Beware the equity cliff
Will 2014 be 1987 all over again? As the equity rally enters its fifth year, parallels are inevitable. But while a short-lived cyclical bear market could happen this year, the secular outlook is likely to remain bullish.
For a developing secular bull market, Gordon Gecko was right when he said “greed is good”. But for an extended cyclical bull market, he was dead wrong. Famously uttered in the 1987 movie Wall Street, Gekko’s words came to describe a year that included the worst market crash in history, brought on by excessive speculation. A sustained run of record highs had enticed retail investors to buy equity mutual funds to an extent never seen before. And the excessive optimism had dropped dividend yields to multi-year lows and P/E ratios to multi-year highs. Alongside rising interest rates, sentiment reversed from extreme optimism and the market fell apart. But economic growth persisted, allowing equities to recover once the speculation had been wrung out and valuations had returned to more reasonable levels. The S&P500 eked out a gain of 2% for the year and would return to record highs, gaining 40% over the next two years.
This look-back throws up parallels to our expectations for 2014. Five years into the secular bull market that started in 1982, the reset in sentiment left equities well positioned to resume their long-term advance. In the first quarter of 2014, equities will be entering the fifth year of the long-term uptrend that started in 2009. As of mid-November, the S&P500 gained 23% a year since that bottom, in line with the 24% annual gain over the same number of trading days after the 1982 low. The 1987 descent started four months later. When the S&P500 rise since 2009 is charted on the same scale as the 1982 to 1987 advance, the implication for 2014 is ominous (Chart 1).
The 1980s, however, is not the only period that presents similarities. In addition to the secular lows of 2009 and 1982, there have been two other secular bottoms during the past 100 years: 1942 and 1921. Over the equivalent trading period after the 1942 secular low, the S&P gained 25%, followed by a cyclical bear market of minus 23% starting about two months later. And the Dow Jones Industrial Average rose 22% a year over the equivalent period following the 1921 secular bottom, followed by a correction of minus 17% seven months later. We have yet to see the global scope of record highs and the consistency of equity fund inflows reach levels that would further confirm the case made by Ned Davis Research in December 2012: that we have entered a new era for asset allocation. It is likely that we have entered an era of consistent outperformance of stocks over bonds, with double-digit stock market returns now the norm rather than the exception.
By the time we see consistent record highs and persistent equity fund inflows, it’s quite possible that sentiment and valuation indicators will be warning that optimism is excessive, leaving the market vulnerable to a cyclical top. Thus around the same time that the retail investor capitulates in earnest, equities could be poised to drop again. Secular bull market confirmation might occur with the highest cyclical risk in three years.
Is this 1987 all over again? Probably not. Consistent with other cyclical bear markets within secular bull markets, the cyclical bear of 1987 was relatively short. The magnitude of the drop, however, was an anomaly, the S&P500 was down by 34%. The 2011 cyclical bear was also relatively short but more normal for a secular bull, the S&P fell 19%.
So if a cyclical bear market ensues next year, a drop similar to 2011 would be more likely than a repeat of 1987. This view is backed by historical tendencies as well as the low probability of a global recession next year. The 2011 decline was also in line with the tendency for cyclical bear markets to be relatively tame when not associated with a recession. Again that describes the 1987 crash, also an anomaly for its percentage decline, but not for its relatively short duration.
When would the current cyclical bull market start to look overextended? Again, historical tendencies offer guidance. The cyclical bull run has already lasted longer than the historic median of 655 days, and in February it will surpass the median for cyclical bull markets within secular bull markets (870 days). The vast majority of MSCI All Country World Index component markets have already been rising for much longer than normal without 20% corrections.
Chart 2 supports the prospects for a sizeable downward movement in the next year, with most markets experiencing stiff corrections or cyclical bear markets. Using MSCI ACWI data since 1987, it features the average one-year pattern (top clip) along with the average second year of the four-year cycle. In the US, the cycle’s second year is often called the mid-term year of the presidential cycle. But the four-year cycles for the MSCI indices are consistent globally, as are the one-year cycles.
For the ACWI and its component markets, the implication is that equities will benefit from cyclical tailwinds early in the year, but will start to encounter headwinds by the second quarter. It’s likely that after six months of rallying, the elevated earnings expectations, expanding multiples and other signs of excessive optimism will have left the markets vulnerable to inevitable disappointments, which would then drive the decline. In the fourth quarter, however, the cyclical influences turn favourable. It’s quite possible that with sentiment at a pessimism extreme and valuations more favourable, investors would focus more on the probable resilience of the global economy, limiting the downside damage, launching a new cyclical advance, and reviving the secular uptrend.
From start to finish, a moderate gain is likely for the ACWI, with most markets finishing in the black. Although four-year cycle tendencies show that despite a year-end rally the ACWI would still be down for the year, the secular backdrop suggests a better outcome. During US secular bull markets since 1921, the S&P500 has gained a median of 14% in the cycle’s second year, which describes 2014. The data history enables us to look at only six cases for the ACWI (compared with 14 for the S&P500), but the median gain has been similar, showing a 10% gain. But also considering the probability that equities would be recovering from a cyclical bear market, more than a single-digit gain is unlikely for the big benchmarks in 2014.
Among regions in 2014, emerging markets stand to benefit from relatively attractive valuations, their improving economic momentum and the broader signs of a global economic expansion supported by monetary conditions that are likely to remain accommodative even after the Federal Reserve starts to taper quantitative easing.
We would also recognize the tendency for emerging markets to benefit from bullish global breadth, especially with seasonal tendencies favourable not only for equities in general, but especially for the relative strength of emerging markets. Over the November-January period since 1994, the MSCI Emerging Markets Index has gained a mean of 11%, nearly three times the ACWI’s mean gain, with the MSCI Latin America Index gaining 19% on average.
Historical tendencies also suggest that emerging markets will continue to lead the market higher over the first quarter. But rising market risk in the second quarter might be a problem for those markets, especially if their outperformance has closed the current valuation gap by then. Emerging markets would be likely to lose their leadership on a broad global market descent in the second and third quarters, with the US and UK holding up better. With the global economic outlook remaining favourable, the fourth quarter would present an opportunity for emerging markets to reassert themselves on the resumption of the global secular bull, especially if they would again appear relatively cheap by then.
In assessing upside potential and downside risk for the next year, we can keep an eye on our reports of market valuations, cyclically-adjusted valuations, and both the trailing and expected earnings growth. But at the same time, we would resist the temptation to draw conclusions based upon any one valuation number, or even a set of numbers. Instead, we would stay focused on a more comprehensive approach that considers earnings yields in the context of interest rates and economic growth. In Chart 3, the indicator considers the relative valuation of the MSCI World Index versus a GDP-weighted bond-yield composite by determining the spread between the earnings yield and the bond yield, then adjusting for global growth by adding GDP-weighted real economic growth to the spread. The result is a growth-adjusted relative valuation indicator, similar in concept to the dividend discount model.
The secular bull case has got support from the recent trend toward more historically normal correlations, such as the shift back towards inverse correlations between stock prices and bond yields. And the continuation of that trend could make this indicator especially useful. In the absence of economic growth to lift earnings expectations and support higher multiples, a rise in rates and/or falling earnings yields would be more likely to threaten equities than they would if economic growth were strong, in which case the growth-adjusted spreads would remain relatively wide. But if economic growth were to gain momentum, rates could rise more than they would otherwise, and earnings yields could fall more than they would otherwise, before weighing down stock prices. With growth coming through, equities would be relatively resilient in the face of rising yields.
For the MSCI World Index, the growth-adjusted spread remains relatively wide, with favourable implications. The MSCI World Index has risen at an 8% annual rate when the indicator has been above 2% and dropped at a 3% annual rate when it has been below that level. Moreover, most MSCI country indices have positive growth-adjusted spreads, with the majority of the spreads above their historical norms.
As a market indicator, the spread has had an inconsistent track record across markets. But we have found that in sorting the spreads of the 29 markets from the most positive spread to the most negative, relative potential can be assessed based on this metric. With monthly rebalancing since 1994, an investment in the list’s top quartile would have returned an annual 9.4%, while the bottom quartile would have returned 5.3%. Currently the two markets with the most positive spreads are China and South Korea, which together account for a third of the MSCI Emerging Markets Index weight. While the positive rating is consistent with our overweight allocation, the bottom quartile includes three other emerging markets that account for close to 20% of the index’s weight – India, South Africa and Mexico. Into 2014, the report will be one of the key determinants of which emerging markets will continue to outperform or start to face headwinds in advance of a global decline.
The report’s top quartile also includes Germany and Switzerland, which account for more than 40% of the MSCI Europe ex UK Index. But Europe is also represented in the bottom quartile, which includes markets afflicted by the sovereign debt crisis: Spain, Portugal, Italy and Ireland.
One thing we know for sure about 2014 is that our recommended strategies will be based not on forecasts and projections, but on the composite messages from our models, rankings and key indicators. The greater the confirmation, the greater the level of conviction we will have, and the more decisive our recommendations will be. The greater the divergences and mixed messages, the greater the chances that conditions are changing and the more likely we will be to shift positions.
The starting point for our three-way allocation recommendations is the global balanced account model, which currently calls for 64% stocks, 32% bonds and 4% cash. We are in line with the model with a recommended allocation of 65% stocks, 25% bonds and 10% cash. And we might move to our maximum equity allocation of 70% in anticipation of further model improvement when the model’s stock/bond seasonality indicator turns bullish at the end of the month. As 2014 progresses, the model will warn us if excessive optimism, worsening internals and/or a more precarious macro outlook start raising the risk of a setback. And we would look for confirmation from the indicators in our Rally Watch report, growth-adjusted valuations, and other key indicators. Although the tendencies discussed earlier suggest that the outlook will start to worsen late in the first quarter or in the second quarter, we won’t cut back until it actually does.
Throughout the year we will keep in mind that even if the cyclical outlook deteriorates, the secular outlook is likely to remain bullish. In fact, it would be supported by the valuation improvement that a cyclical drop would produce. While market conditions are getting closer to the greed extreme of the cyclical fear/greed spectrum, they are still relatively early in recovering from the fear extreme of the secular fear/greed spectrum. In 2014, rising retail investor inflows and other signs of greed could be a contrarian warning for the rest of the year, yet with positive implications for the rest of the decade. The return of risk appetite in business, consumer and investor activity stands to support the next phase of the apparent secular bull market in equities.
From a secular perspective, more greed would be good. Although Gekko’s words were a contrarian anecdote about 1987, they were prescient about the decade to follow. That’s something to keep in mind as 2014 unfolds.
Tim Hayes is chief investment strategist at Ned Davis Research.