Is the Stock Market Running on Borrowed Time?

Originally posted at Briefing.com

This bull market began in March 2009. That makes it 66-months old. Is it running then on borrowed time? The answer could be: yes, no, and maybe.

No one knows for certain what the future holds, yet that isn't a paralyzing factor for the stock market, which discounts its belief about the future into present values.

With that, we'll briefly review the relevance of why yes, no, and maybe are all reasonable responses right now when it comes to the following question: Is the stock market running on borrowed time?

Yes: The average length of bull markets since 1962 is 48 months, according to data from Birinyi & Associates obtained by Bloomberg. Four of the nine bull markets since then, however, have risen for about six years.

No: Fundamental forces continue to align favorably for the stock market. Interest rates are low; inflation is low; and earnings continue to grow.

Maybe: Profit margins are at record highs and have a long history of mean reversion.The US dollar is strengthening against major currencies, which will pinch earnings prospects for US multinational companies should it persist.Geopolitical dealings have grown increasingly testy.The Federal Reserve is still sitting at the zero bound, but is starting to grow more vocal about the possibility that rates could move off the zero bound faster, and higher, than is currently expected if incoming data show increased economic momentum.

We Have a Situation

What, then, are investors to do? The answers are as varied as the ones above.

That's because the Federal Reserve has created a situation whereby the opportunity cost of being out of the market could hurt as much as the penalty of being in the market if something wicked this way comes.

What we mean by that is that the Federal Reserve has artificially supported stock prices by repressing interest rates with its unconventional monetary policy.

Investors can't afford to be out of the stock market because of that policy, yet they can't afford to be completely in the stock market at this juncture either because the artificial price support will drop when interest rates rise off the zero bound or an event unfolds that is outside the Fed's control.

In this sense, it is the best of times and the worst of times for investors.

There is a reasonable basis to believe there is still more to come in terms of stock market gains as the Fed sits at the zero bound, yet you just can't help but sense, based on fairly recent history, that easy monetary policy for too long is going to lead to a hard fall at some point down the road.

The Cornerstone

When that point is reached is the great unknown, which is why it is the cornerstone of the wall of worry the stock market continues to climb.

It hasn't hit in spades for the broader market in more than three years, yet there have been some trap-door moves along the way in certain pockets of the market that have offered a taste of how quickly things can change when sentiment and price momentum shift.

With our last market view update in June, we suggested to "proceed with caution" in the near-term.

It wasn't a call to get out of the market. Rather, it was a directive to think in terms of how to protect capital gains without missing out entirely on the potential for further gains that might be a function of animal spirits kicking in. With that, we encouraged:

  • Rebalancing by rotating some profits from industries/sectors that have outperformed to industries/sectors that have underperformed
  • Taking some profits and holding that cash in reserve; and
  • Entertaining a stock replacement strategy whereby one sells some stock and uses a portion of the profits from the sale to buy a call option on the stock

We recognize that a view that doesn't scream anything other than "BUY, BUY, BUY!!!" can be construed as a bearish view.

We were not bears then and we are not bears now.

The risk-reward dynamic isn't as appealing as it once was, especially with the S&P 500 rising another 4.0% since our last update, yet there is no denying that the Fed put remains a tying factor for the market. Meanwhile, the fact that earnings growth and M&A activity are picking are like double and triple knots that are keeping the stock market from tripping on its laces.

The Chase May Be On

At its current level, the S&P 500 trades at approximately 17x trailing twelve-month earnings and 15x forward 12-month earnings. Those are full valuations, as we have said before, yet they are not egregious when taking into account the level of interest rates and inflation.

A lot hinges, however, on interest rates and inflation rates staying where they are and companies delivering on earnings estimates that are pinned on continued margin expansion. Those are some big assumptions, yet there is a lot of willful acceptance of them because those elements have held intact for quite some time now.

IF things stay on course, then price returns for the S&P 500 should match up closely with earnings growth. Multiple expansion should be harder to come by since the market priced in so much good news for this year in 2013 when it surged 30% on 5% EPS growth.

The latter point notwithstanding, we can't dismiss the possibility of multiple expansion into year end as underperforming money managers look to play catch up to their benchmark.

A CNBC.com article on August 28 cited a research note from S&P Capital IQ Fund Research that indicated nearly 80% of actively-managed, large-cap mutual funds were underperforming the S&P 500 in 2014. With bonuses (and maybe jobs) on the line heading into year end, the effort to play catch up could be a self-sustaining force for the stock market barring a true negative shock.

What that reported underperformance also suggests, though, is that there is a generally cautious mindset among fund managers that is predicated on the notion that the stock market has gotten ahead of itself. To be sure, they have an awareness of the artificial price support propping up the market and an appreciation for how quickly that can be undone when it is removed.

What It All Means

This is an environment right now where, frankly, anything is possible. The market could go up big, it could go down big, or it could just go sideways.

We view it as such because sentiment, more so than earnings, is driving the market. That's why a 2% decline in the market after a 200% move off the March 2009 low suddenly leads to an eruption of accusations that it is the beginning of the end of the bull market.

Sometimes a 2% decline is just a 2% decline after a big price move.

We digress.

With earnings increasing, interest rates and inflation rates remaining low, and the Fed sitting at the zero bound, the stock market has a fundamental right to keep moving ahead. We said as much in June when we also suggested investors proceed with caution.

That view remains the same.

We don't love this market, but we have to respect it because of its abiding fixation on the Fed's zero interest rate policy.

When the fed funds rate is raised for the first time is probably when there will be a stronger sense that this bull market is running on borrowed time. That time isn't now.

About the Author

Chief Market Analyst
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