High Anxiety Over High Equity Valuations?

“Bull markets are born on pessimism, grown on skepticism, mature on optimism, and die on euphoria.” — Sir John Templeton

With most major domestic stock market indices rallying sharply post-election, it’s natural for investors to question how long this rally can last – particularly when it occurs near the eighth birthday of a bull market.  The post-Great Recession bull market has carried the S&P 500 up nearly 300% (total return) from its March 2009 lows and now holds the distinction of being the second-longest bull on record.  Equity valuations were arguably stretched prior to the presidential election last November.  From the election to date, the S&P 500 has rallied nearly 11% (total return) – even though analysts have lowered their 2017 earnings forecasts by 1% over the same time period.  Clearly, this rally has been fueled by high levels of investor optimism (dare I say euphoria?) that the promised tax reforms and massive spending on infrastructure will soon materialize.

So are investors merely optimistic or have they reached a state of euphoria?  Does this ‘ole bull have some life left in him yet or is he enjoying his last hurrah?  To try to answer these questions, we must first identify and understand the circumstances commonly present at the start of previous bear markets, then determine if one or more of these conditions are currently in place.

What Makes a Bear Market?
Over the previous 90 years, the S&P 500 has endured 10 bear markets lasting an average of a little over two years with a peak-to-trough decline of -45%.  After reviewing the circumstances present during each bear market, we found that four conditions in particular were frequently a part of the economic backdrop at market turning points.  Recessions were the most common condition, present in 8 of the 10 previous bears.  There were five instances of extended equity valuations with unexpected spikes in inflation and aggressive tightening of monetary conditions each present four times.

When a recession coincided with the start of a bear market, investor outcomes tended to be worse.  Those bear markets experienced peak-to-trough declines of 49% and lasted 2.5 years on average.  By contrast, the two bear markets that occurred without a recession averaged just five months with peak-to-trough declines of only 31%.  Those losses were recovered rather quickly.  It’s worth noting that the two non-recessionary bear markets were also the only two instances in which only one condition was in place.  That condition?  Stretched equity valuations.


Though history shows that extended equity valuations can trigger a bear market, the odds are against it without the presence of at least one of the other three circumstances common to multiple market inflection points.  Should a bear market begin with only the high equity valuation condition in place, history also shows that both the duration and peak-to-trough losses suffered are likely to be below average.

So is the Bull Market Over?
To quote Soren Kierkegaard, “Life can only be understood backwards, but it must be lived forwards.”  While we’re certain we’ll be able to correctly answer that question once we have the benefit of hindsight, we’ll have to rely on our economic “dashboard” of several carefully-selected indicators highly correlated with trend changes in the four common characteristics of bear markets.  Data from these indicators is reviewed regularly by our Trust Investment Committee and any trend changes will be carefully evaluated.

What are these indicators telling us currently?  Equity valuations are stretched, but the onset of a recession doesn’t appear imminent, inflation remains under control and monetary policy remains accommodative.  In our view, elevated equity valuations alone will be insufficient to slay the bull and welcome the bear.

Our portfolios are constructed to reflect each client’s unique goals, time horizon and risk tolerance as determined in his or her financial plan.  These plans are prudently monitored and adjusted to help you stay on track.  But remember that having a plan is just a starting point.  It’s important that your plan adjusts with your evolving goals and life circumstances which is why we like to periodically meet with you to review your financial plan.  We’re here to help you achieve your goals in both bull and bear markets.  Give us a call today.

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