Is This the End of the Eight-Year Bull Market?

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Stocks have made a significant move since the November elections. But over the last few weeks, the market has taken what Coca-Cola used to call “the pause that refreshes.”Some argue this is a natural consolidation before the next leg up. Others insist it’s the beginning of something more ominous, perhaps the start of a long-feared bear market. These voices grew louder after Tuesday’s 1.2% drop – the S&P 500’s worst day since October.

No one can say with certainty what the market will do next, of course. But history suggests that a downturn of 20% or more – the definition of a bear market – is not a likely near-term prospect.

Here’s why…

Most bear markets are started by a) a recession b) a financial crisis or c) extreme valuations combined with euphoric sentiment.

Let’s take a look at each.

It’s the Economy, Stupid: RBC data show that seven of the past eight bulls were ended by an economic contraction. Recessions generally follow periods of strong growth that cause the economy to overheat – and the Federal Reserve to overreact by taking interest rates too high too fast.

But can anyone truly believe that this economic expansion – the third-longest on record – is in danger of overheating?

True, hiring and wages are up. Yet since bottoming out eight years ago, real GDP has grown at an average rate of 2.1%. That’s the slowest economic recovery on record.

Yes, the Fed is now in a tightening mode. But the market has already discounted two more rate hikes this year. And Federal Reserve Chair Janet Yellen has gone out of her way to reassure businesspeople and investors that any further tightening will be “data dependent.”

Translation: If the economy can’t support more Fed tightening, we won’t get it. 

Moreover, I would argue that the Fed’s plan to raise interest rates is positive. It would be good to normalize rates so that the Fed can cut them again, if necessary, in the next economic downturn.

Artificially low rates have acted like rocket fuel for U.S. stock and bond markets over the last decade. But the central bank shares my repeated assessment in this column that the economy, the housing market and corporate profits are all on the mend.

No Crisis Arises: How about the chances of a financial crisis? The last vicious downturn began with the collapse of Bear Stearns and Lehman Brothers in 2008 – and set off a panic on Wall Street.

But things are very different today. Banks are in far better shape. Cash reserves are up. Asset quality is up. (Thanks, in part, to the solid housing market). And so are bank profits.

Indeed, the financial industry has been one of the strongest sectors of the market lately. Over the last year, Citigroup (NYSE: C) is up 38%. JPMorgan Chase (NYSE: JPM) is up 47%. And Bank of America (NYSE: BAC) is up 68%.



Clearly, the big banks are not teetering.

Stocks Ain’t Cheap: How about valuations and sentiment? Here it seems that rational investors might have reason to pause.

Over the last century, the S&P 500 has traded at an average of 16 times trailing earnings. Today, it sells for 20 times earnings. So is the market 25% overpriced?

Not necessarily. For one thing, that number is distorted by the energy sector. Multiples are much higher there than average because – thanks to rebounding oil and gas prices over the last year – profits are about to take an enormous jump.

Exxon Mobil (NYSE: XOM), for example, sells for 44 times earnings. PetroChina (NYSE: PTR) sells for 149 times earnings. British Petroleum (NYSE: BP) sells for a whopping 944 times earnings.

Of course, most U.S. oil companies haven’t even had the “E” over the last year to create a P/E ratio. They are about to swing from losses to profits.

More importantly, I’d argue that a higher-than-average price-to-earnings ratio for stocks is warranted at a time of expanding economic growth, low inflation, near rock-bottom interest rates and rising corporate profits.

Especially since investor enthusiasm is muted at best.

Since the market bottom on March 9, 2009, an investment in the S&P 500 with dividends reinvested has quadrupled. The Nasdaq 100 has quintupled.

Yet most folks have been running to safety instead. Merrill Lynch recently reported that since that market bottom, investors have plowed $1.5 trillion into low-yielding bond funds, compared with just $256 billion into stock funds.

Indeed, it was only two weeks ago that year-to-date inflows into stock funds surpassed inflows into bond funds. That means there is still plenty of cash and bond money available to move into stocks.

And investors are hardly suffering from irrational exuberance.

Investment legend John Templeton famously said that bull markets “are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.”

My reading of investment sentiment indicates that we are somewhere between skepticism and optimism.

That – along with an improving picture for corporate profits – would indicate there is more upside ahead.

Good investing,