The following phrase has lost investors more money than just about any in history:
This time is different
That is because history typically does have a way of repeating itself. Thus, to predict that things will be different this time around is often a fool's errand leading to hefty losses.
Unfortunately every now and then that saying is actually very true, making it all the more difficult knowing whether to heed history or ignore it. That is the crossroads we stand at right now where one path leads to a continuation of the 7 year bull market. The other points to the beginning of a new bear market.
The purpose of this article is to share with you some important facts that may indeed point to why this time may be different. And thus why this bull market stays aloft against all the historical odds. Then I will share the details that will eventually pave the way for the next bear and how to invest during these trying times.
Just the Facts Ma'am
No doubt you have read many articles this past year pointing out all the ways in which the current economic and stock market picture looks quite like the beginning of past bear markets. I have put forward many such comparisons. However, I have to admit that none of those past periods had bond rates this low. In fact, in the past 140 years the 10 year Treasury rate has never been this low for an extended period of time.
Low rates punish those who wish to hold cash. This forces many to take on more investment risk to gain a decent rate of return. The stock market being one of the main beneficiaries.
Long story short, this time may be different allowing stocks to reach higher valuations since they are more attractive than putting money to work in bonds or cash. This relationship will hold up as long as rates stay low and there is no fear of a looming recession. Once either of those concepts comes into question, then stocks will begin to fall in a meaningful way.
More . . .
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The Goldilocks Scenario
If you boil it down investors are still bullish because of the current Goldilocks Scenario. That is where economic activity is slow enough to keep the Fed from raising rates...but not so weak as to worry folks about a looming recession.
The merit of why this is attractive is not readily apparent. So let me spell it out for you.
The simplest way to explain it is to say that bonds are the #1 competitor to stocks for investment dollars. The lower the bond rates, the more attractive stocks become.
Why is that?
This is where the Earnings Yield (EY) comes in (S&P 500 annual EPS divided by S&P 500 price...aka the inverse of PE). The best way to appreciate the validity of the earnings yield is to imagine you buy up every share of S&P 500 stocks and take them private. If that were the case you would no longer care so much about the daily fluctuation of stock prices. Instead you would be concerned about your rate of return, which is the amount of profits the companies pay out relative to the cost of your investment in the companies.
We all appreciate that owning any individual company is risky. But owning the bulk of Corporate America is not that much more risky than investment in the US government via treasuries. Thus, the risk premium for owning the S&P 500 should not be that much greater than the 10 year Treasury.
As it turns out the average spread between the 10 year and the S&P 500 earnings yield going back to 1970 is only 0.06%...basically nothing. (This comes from data I pulled from http://www.multpl.com/s-p-500-earnings-yield, which is using a more conservative calculation of earnings than most other sources...but the basic truth remains that the lower bonds rates are, the better it is for stock prices).
According to Multipl.com right now the Earnings Yield is 4.2% while we see that the 10 year stands at 1.5%. The extra return that comes from stocks relative to bonds is why stocks stay aloft at this time. And this relationship is the reason why virtually all other comparisons of this investment landscape to prior periods may be irrelevant.
(Read that last paragraph again...and then one more time so it sticks. Then continue).
Over the last 140 years, the 10 Year Treasury has never been this low. Repeat...it has NEVER been this low. And certainly not this low for such an extended period of time. Thus, all the normal ways we compare this time period with the past to judge if the environment is bullish or bearish may be irrelevant because none of those past periods had rates this low, which tips the scales towards stock ownership.
When Does the Next Bear Market Start?
If all of this is true, then it says the bull market stays in place until bond rates come higher or earnings go significantly lower, thus wrecking the Earnings Yield math advantage over the 10 year yield. That is why slow growth is not an issue because it still keeps earnings high enough to produce better earnings yield than Treasury yield. And that is why every time the Fed seems on hold with moving rates higher is celebrated with a stock rally.
Bond rates will go higher if inflation picks up or the Fed actively raises rates. Neither seems like a serious concern now.
The main cause of lower earnings would be economic contraction (read: recession). That is a tad bit more of a concern at this time given slowing worldwide growth. Plus we have seen a recent weakening of key economic data such as ISM Manufacturing, ISM Services and the paltry Employment data the past two months.
These signs do slightly increase the odds of recession. Not enough for this bull party to fall apart right now...but enough to make one ponder what the next round of data says before rushing too much higher. This is certainly a big reason behind the recent pullback from the highs.
What Should You Do Now?
Like I stated at the outset of the article, the market is at a crossroads. The low rate Goldilocks Scenario shows what could keep the bull market going higher. Unfortunately the weakening of economic data may pave the way for the next bear.
Those who blindly follow the bull will have a rude awakening when the bear arrives. And those with a "sky is falling" approach will miss too much of the upside potential. There is a better way, but it takes constant study and vigilance, plus the reflexes to take decisive action when the time is exactly right.
Starting today you are invited to look over my shoulder as I do this work for my personal portfolio, the Reitmeister Trading Alert.
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Wishing you great financial success,
Steve Reitmeister has been with Zacks since 1999 and currently serves as the Executive Vice President in charge of Zacks.com and all of its leading products for individual investors. He is also the Editor of the Reitmeister Trading Alert.