Written by: Benjamin Bimson CIMA® / CIO, BCJ Financial Group
When will the bull market end? Will we get clobbered when the market crashes? Is that latest headline a sign that we should run for the exit? One thing that 2008 did to all of us is establish a very strong bias against “ever going through that again!”
The practical thing for us to do is decide what is worthy of concern and what is not. We want is to understand what could cause this bullish trend to stop and it is not a matter of calling the market or becoming a guru (see last week’s commentary). It is a matter of taking the evidence that we are presented with and creating actionable solutions.
What could be a concern?
The first concern is Stock market valuations. P/E ratios are very high. However, despite being high, it is not likely a top yet. With the S&P 500 growing 15% through the end of October, P/E ratios have only gone up 3.5%. The year over year P/E growth has slowed dramatically because corporate earnings have grown fast enough to slow the increase. As the following chart illustrates that rise in the S&P 500, we can see that there has been substantially less change in the P/E ratios. This indicates that although high, P/E ratios are not yet telling us that the top is in.
The second concern is earnings for 2018. Throughout any bull market expansion, it is usual to have increasing growth charts for corporate earnings. The consensus estimates for S&P 500 earnings for next year are very high.
2018 estimates have some big shoes (numbers) to fill. The latest consensus estimated (November 8, 2017) earnings per share for 2018 currently estimates earnings growth of 15.4%. As of the last reporting date, 2017 has already seen earnings per share growth of 17.8%! If companies cannot meet the expected growth numbers in 2018, it could spell a reason for concern. We will be watching that one close!
The third concern is that the Fed is tightening interest rates and Jerome Powell is likely to be taking over as the Fed Chairman in February 2018. He is anticipated to continue the current policy of slowly normalizing rates. However, rising interest rates are a real watch-worthy item and it is a bullish indication for the market. The current pace of rate hikes and Fed transparency is very market friendly.
The fourth concern is yield curve flattening. This one has been getting a lot of press lately. The normal headline reads that since the yield curve is near the lowest reading since 2008, recession is likely to follow.
The yield curve has in fact been flattening through 2017. It is not yet however, indicating an extreme low – and certainly has a ways to go before inverting (often interpreted as a sign of pending recession). Even an inverted yield curve is not necessarily a sign of impending market doom. Let’s put this into perspective. In the 90’s the brief near inversion was nearly 3 years before the end of that bull market. We would say it is worth paying attention to this but not yet a sign of the “end times.”
The fifth concern is inflation. Currently inflation and interest rates have been low. This is bullish for the market, but if that flips around, it would be interpreted as bearish.
The sixth concern is investor sentiment. The market has been unusually lacking in volatility this year. With so much gain in the market, many investors have become both complacent and some have become more easily spooked by small moves down (on a percentage basis).
The trends we look for are signs that over optimism is creeping in, but if we continue on the current course, we are not in an excessively optimistic state, and in this case a little fear is a good sign. Too much investor complacency and no fear in the market is normally a bad sign if other signs are also indicating a market top. It can remain high in positively trending markets, so we never take it as a data point in isolation.
The last concern is the market trend itself. The market is always right. Market breadth measures how many of the stocks in indexes are participating in the gains. When broad participation is evident, it is a good thing. When fewer and fewer are participating, even when indexes notch record closes, that can be concerning.
Despite some recent divergences, it isn’t really clear whether that will spill into something more sinister at this point and data does not support defining the recent highs as tops. Essentially, long-term trends are intact so try not to listen to the short-term noise.
With so much to worry about, you can still sleep at night. None of the concerns mentioned above should be viewed in isolation. Together, they paint a far more informed view. For now, it appears this is not over yet. The boogie man may in fact come to visit but it is unlikely that he is in the closet tonight. Tomorrow is a new day with new data.
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