Signs Of An Aging Bull Market

When investors hear "bull markets are bull markets until they aren't," their initial response is "no, duh!." However, if that statement is so obvious, why do we spend so much time in trying to predict the future? It is interesting that we are extremely skeptical of fortune tellers, palm readers and psychics but flock to Wall Street analysts and economists that are nothing more than "fortune tellers" in suits.  The reality is that no one is actually prescient. It is all a "best guess" with nothing assured except what "is."

Currently, the bull market cycle that began in 2009 remains intact.  It is, what "is." That trend is clearly shown in the chart below.

However, it is important to understand that what currently "is," will not always be the case. The reason that "bull market" cycles exist is because of previous excessively negative investor sentiment. Like the snap-back of a rubber band, when investor sentiment is stretched too far in one direction it will eventually "revert" by an equal amount in the opposite direction. This is why for each and every bull market, there is a bear market. 

Again, this seems quite obvious. However, if it is so obvious then why are investors continually sucked into bull markets believing that they will last indefinitely only to be crushed by the subsequent bear market?

The following are some indications that we are well into an aging bull market cycle.  The older the bull market, the more susceptible to infection it becomes.

The current bull market cycle is now extremely long by historical measures. The chart below shows the historical length of economic recoveries (number of months) which drives bull market cycles, as compared to the subsequent market drawdown (percent decline) during the following recession.

There are only 5 economic recoveries that have lasted longer than the current “muddle through” growth cycle. The first was the economic recovery driven by massive government make-work projects during the Great Depression. The next was during the space race of the 60’s and the final three all occurred in the 80’s and 90’s as inflation and interest rates fell sharply following their peaks in the late 70’s.

Is it possible that the current economic cycle can continue longer? Absolutely. However, considering that we have none of the ingredients seen in the previous extended recoveries, combined with the Federal Reserve extracting their liquidity support, there is a high degree of risk that will not be the case.

Investor Exuberance

But when it comes to investing, “exuberance” can always outlast fundamentals.

Investors are once again reverting back to their old habits of rushing in to buy market peaks. This is never a sign of a “new bull market,” but rather one that is well aged.   As I quoted in Friday’s missive:

“Despite talk of flagging investor confidence and increased scrutiny of market participants, data from retail brokers show that the retail crowd is more engaged than ever,” Avramovic wrote in a report last week.

Combined daily average revenue trades at E*Trade Financial Corp., Charles Schwab Corp. and TD Ameritrade Holding Corp. rose 24 percent in the first quarter from the previous year and reached the highest level ever, according to Raymond James Financial Inc. analyst Patrick O’Shaughnessy.

All of this could conjure up the old Wall Street trope that retail investors are always late to the bull-market party and their exuberance is a sign that the keg is almost kicked. Not to mention that U.S. equity mutual funds are winning net inflows for a second year after six years of withdrawals."

Also, if there was ever a sign of irrational investor exuberance it is this:

“Investors are piling into the shares of small, risky companies at the fastest clip on record, in search of investments that promise a chance of outsize returns.

The investors are buying up so-called penny stocks—shares of mostly tiny companies that aren't listed on major U.S. exchanges—at a pace that far eclipses the tech boom of the late 1990s. “

It should not be surprising that now six years into the current market boom that individuals are now jumping into the stock market. After all, the media has continually berated them for the last six years for “missing out.”

This exuberance can also be seen in the two following charts of excessive bullish sentiment and extreme lows in bearish sentiment.

The following chart of the Volatility Index as compared to the S&P 500 is another case of excessive investor complacency. The volatility index is now at the lowest levels since the last financial crisis as the “fear” of a market correction is virtually non-existent.

Credit Market Froth

Yves Smith wrote a great piece this weekend entitled “Widespread Signs Of Credit Market Froth.”

“In the runup to the crisis, all it took was reasonably attentive reading of the Financial Times to discern that Things Were Going to End Badly.

It is important to understand that financial crises are credit crises. The dot-com bubble was enormous, and margin debt was at a high level before it imploded. But the amount of borrowing related to equities simply wasn’t that large relative to the economy.

I’m getting a bad case of déjà vu from reading the Financial Times over the last week. And remember, this comes against a backdrop of a rise in investors willing to take on more credit risk out of desperation for yield.

Now that central banks have improves their rescue playbooks, a September-October 2008 outcome seems unlikely. But the diversion of resources and profits from potentially productive real economy to the credit market casino has only become more deeply institutionalized. It’s hard to see how this resolves, but the ending is unlikely to be happy for ordinary citizens.”

Margin Debt

Historically, it has not been the increase in margin debt that was the cause of concern. Rather, it is the unwinding of that leverage that weighs on asset prices. The decline in asset prices triggers a waterfall of selling as liquidations to meet margin calls are met by more liquidations to meet more margin calls.

It is important to understand that a “crisis” isn’t necessary to create a leverage fueled market liquidation cycle. Just an “event” that spurs enough selling to trigger the first margin calls.

M&A Madness

Last week, I visited with the portfolio manager of a major global equity income fund who was making his case as to why Europe still had "legs" from an investment standpoint. It was at this point that he directed my attention to the recovery in M&A activity as support for his point.

With margin debt just off record levels and complacency near historic highs, I was more concerned about the surge in domestic M&A activity. Such activity is generally focused near the ends of economic cycles as other investment opportunities wane.  Of course, the last time the U.S. was at these levels was in 2006. 

Stretching The Rubber Band

The last chart in our picture book series is one I have shown you many times before. It is the deviation in price from a very long term (36 month) moving average. Market prices, in many respects, are controlled by “gravity.” The only way that there can be an average price is because prices have traded both above and below that level in the past.

Therefore, these moving averages exert a “gravitational pull” on current asset price levels. The further from the average that prices deviate the stronger the gravitational pull. The chart below shows that current price levels are now extended to levels only witnessed four previous times in the past. None of them ended well for investors.

The reality is that no one really knows when the next bear market cycle will come. Bull markets do not historically "die of old age" but are killed by some infection that rapidly changes investor's attitudes and expectations. It is at this point, where the "rubber band" is stretched to its limits, that someone yells "free hotdogs" at a weight loss camp. The rush for the exits leads to a forced liquidation cycle that creates a "mean reverting" event. This is why bear markets are short, violent and generally extreme.

It is unlikely that this time will be any different. For many individuals, this analysis will be ignored if a market correction doesn't ensue next week. The hypnotic chant of the "bullish mantra" will lull individuals from a momentary state of consciousness back into the dream world of complacency. It is from that place that investors have typically harbored the worst outcomes.