, such as the historical sizes and durations of prior market moves over the last century, you can calculate the probabilities of what may occur in the future.
When you have seasonal or cyclical patterns, you can also begin to draw out a market roadmap that’s a bit better than a random guess.
But when you put all of this data together and find that they are all pointing to the same thing, you have a synergy effect. With several non-redundant measurements coming to the same conclusion, it seems that the probabilities set by a unanimous consensus of the group are higher than the probabilities of each metric on their own.
Those probabilities are pointing to a bearish event in 2017. So even if you agree with the current bullish market fundamentals or you have a positive outlook based on President Trump’s agenda for the country, you should not dismiss the unanimous conclusion compiled from several decades of data. Caution is definitely warranted here.
Watch the Weather
Despite all the dark clouds looming on the horizon, the market price behavior should be the final judge and jury of whether or not the bear market comes out of hibernation. Don’t liquidate your stocks, buy portfolio insurance, put on hedges, and/or go short unless the price indicates that it is the right time to do so. Being right but early can have the same effect on your account as being dead wrong.
A couple of things that one could use to gauge the weather in the current market environment are the market’s price structure and the trend relative to moving averages.
On the long-term timeframe, the price structure is bullish. The S&P 500 has made higher monthly highs for five consecutive months and it has not broken a prior month’s low since November. A series of higher highs and higher lows is an uptrend.
On the daily timeframe, the market is well above the most widely-watched moving averages. The day after the election, the S&P 500 rocketed higher and has closed above the rising 50-day Moving Average every single day since. In addition, the market has only closed below the 200-day Moving Average once in nearly a year. (That was the short-lived break right after the Brexit vote.) Staying above the moving averages and posting a string of new record highs is not what you see in a market that’s bearish.
The combination of P/E ratios, market stats of prior size and duration, and market cycles are forecasting a major storm ahead. But when we observe the current price behavior of the market, there’s nothing in sight but blue skies.
Our first indication that the storm clouds are moving in would be a close below the 50-day Moving Average. Once that happens, a trader could start looking for setups on the short side.
A break below the 200-day Moving Average (one of Paul Tudor Jones’ favorite metrics) would tell us that we’re in a downpour. You don’t want to have any long exposure when that happens. Also, a break of a prior month’s low would be a lightning strike. If it hits at the right place and time, major damage can occur.
As storms start rolling out across the US this spring, remember that the deadliest storms for the stock market are expected to hit in the second half of the year. When it rains, it pours. So it’s best to start prepping for it now!
