2 Charts That Show Why the Bull Market Isn’t Over

stock market - 2 Charts That Show Why the Bull Market Isn’t Over

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Yields are climbing, and the stock market is freaking out. As of this writing, the Dow and S&P 500 are both about 5% off all-time highs, while the growth-centric Nasdaq is nearly 7.5% off recent highs.

Is this really how this bull market ends? Rising yields kill valuations, and higher interest rates stifle economic growth?

It sounds reasonable. But, I don’t think it will happen just yet. Historical data suggests that bond yields still need to go significantly higher before they put any real and lasting pressure on equity valuations. Meanwhile, hiking interest rates this late in a business cycle is worrisome and could lead to a recession. But, GDP growth remains below the long-term trend due to a massive decline in 2008. Historically speaking, the U.S. doesn’t head into recession territory until GDP growth is above trend, meaning this economy still has firepower before the bust phase.

Overall, stocks have become riskier over the past several months. There are many reasons investors should be more careful now than before. But, data suggests that the bull market isn’t over just yet, and that stocks remain the best place to put your money.

Valuations Can Sustain Higher Bond Yields

The biggest concern with the stock market right now is that as bond yields move higher, that will inevitably pressure equity valuations which have been propped up by all time low interest rates.

In theory, this is true. But, when you look at the data, you’ll see that yields still have a long ways to go before they inflict any serious and lasting damage to equity valuations.

The theoretical expected return on stocks is commonly seen as the current dividend yield plus earnings growth. That assumes a constant P/E multiple. But, because we know that P/E multiples change all the time, a more practical interpretation of the expected return on stocks is dividend yield plus earnings growth plus earnings yield, where earnings yield is a proxy for changes in P/E. For earnings growth, we can use real GDP growth as a proxy.

The theoretical and practical expected return on bonds is the current yield. We can use the 10-Year Treasury yield to approximate this.

The broad concern is that the expected return on stocks is going lower thanks to a lower earnings yield, while the expected return on bonds is going higher thanks to rising rates. This combination implies that the equity risk premium is shrinking, and a shrinking of this premium usually causes a sell-off in stocks.

The long-term average equity risk premium, under this definition, is 5% since 1980. Right now, we sit around 6%, a whole 100 basis points above the long-term average spread. Also, as can be seen in the chart, the stock market doesn’t tend to peak until that spread drops below 5%, as it did in 2008 prior to the crash, throughout the entire Dot Com Bubble, and leading up to the crash of 1987.

From this perspective, the market can sustain higher yields at current levels.

GDP Growth Is Still Behind Trend

The above calculus is irrelevant if we are heading into recession. In that scenario, it doesn’t really matter where yields are, because the economy is shrinking and everything tends to go down when that happens.

But, data suggests we are still a ways away from a recession taking place. Data from Advisor Perspectives suggests that, looking back to World War II, U.S economic recessions tend to happen when GDP is above trend (with trend defined as the exponential regression on log plot of real GDP). Before 2008, real GDP was above trend. Before the Dot Com Bubble burst, real GDP was above trend. The same is true with recessions in the early 1990’s and early 1980’s.

Time and time again, recessions in the U.S. have been preceded by above-trend GDP. Of the seven U.S. recessions since 1970, all seven have been preceded by above-trend GDP.

Today, real GDP is below trend by a whopping 13.7%. There are many reasons for this, the biggest of which are that the 2008 recession was very large and the recovery has been very slow. 

The recovery is starting to speed up now. But, we still have a long ways to go before the next bust phase. Indeed, data suggests we are just entering the real boom phase. That boom phase will inevitably be followed by a bust phase, but that is a few years down the road.

Bottom Line on the S&P 500

The markets are struggling right now because risks are piling up. Investors shouldn’t ignore these risks. Rates are coming up. That does add pressure to equity valuations. And the Fed is hiking late in an expansion cycle, which heightens recession risk.

But, data suggests that these risks won’t materialize into serious and lasting stock market damage until a few years down the road, when the economy is a few innings into its robust growth era and 10-Year Treasury yields have normalized to 5% and up. Until then, the market should remain in a strong uptrend.

As of this writing, Luke Lango did not hold a position in any of the aforementioned securities. 

Article printed from InvestorPlace Media, https://investorplace.com/2018/10/2-charts-that-show-why-the-bull-market-isnt-over/.

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