A Never-Ending Bull Market? C’mon, Man

What, if anything, could stop this bull market in its tracks?

In a world where it seems like U.S. equity markets are living on a different planet than the rest of us, the stock market’s ability to shrug off tariff spats, inflation fears, or the occasional presidential tweet storm can seem mystifying, baffling, or even downright irrational. Yet all is right with the world so long as investors look forward to opening their monthly 401k statements like brightly-wrapped presents, which has pretty much been the case since March 2009. That’s nine years. Nine. Years. The longest bull market run since historians had the sense to stop numbering world wars with roman numerals.

What, if anything, could bring the bull market to its knees? Is there anything down the road that could derail this financial train from its 24-carat tracks? No one is suggesting that a bear market is waiting around the corner, ready to pounce and rip the juicy profits from retirement knapsacks. Rather, is there an economic, political, or social maelstrom that could cause investors to rise up and reboot their equity portfolios for the first time since the release of the iPhone 3? (June 8, 2009)

Trade Wars

Tariffs pose a risk to S&P 500 earnings through two channels: lower revenues from exports, and higher input costs and weaker margins. The U.S. has already imposed tariffs of $79 billion of U.S. imports and proposed tariffs on an additional $702 billion. The combined $781 billion in targeted goods represents 27% of total US imports.[i] Nonetheless, trade wars are taking a back seat to the fundamentals of the U.S. economy, which at the present moment is hitting on all eight cylinders. That’s the down and dirty story of the stock market. But if trade wars escalate, it could move to the front seat.

The spillover effects from a trade war can be substantial and last quite long. Economists like to talk about the multiplier effect, where a change in a particular input leads to a larger change in output. Fiscal and monetary stimulus have significant multipliers which can cause an economy to expand. Conversely, negative multipliers can go along with out-of-control trade wars. What’s happened since the beginning of 2018 with regards to tariffs may only be the equivalent of warning shots.

Rising Inflation

Tariffs are one of many economic policies that can be considered pro-inflationary. Tariffs are supposed to restrict the flow of goods and services, and there hasn’t been a time in history when the restriction of consumption has not been inflationary for consumers. It just defies logic.

But whereas consumer prices are creeping up, wages overall are not. However, that doesn’t mean they won’t with time. According to Richard Bernstein, CEO of Richard Bernstein Advisors and a long-time strategist on Wall Street, including a two-decade career at Merrill Lynch, the present market cycle has been tremendously elongated because the U.S. was coming out of a credit bubble, and there was no credit available to juice up the early stages of the expansion. Yet at every stage of this economic cycle, normal things have happened: they just happened more slowly than what people would have normally expected.[ii] The recent behavior of the bond market, including the dramatic procession towards a flat or inverted yield curve, suggests that Bernstein’s theory is correct. Because inflation is the kryptonite of income, and since inflationary expectations troughed in the summer of 2016, stocks and commodities have dramatically outperformed fixed-income and income-oriented investments.[iii] But while most people think that nothing much has happened with regards to inflation for the past few years, the bond market is paying a huge amount of attention to this increase in inflation. However, the uptick in inflation is happening so slowly that nobody is paying attention. It’s like watching paint dry.

Slowing Economic Growth

According to the Congressional Budget Office, the secular growth rate of the U.S. economy has clearly slowed.[iv] One of the reasons could be that politicians have used the two-year election cycle to juice the economy. They’ve used debt, which is a long-term liability, to pump up consumption. Politicians love happy voters: think Herbert Hoover’s “a chicken in every pot, a car in every garage.”

This is not a partisan issue; it’s been happening for decades and could be considered a drag on the economy’s secular growth rate. Politicians are taking a short-term asset, consumption, and financing it with long-term liabilities (10, 20, and 30-year Treasury debt). This means future interest payments can’t be used for domestic spending or investment, which essentially weighs down the long-term growth of the economy. The tax cuts of 2017 are a prime example, piling on debt to juice up the short-term economy. Because of political hubris, the U.S. economy growing annually at 2-3% may become the new normal versus an economy that historically grew at 4-5%.

Federal Reserve Action

Current projections indicate that the central bank’s benchmark federal funds rate will be around 3.4% by the end of 2020, a rise of more than 300 basis points from when the Fed’s tightening cycle began in 2015.[v]  Tightening of this magnitude has almost always resulted in recession.[vi]  This is a dangerous tightrope the Fed is walking, and the risk of destructive action can’t be ignored.

Conclusion

According to Richard Bernstein, the stock market is in a late-cycle environment; corporate profits are strong, market liquidity is good, and valuations are within normal ranges. This is not to be confused with a late-in-the-cycle environment, in which case the clock is ticking, and the dreaded abyss lies directly ahead.[vii]

So, what is going to kill the bull? One, a trade war. Such a disruption to the flow of goods and services would disrupt the U.S. and global economies. Two, if inflation ramps up, especially wage inflation. Three, if the economy slows and corporate profits fall, and unemployment rises. And four, if too much liquidity gets withdrawn via the Fed.

A bull market that never ends? C’mon, man.

 

[i] “Assessing the potential impacts of tariffs on S&P 500 earnings and returns,” Goldman Sachs US Weekly Kickstart, July 20, 2018.

[ii] “Bull Market Bucking Mean and Dirty,” Politico Money podcast, July 11, 2018.

[iii]“Bull Market Bucking Mean and Dirty,” Politico Money podcast, July 11, 2018.

[iv] “The Budget and Economic Outlook: 2018-2028,” CBO.gov, April 9, 2018.

[v] “Minutes of the Federal Open Market Committee, June 12-13, 2018,” Federalreserve.gov, July 5, 2018.

[vi] “Fed’s Future Tightening Fraught with Recession, Political Risks,” Bloomberg, January 4, 2018.

[vii] “Bull Market Bucking Mean and Dirty,” Politico Money podcast, July 11, 2018.

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