The bull market may not be over yet
by Raul Elizalde - 2013-06-03
Many analysts are worried that the roaring bull market in US stocks can’t go on for much longer. With an S&P 500 up roughly 120% from its 3/2009 lows, they believe that some type of correction may well be around the corner. Some have become quite vocal about this, insisting that while there may not be reason for stampeding, it is time to “walk away from risk.” But when looking at past data, it is hard to conclude that we are at the end of the bull market. Some indicators actually point in the opposite direction: the market may be picking up steam.
We looked at the last 70 years of market history to see what kind of corrections have taken place during bull markets. We were looking to quantify the potential downside caused by bull-market corrections that did not change the upward price trend.
Periodic market corrections are to be expected as a result of normal price volatility. But we found that these corrections may contain useful hints about the health of the market. Specifically, data going back to 1950 shows that the market tends to experience larger and larger percentage setbacks as the market approaches the end of a bull phase. But these setbacks have become shallower during the current bull market, suggesting that further upside is possible.
For example, in the last two bull markets periods (defined by an upward-sloping 2-year moving average of the S&P 500 index) the market had larger and larger percentage declines. In the period from 1994 through 2000, the S&P 500 had ocassional declines that grew from less than 8% from its previous peak to more than 16%. The same pattern took place from 2004 through 2008. But retracements in this bull market (defined by a 2-year moving average that turned positive in 2010), have become smaller.
Furthermore, larger retracements came hand in hand with a flattening of the moving average, providing another sign that past bull markets were losing steam. But in the last month or so, the S&P 500 moving average has actually steepened, indicating that the upward march is accelerating.
Is there any explanation for this behavior?
One possible factor may be the level of demand for stocks. Through the 1990s demand for stocks skyrocketed, helped by the “dot-com” boom. Similarly, inflows into equity mutual funds and trading volume steadily increased in the 2004-2007 period. As investors increased their equity exposure, marginal demand declined. In other words, there were fewer investors willing and able to “get in” as prices occasionally fell. That made retracements increasingly deep as equity holders sold to lock profits.
Today, however, after years of equity mutual fund outflows, declining trading volume, and a spectacular rally in bonds that lured investors out of stocks and into bonds, equities have suffered from lackluster demand. Large amounts of cash still seem to be available for deployment into equity markets, and a much-expected “great rotation” out of bonds and into equities has not yet showed to be a factor. Marginal demand for stocks, in other words, appears to be substantial, meaning that there is plenty of room for investors to increase their equity exposure. This may explain why corrections have become shallower: investors may well be seeing them as opportunities to buy..
Ultimately, equity prices are related to corporate earnings. But conditions on that front also seem favorable for higher prices. The graph below shows that corporate earnings have tripled in the last 13 years, while the S&P 500 is only marginally higher, even after including dividends.
The arguments above would hold even if the S&P 500 were to fall by as much as 8% from its latest peak, or by about 100 points from its current levels. This means that the market can still inflict considerable short-term pain on investors’ portfolios and yet leave a medium-term positive outlook in place. Whether such a short-term decline is in the cards or not is impossible to know. From a technical standpoint, however, we do not find a compelling reason yet why medium-term investors should walk away from US stocks.
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