Risk Still Exists

Published On: January 29, 2020

Written by: Ben Atwater and Matt Malick

With 2019 behind us, and 2020 beginning, we are writing a series about markets and the economy. 

Throughout the series, we have explored the present bull market, which commenced on March 9, 2009. Our essays to date have addressed the strong labor market and solid consumer confidence, benign inflation and low interest rates, unprecedented late cycle government stimulus and what’s been interesting, even unique, about this bull market.

Today, we finish the series with an examination of what might go wrong to end this great bull market.  One of the realities of markets is that nobody has ever consistently predicted them.  Markets are largely unknowable.  In other words, we have no idea why or when the bull market will end. 

Rather, the set-up in this article is to help us remember the fragility of markets and the economy.  Things have been very good, so we tend to forget they can go south quickly. 

First, let’s acknowledge that any of the positive things we’ve analyzed in this series can turn to negatives and potentially upend the bull market.  These include the following risks: peak employment, slowing U.S. consumer, higher inflation or interest rates, curtailed government spending or higher taxes, the end of quantitative easing, loss of technology stock leadership or overconfidence.  Obviously, the biggest risk generally is that the U.S. economy falls into recession. 

Of course, other risks exist as well.  Coronavirus, is a great example of something that nobody heard of two weeks ago, but has the potential to disrupt the worldwide economy.  Like Ebola, SARS and Avian Flu it’s unlikely to derail things, but possible.  So are any number of scenarios we haven’t envisioned. 

The backdrop for the market is that it has been virtually perfect and therefore investors have richly valued stocks.  Although valuation in and of itself is rarely the cause of a bear market, high valuation does set the stage for meaningful bear markets when circumstances, events or narratives change in meaningful ways. 

To read the previous essays in the series please visit our blog.

• At the most fundamental level, growth in corporate profitability is what should drive individual stocks and stock markets over long periods of time.  Earnings growth has been supportive of the current bull market.
• Earnings growth, however, hasn’t been perfect.  It’s experienced some fits and starts during the bull market. 
• Near-term earnings peaked in the third quarter of 2018.  The S&P will ultimately need to see earnings growth restart, take out the 2018 peak and continue higher over the next few years for the bull market to continue. 

• The cyclically adjusted price-to-earnings (P/E) ratio, commonly known as CAPE or the Shiller P/E, is a valuation measure applied to the S&P 500 equity market. It is price divided by the average of ten years of earnings, adjusted for inflation.  CAPE helps consider the impact of different economic cycles on corporate earnings. 
• Most strategists and analysts scoff at CAPE, largely because it has virtually zero short-term predictive ability and can remain depressed or inflated for years. 
• In our view, though, it’s foolish to ignore the fact that this bull market has once again put valuations in very rich territory with comparisons only to 1929 and 2000, precarious years in market history. 

• Another long-term valuation measure that is arguably more obscure than CAPE is U.S. Total Market Capitalization to GDP.  In other words, it’s the value of the publicly traded stock market relative to the size of the U.S. economy. 
• Also, much like CAPE, it’s a measure Wall Street doesn’t take seriously because it has no short-term predictive ability. 
• But the measure shows stocks to be more expensive now than in 2000, an astonishing feat. 

Markets are totally unpredictable.  All the same, risks (valuations) and opportunity (momentum) currently exist.  The only way to effectively balance the dichotomy is to employ a disciplined investment strategy over long periods of time.  This includes investing based on your goals, rather than investing based on market forecasts, political leanings or animal spirits.  Through all market cycles we will continue to work hard to keep your goals at the forefront of your investment strategy.