The trouble with bull markets

There is a good reason why we lack a definitive account of what characterises the end of bull markets, in the sense of a prescriptive set of conditions that must be met for such an outcome to be logically anticipated by investors. Such a set of rules would of course be self-fulfilling (and therefore worthless) if widely known and acted upon. Only with hindsight, when earnings and economic data are revised to accord with reality, do we typically discover for certain what should have told us the end was approaching.

What we do know from historical precedent is that bull markets (a) tend to end with a whimper, not a bang and (b) are rarely triggered by specific causes that have been prominently highlighted for months in advance. Given their current dominance of the headlines, it seems unlikely therefore that either a new Greek crisis or a September interest rate rise from the Federal Reserve will be the trigger that abruptly brings the current bull market to an end.

That is not to say that either event will pass without short term market impact. The experience from previous Greek crises and the taper tantrum of 2013 attest to that. There is a difference however between a temporary market squall and an enduring change in market valuations. Bull and bear markets are measured in years rather than in weeks, and are defined by enduring change, not just volatility.

The fact that the current bull market has run a longer course than most historical precedents clearly increases the likelihood that it is now approaching an end. Yet the length of a bull run is a far from conclusive measure of its maturity. It is notable that some of the characteristics that in the past have been associated with a market peak have yet to manifest themselves this time round.

More often than not, for example, as Ken Fisher points out in his latest book, if a bull market is close to expiring you would expect to see large caps outperforming small caps and growth stocks outperforming value. Yet this has only been the case for a relatively short time and neither trend has been decisively confirmed.

Sentiment meanwhile is a long way far from euphoric, even if, as the Leuthold Group correctly observed the other day, readings on most measures remain broadly positive. Fans of trivia, looking for reasons to be positive, might also throw in the fact that the modern US stock market has never had a negative year in a year ending in a 5.

And yet from observation genuine reasons for concern are accumulating. One is simply the scale of the improvement in leading stock market indices since the last bear market. In a book about the investment methods of Sir John Templeton which we wrote four years ago, Sandy Nairn and I took a stab at speculating how our subject would have seen the outlook for equity markets at the time.

Based on a historical analysis of real yields and the valuation of equity markets, we confidently predicted that his answer about equities in autumn 2011 would have been a positive one. Although valuations were then somewhat above their long term average, it would “not be unreasonable”, we wrote, to expect that over the next 10 years leading equity markets would at least double.

Yet, as it turns out, with the help of substantial central bank largesse, less than four years later three of the four markets we looked at – the S&P 500,Topix and the Dax – are today already within a whisker of reaching that target. Only the UK market remains stubbornly pedestrian. It is no stretch to say that markets which double every four years from a starting point of above average valuations are rising at an unsustainable pace.

We would not be so confident today. On any objective measure equities are now richly valued, which tells us with confidence that future ten-year returns will come in below their long term average. Government bonds, of course, are even more richly valued. Peter Spiller, long-serving manager of the Capital Gearing investment trust, calculates in his most recent annual report that the real discount rate implied by current asset prices has fallen, effectively, to zero.

That is a bleak backcloth. Yet p/e ratios, whether cyclically-adjusted or not, are notoriously poor guides to year ahead outcomes, and therefore themselves tell us nothing useful about whether the bull market will be over soon. With global growth apparently picking up, Europe beginning to emerge from its torpor, and the oil price dividend still to come, it is not difficult to come up with plausible grounds for thinking that the bull market could run on. Interest rate rises are certain to be constrained by policy intervention.

Analysis of Templeton’s remarkable long term track record shows that he owed his success entirely to his ability to avoid the worst of bear markets. His line of retreat was into bonds and cash on an orderly basis, guided primarily by valuations, but helped also by his extraordinarily well-developed market antennae.

He knew the difference between knowing for certain that a bear market was coming and being taken by surprise when it happened. What he never had to encounter was a market where even the conventional lines of retreat appeared quite as unattractive as they do today – a new test paper that central banks have set investors without (it seems) knowing for sure themselves what the answer is.

This column, written before Greece’s decision to call a referendum on its bailout terms, first appeared in print in the Financial Times on June 29th 2015 (online the day before).