Broad agreement seems to be spreading on Wall Street that we are late in this economic and market cycle.
But what exactly does that mean for investors when no one knows for sure how long it can “stay late” — or how generous the market might be before the cycle turns from “late” to “over?”
Perhaps it’s no surprise that strategists are checking their watch and eyeing the door at this stage. For the literalists who date the start of this bull market to the March 9, 2009, bear-market low, this has been the second-longest advance on record without a 20 percent drop. The U.S. economy has been expanding almost as long, and equities are as expensive as they’ve been at plenty of bull-market peaks, if not all of them.
As some veteran strategists give their outlook for the market in 2018, it’s as if they hear a clock ticking loudly in the background.
Michael Hartnett, global strategist at Bank of America Merrill Lynch, has been correct in his bullish stance this entire year, which he describes as the emergence of an “Icarus trade” embracing risk and courting overconfidence. He now foresees a “big top” in risk markets in the first half of next year after perhaps another 10 percent gain in the S&P 500, as faith in growth and central banks peak together.
Wharton School professor Jeremy Siegel, best known for his predominant bullishness and for authoring “Stocks for the Long Run,” told CNBC last week he expects “one more push” up to new highs for the indexes. But he suggested stocks were “clearly near to a top,” and 2018 could be positive but less rewarding and more volatile for investors.
Ned Davis of Ned Davis Research has also described the bull market as being in the “very late innings.” Doug Ramsey, chief investment officer at Leuthold Group and a student of market cycles, says the sturdy rally still deserves the benefit of the doubt and shows few typical signs of an imminent peak. But he confesses “very limited visibility into 2018,” given how expensive and well-loved equities are, and the fact that the factors keeping him bullish are the most short-term ones.
And in a column on Friday, CNBC’s Patti Domm nicely portrayed the way individual investors have been embracing stocks more eagerly, which tends to happen in the latter phases of a market ascent.
It’s hard to dispute any of these observations outright by using a broad sampling of economic data or market stats.
David Rosenberg, chief economist at Gluskin Sheff (who admits to having turned cautious early the past couple of cycles) detailed in recent months where things stand now across 15 economic and market indicators versus the average expansion. Measures such as the drop in unemployment, gain in consumer confidence, increase in corporate profit margins and high-yield bond spread decline have already achieved 100 percent of the average improvement of past cycles.
Of course, part of this is explained by the fact that the last recession was far deeper than preceding ones, so these indicators started at unusually depressed levels. And the fact that they’ve already notched the “average” improvement of prior cycles ahead of a recession simply means this is an “above average” cycle in terms of duration and cumulative progress.
Similarly, Goldman Sachs’ David Kostin shows the median stock in the S&P 500 has almost never been more expensive in measured history across eight metrics. Yet he’s calling for about another 10 percent advance in the index next year — in a report titled “Rational Exuberance.” The forecast effectively acknowledges that bull markets tend to overshoot “fair value” when a shock doesn’t come along to prevent it, and he figures this cycle can get closer to the stupendous gains of the 1990s run.
The chart below shows the S&P 500’s valuation across eight metrics, according to Goldman Sachs:
One late-cycle indicator that has the worrywarts running full tilt is the narrowing Treasury yield curve. Short-term yields, such as on the two-year note, tend to rise faster than the 10-year yield as a cycle matures. This gap is now below 0.65 of a percentage point, generating a fair amount of worry that the bond market is signaling an oncoming recession.
Yet in the past, there was no worthwhile stock-market signal from the yield curve unless it “inverted,” with short yields higher than long yields. And the average time from inversion to the start of a recession was more than a year.
If the flatter yield curve today is mostly saying that inflation remains structurally restrained and the Federal Reserve is likely to be just about finished tightening within a year or so, just how scary is that message today?
Complicating all this “late-cycle” talk is the fact that stocks often do just fine in this phase — sometimes even accelerating higher in the final quarter of a bull market.
Consider a scenario Hartnett considers a risk to his “big top” prediction: “Tech bubble … AI/robots cause wage deflation extending era of excess liquidity, bond yields fall, Nasdaq exponential; ‘Icarus unleashed’ bubble could end in 2019 with bear market on hostile Fed hiking, Occupy Silicon Valley and War on Inequality politics.”
Quite a contrast to a cycle ending in a whimper.
What “late-cycle” might mean for investors in practical terms is that long-term return expectations should remain modest and volatility should pick up from record-low levels. But radically cutting back on equities is a long-odds strategy, given that it can stay late for quite a while.
It would not be surprising, though, if next year the main source of turbulence and anxiety turns toward “late-cycle eruptions,” such as rising labor costs pinching profit margins in certain sectors and bouts of agita about the Fed being “behind the curve” and needing to tighten faster.
Late or not, that might be more interesting than this year’s orderly, low-drama climb.