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Wall Street Journal / Life - Entertain

After Nine Years, How Long Can This Bull Live?

Living for so long with the bull market, it’s easy to buy into the idea that the only things that can halt it are a recession or the Federal Reserve.


Things look fine, but extended market calm can lead investors to make unwise assumptions. Photo: Michael Nagle/Bloomberg

By

James Mackintosh

39 COMMENTS

Bull markets, market bulls always insist, don’t die of old age. Nine years into an extraordinary run for U.S. stocks, it’s easy to buy into the idea that the only things that can halt the market are a recession or the Federal Reserve.

The claim is only half right. Long periods of calm lead investors and companies to make silly assumptions, leaving them dangerously exposed to shifts in fundamentals. With the economy now appearing to be in the last phase of the cycle, in which the Fed starts worrying about too much growth rather than too little, some of the easy assumptions of recent years are starting to be challenged—and could threaten the most popular stocks.

For nine years U.S. investors have had easy money, higher profit margins and—mostly—rising valuations, even as the economy had its slowest recovery since World War II. Wall Street won, while Main Street suffered.

Fatter Margins

Since the crisis, most of the S&P 500's gains are due to fatter profit margins and a higher valuation, while sales have risen more slowly than usual.

Breakdown of the cumulative price change since March 2009, by contributor

%

250

225

Price

Revenue

Forward PE ratio

Margin

200

175

150

125

100

75

50

25

0

–25

’18

’10

’11

’12

’13

’14

’15

’16

’17

2009

Breakdown of the cumulative price change since March 2009, by contributor

%

250

225

Price

Margin

Forward PE ratio

Revenue

200

175

150

125

100

75

50

25

0

–25

2009

’18

’17

’16

’15

’14

’13

’12

’11

’10

Breakdown of the cumulative price change since March 2009, by contributor

%

250

225

Forward PE ratio

Price

Margin

Revenue

200

175

150

125

100

75

50

25

0

–25

2009

’18

’17

’16

’15

’14

’13

’12

’11

’10

Breakdown of the cumulative price change since March 2009, by contributor

%

250

225

Price

200

Forward PE ratio

Revenue

175

Margin

150

125

100

75

50

25

0

–25

’16

’15

’14

’13

’12

’11

’10

’09

’17

’18

Note: Margin, revenue and PE ratio prorated to sum to price.

Source: Columbia Threadneedle

Now Main Street is finally starting to do better. Jobs are plentiful, unemployment is low, wages just might, perhaps, be picking up, and the bond market is once again priced for inflation rising to the Fed’s 2% target over the next two years.

Main Street’s gain could be Wall Street’s pain. But the economy isn’t a zero-sum game, and it could all work out well. Everything depends on the balance between the cost of money and the return on that money—in simple terms, whether corporate earnings will rise enough to offset the damage done by higher bond yields.

Higher bond yields equate to a higher discount rate, making future earnings worth less today and reducing the valuation. But if bond yields rise purely because the (global) economy is improving, future profits should go up too, offsetting the fall in valuation and keeping stock prices unchanged.

The concern last month was that bond yields were rising in part because of uncertainty about where inflation and Fed rates were going, not merely because the economy was stronger.

The selloff might have been a lot worse if it hadn’t been for soaring earnings forecasts on the back of the corporate tax cut. Analyst estimates of S&P 500 earnings over the next 12 months in January jumped 8%, for their biggest monthly gain since Thomson Reuters IBES data began in 1985. Tax cuts are nice for shareholders but only lift shares once.

Earnings Optimism

The Trump tax cuts have led to unusual upgrades of estimates of this year's S&P 500 operating earnings.

S&P 500 operating earnings estimate for each year

$160 a share

150

2018

140

2016

2017

2015

130

2014

2013

120

2012

110

100

2011

90

80

2010

70

2009

60

50

2010

’11

’08

’12

’09

’16

’13

’14

’15

’17

’18

2007

S&P 500 operating earnings estimate for each year

$160 a share

150

2018

140

2017

2016

2015

130

2014

2013

120

2012

110

100

2011

90

80

2010

70

2009

60

50

’18

’17

’16

’15

’14

’13

’12

’11

2010

’09

2007

’08

S&P 500 operating earnings estimate for each year

$160 a share

150

2018

140

2017

2016

2015

130

2014

2013

120

2012

110

100

2011

90

80

2010

70

2009

60

50

’13

’08

’15

’12

’16

’11

2010

’09

’14

’17

2007

’18

S&P 500 operating earnings estimate for each year

$160 a share

2018

2017

150

2016

140

2015

130

2014

120

110

2013

100

2012

2011

90

2010

80

70

60

2009

50

’09

’10

’11

’12

’13

’14

’15

’16

’17

’18

’08

’07

Source: Thomson Reuters Datastream

If bond yields are set to keep rising, as many believe, earnings will need to be supported either by higher profit margins or higher sales.

S&P profit margins are already fat, having hit a new high at the end of last year, as Ed Yardeni of Yardeni Research points out. Higher bond yields hit margins at leveraged companies directly as they pay more to borrow, while rising wages also pressure margins.

Stronger sales look like a better bet. Main Street’s decade of malaise has crimped sales growth, but unless Americans change their savings habits, higher wages mean higher spending. The consensus belief in synchronized global growth means more sales abroad, too.

Higher wages leading to more sales can more than offset tighter margins, especially if corporate investment were to ignite productivity gains.

The stock market isn’t prepared, because it has been transformed in the past nine years. When the S&P bottomed in March 2009, the top five constituents were Exxon, Procter & Gamble , Johnson & Johnson , AT&T and Chevron , then offering an average dividend yield of 4.2%. Investors wanted boring, predictable companies giving them money back immediately, not hopes of a dividend some time in the distant future.

Those companies have been swept away, with their total value now just 6% of the market, down from 14%. Instead, the market is dominated by Apple, Microsoft , Alphabet, Amazon and Facebook , yielding 0.65% and making up the same share of market capitalization that the old-school top five did at the market trough. Investors dream of disruptive long-term growth and are willing to wait for their rewards—as should be expected when bond yields are low.

As the story switches to rising yields, the shunned higher-yielding stocks offering immediate reward should come back into favor. Technology and other high-growth, high-margin, high-capital-spending stocks should be less appealing because growth will be available from cheaper stocks, too. The assumptions many investors cling to are that money will stay easy, inflation will stay low and workers will be happy to accept what they’re given—so watch out if those are proven wrong.

Of course, this economic cycle has been much slower than usual. Perhaps the extended mid-cycle of low inflation and little wage pressure will continue. Maybe supply and demand no longer applies in the job market. Maybe the days of boom and bust are behind us. But more likely is that the shift to late cycle is under way, and that the pickup in equity volatility is a sign of the higher uncertainty that shift brings.

Nine years on, there are ways for stocks to keep rising along with bond yields, but investors need to position themselves to profit from Main Street winning, too.

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