Full Recovery in Stocks
Since the Great Recession of 2007-2008, America has been engaged in an agonizingly slow, but steady, economic recovery. Stocks have been a linchpin of this recovery, shaking off periodic dips to maintain forward momentum despite a host of daunting world events. The past month, especially the past week, serves as a perfect example of this market resilience.
Both the Dow Jones Industrial Average and the S&P 500 closed at record highs on July 12, capping off several weeks of gains. The Dow ended the week on a positive note at 18516.55 for four straight days of record highs and a 2% weekly overall gain. The S&P 500 dipped slightly on Friday to finish at 2161.74, but still finished up 1.5% for the week. Since the dip in stocks triggered three weeks ago by the British vote to leave the European Union (Brexit), the S&P 500 has risen by more than 8%. The NASDAQ is in an overall upward trend as well.
Perhaps the most remarkable aspect of the new record highs is that they are taking place in an extremely turbulent time with world events. Only a few weeks after Brexit, a terrorist drove a commercial truck through a crowd in Nice, France, killing over 80 people and injuring over 200 more. We barely had time to process this horrific attack before learning of a failed yet unnerving coup attempt in Turkey and more shootings of police in Baton Rouge.
In such an unstable world, why do US equities keep rising? As strange as it may sound, instability can itself be a driving force keeping a bull market going. Optimistic US economic data, balanced by troubled world economic and geopolitical news, appear to be keeping our stock market growing at a steady rate in the macro scale.
Low Interest Rates Keep the Old Bull Charging
The current market may be a bull market, but it is not a raging one. Despite several correction scares, we are in the second-longest bull market in history, surpassed only the almost decade-long run from October 1990 to March 2000. If the current bull can hang on for another 768 days without a 20% or greater market decline, we will have a new champion.
What is keeping the bull alive? Interest rates play a large role. Bull markets tend to die when optimism overrides economic fundamentals for too long — the famous "irrational exuberance" that former Federal Reserve Chairman Alan Greenspan coined during the dot-com bubble of the 1990s. A subsequently overheating economy can lead to overvaluation of stocks and higher inflation. The typical Fed response is to raise interest rates to drive money out of stocks toward fixed-income investments – but to do so invites slowing the economy and risking a recession. The measures taken by the Fed to stimulate the economy out of the Great Recession were so sharp that they may have reset the natural balancing point of these forces.
Since the Federal Reserve dropped the rates to near zero and embarked on a bond-buying program to promote economic stimulus, stocks became disproportionately attractive to investors seeking even modest gains. Unfortunately, the money pumped into the system through these methods did not produce sharp enough economic growth to allow the Fed to raise interest rates back to normal levels.
Thus, the Fed is in a box — interest rates are so low that they are, to some extent, artificially propping up stocks. Economic growth, meanwhile, remains too weak to risk anything but a slow rise in rates, and recent economic shocks and worldwide turbulence have caused the Fed to delay even a small additional interest rate hike (It pushed rates one-quarter point last December — the first increase in nearly a decade.) According to a Wall Street Journal survey, just over half of economists believe that another interest rate hike will not take place before December.
Instability is prolonging the bull market in several ways. It adds to the likelihood that interest rates will stay low for some time by keeping central banks cautious. Moreover, the nature of the current instability (more global than domestic) and weakness in global economic growth relative to the US is creating a stronger dollar, which in turn can hold down inflation.
Not all instability is the same, however. Should the next terrorist attack be more novel and insidious — for example, successfully disrupting the power grid, satellite and cell phone communication, or other infrastructure — the dip in equities is likely to be more severe and the recovery time will be longer. The main point: history tells us that the market eventually will recover.
Watch for Overvaluation
Overvaluation of stocks can kill bull markets. Currently, the forward P/E (price-to-earnings) ratio of the S&P 500 is 17 — higher than the approximate long-term average of 15 but not in dangerous territory. However, corporate profits are being affected by an "earnings/profits recession." Profits went negative in the third quarter of 2015 and that trend has continued so far through 2016.
Wall Street expects rebounding profits and the early returns on earnings season seem promising, but the bull market is in jeopardy if profits continue the recent downward trend of many large companies. The hope is that earnings will, Goldilocks-like, come in just right, recovering enough to point to increased economic growth but not so strong that the Fed rethinks their interest rate policy.
Other signs underscore optimism on profits and stocks in general. For example, money has been flowing out of US equity funds for the majority of 2016, but that situation recently reversed. During a one-week block bridging the first two full weeks of July, mutual fund investors directed $7.8 billion back into the US equity fund market.
The current balance of optimism and pessimism (along with basic market forces) periodically bleed off excessive pressure and keeps the economy growing relatively slowly – excellent conditions to keep the bull market churning.
Most signs point to continued slow growth in the US economy and therefore a continuation of the bull market for some time. It remains to be seen whether this bull market can become the longest in history. Economists are split on whether the balance of forces can last for more than two years, but at least one driver (interest rates) looks to be favorable for the long term.
The past week's milestones drive home one point: stocks eventually prevail. Corrections and recessions are persistently followed by growth. Financial shocks and volatility are inevitable, and unfortunately are on the increase. Even so, markets eventually recover and thrive regardless of the size or the nature of the financial shock.
It can be difficult to avoid panic selling during these unstable times, but as a long-term investor, you should exercise discipline. Stocks may have already dropped by the time you read this from the Turkish coup, the Baton Rouge police shooting, input from the Presidential race, or some other market disruption. If so, recent history suggests that this resilient market will raise them up again.
Economically, it is fortunate that America's stock market can tolerate global instability and the sharp rise in brutal terrorist attacks. However, it is disturbing that such events are becoming commonplace and we — and the markets — are coming to accept this as the new normal. We can only hope that our leaders find a way to address instability while keeping America's well-being and economy intact at the same time.