The present bull market in US equities is an odd beast, to be sure. Since its depressed lows of March 2009, the S&P 500 index has risen by some 177 per cent. In 2013, it delivered a total return of 32 per cent – its best showing since the go-go days of the late 1990s. Pretty much throughout the past five years, though, many investors have denounced the gains as artificial and doomed to a sticky end, earning the upswing the nickname of “most despised bull market in history.”
The temptation to join with the sceptics has grown lately. The S&P is now looking dear according to long-term valuation metrics, while the boost from share buybacks and newly-printed money is likely to fade this year, as I discussed in my recent video with top economist Andrew Smithers. And despite reservations among many investors, the exuberance among pundits has reached levels seen ahead of major tops in 1973, 1976 and 1987 (bit.ly/1cK6k5E).
Nevertheless, there are still quite a few heavyweight investors who reckon the outlook for the world’s most important stock market index is set fair in 2014. In their view, the US economy is likely to keep strengthening, feeding through into yet more gains on Wall Street. These intelligent bulls got it right in 2012 and 2013, even as many others were warning of impending trouble. So, it’s clearly worth paying heed to what they’re saying now, especially if you’re a US-sceptic.
Sizing up the bull
The current bull market is on course to celebrate its fifth birthday in March. (I date the cycle as having begun in 2009, and regard the mid-2011 bear market as a mere mid-cycle shakeout within a larger bull market.) This makes it fairly long in the tooth by past standards. Since 1871, the median bull market in the S&P has lasted 32 months. Only four out of 25 have gone on for more than 60 months.
As analysts from JP Morgan point out, though, the record of bull markets that have lasted this long could actually be a cause for optimism. “2014 will represent the sixth year of the US equity bull market which began in March 2009 and is progressing like a ‘classic secular’ bull market. Historically, by looking at previous equity market cycles, the sixth year of a bull market has been very strong, which is why we see another very strong gain in 2014.” These analysts have a target of 2075 for the S&P 500 this year.
My own quick look back over the last 140 years or so seems to bear this view out. Of the four bull markets that made it past the 60-month mark, all yielded positive returns. Not only that, but the returns were significantly positive, as the accompanying chart shows. Note that this only looks at price returns, so with dividends included the returns would have been better still.
No QE might be a blessing
Quantitative Easing has been a decisive influence in the bull market in equities since 2009. During periods when the Federal Reserve has been conjuring up new money and using it to buy bonds, the S&P 500 has generally gone up. And, on the two occasions it tried to withdraw that stimulus, in 2010 and 2011, stocks took a nasty tumble. In 2014, the Fed is expected to pull back gradually from QE, which has made many investors understandably nervous.
According to one of the most prominent and successful bulls of recent years, the end of QE is actually something to be welcomed. Fisher Investments UK – the British arm of the investment firm run by the legendary Ken Fisher – claims that money printing has been holding back the US economy by making banks reluctant to lend to businesses.
“QE itself dis-incentivises lending by making it less profitable,” says Fisher. “Banks make profits by borrowing money at short-term rates and lending at longer-term rates, making a spread on the difference. With short-term interest rates pegged at zero, lower long-term rates flatten the yield curve and thus reduce the profit banks make on new loans, so they’re less inclined to lend aggressively.”
Once QE ends therefore, and long-term rates rise, the effect on the economy should be positive. “Ending QE should allow the yield spread to widen, boosting banks’ potential operating profits and the motivation to lend. This should allow money-supply growth to accelerate, providing a significant economic tailwind. What’s more, with banks lending more enthusiastically, businesses should have access to more capital for growth-orientated spending.”
Why US stocks may be cheaper than you think
A key worry among US equity bears is that the market has become very expensive during the boom of the last five years. Probably the most popular tool to prove this argument is the 10-year cyclically-adjusted price-to-earnings ratio, popularised in the work of Professor Robert Shiller. Currently, this metric stands at some 25.3, more than one standard deviation above its long-term average. Only rarely has it gone much higher than this, and this has usually given way to poor returns on Wall Street.
“The Shiller PE suggests stocks might be as much as 50 per cent overvalued,” says Andrew Goldberg, Global Market Strategist at JP Morgan Asset Management. “But this is a backwards-looking measure, and one that is very skewed right now. In 2008-09, we saw a 92 per cent decline in real earnings for the S&P 500, essentially the biggest drop ever. I hesitate to believe that next year in the stock market is going to be impacted by something that happened five years ago, during the worst crisis in recent memory.”
Mr Goldberg reckons that valuations based on forecast earnings are the most sensible approach to valuing US stocks at this time. On this measure, the S&P currently trades on a multiple of 15.3 times, compared to a long-term average of 14.9. “If you look at history, markets don’t typically just stop when they reach “fair value” levels. They can run for a year or two beyond there,” says Mr Goldberg.
(You can watch my video interview with him here, which includes his views on some of the most attractive areas of the US market: bit.ly/1a5Lz3C)
Our tactics
I am not a fully paid-up bull when it comes to the US stock market. Where I split with the genuine optimists is over the medium- to long-term outlook. With the debt overhang unresolved, I think the difficult period for equities that began in 2000 may have further to run. For now, though, I am sticking with the trend for a very simple reason: because my momentum model is still firmly in bullish mode.
Over time, this model has outperformed the market by more than 1 per cent a year, but while incurring much lower risks. Its last signal was a “buy” back in July 2012. None of its “sell” conditions are near being met right now, so I continue to recommend holding tactical long positions for now.
