Market views: Is the US equity bull market ending?

US stocks have been on a tear since Donald Trump was elected president, but this week saw the sharpest fall for months, as the bond sell-off stoked fears of further interest rate rises. That would mean financing being harder to come by for companies.

That said, the S&P 500 is still up 36% since November 8, 2016 and a whopping 314% from the March 6, 2009 trough after the 2008 financial crisis. What's more, it hasn’t seen a 3%-plus correction for more than a year.

Of course, this rally has been fuelled by wholly unprecedented monetary and fiscal stimulus, and it had to reverse at some point. 

Aron Pataki, lead portfolio manager for global real return
Newton Investment Management

With incentives to take risk having never been greater, investors and speculators have pushed many metrics to extremes seldom seen before. Despite US stocks falling this week, valuations are at eye-watering levels, particularly in the US. Valuation has become more elevated on the back of even higher corporate margins.

The S&P 500 index's cyclically adjusted price-earnings ratio of 31 times, which has only been higher during the late 1990s bubble, implies an expected return of over the next 10 years of approximately 0% per annum.

If one takes out the effect of corporate margin, looking at the price/sales ratio of the S&P 500 index, the market is now at its most expensive in history. This expected return profile continues to suggest that this is yet another extended cyclical bull market rather than a sustainable secular expansion.

The present economic environment is likely as good as it gets. The consensus believes if inflation continues to drift up, then policymakers will increase policy rates. This could eventually lead to a substantial tightening of financial conditions, which would not be constructive for risk assets.

That said, so much growth has been dragged from the future we still regard further economic disappointment or indeed some more esoteric left-field event as an equally likely scenario.

There has been a lot of optimism about the recent US corporate tax reform bill, but we don’t think the impact will be very material. The reality is that there are many profitable companies that are using intuitive ways to zero out their corporate taxes. According to a report of the Institution on Taxation and Economic Policy, the average effective tax rate in the US is much closer to 22%, so a cut of the statutory federal corporate tax rate from 35% to 21% is very academic.

In our view, the hype about the tax reform and higher capital expenditure leading to an acceleration of economic growth is not justified, and perhaps the euphoria is overdone.

We think the US equity market is pricing in lot of good news related to the tax reform and potential infrastructure spending. Right now there’s an awful lot of scope for disappointment.

A 20% drop in earnings, coupled with a couple of points price-earnings de-rating, could lead to a 40% fall in equities very easily. We’re not forecasting that, but it wouldn’t be surprising.

Gaurav Malik, global head of equity portfolio strategy on the active quant equity team
State Street Global Advisors

Our base case calls for another positive year for the US economy and stock market, underpinned by steady global growth and tame inflation to support corporate earnings and risk assets in general. With the Federal Reserve raising interest rates, we expect a further bear flattening of the yield curve.

The current slope is consistent with past business cycles that had another two or three years of expansion left. We could see equity market corrections of 5% to 10% before the next recession, but no significant and lasting selloffs.

The recent market correction offers some reassurance that markets aren’t outstripping strong fundamentals. A pause in the market’s direction reflects legitimate questions about whether some pillars of the long-running rally—low rates, low inflation and easy monetary policy—are beginning to shift.

In our view, the most serious risk to this outlook is a persistent surge in inflation, which could have a number of triggers. With fiscal stimulus from US tax reform pushing down unemployment, long dormant wage pressures might emerge, and we could experience a supply shock if energy prices spike higher. To avoid falling behind the curve, the Fed would hike rates more aggressively than its planned trajectory.

An abrupt tightening in financial conditions could disrupt the comfortable balance of low rates and moderate growth that has kept market volatility subdued. If volatility measures spike and stay up, we would see a great unwinding of strategies like risk parity that have used volatility reversals as buying opportunities.

In the worst of all possible scenarios, the Fed might overshoot, choking off growth while inflation climbs even higher. Based on historical periods of stagflation, equity markets could sell off by as much as 30%, and US Treasuries and gold would look attractive again. But this is far from our base case; we believe that a recession is unlikely as long as global growth remains robust and capacity under-utilised.

Outside of a recession, US equity markets tend to hold up. Certainly, we do not expect a recession in the next year as the Federal Reserve [Fed] proceeds at a measured pace. While some valuation metrics are above fair value, it’s still too early to pull back.

Historically, some of the strongest equity returns come in the mature phase of a bull market. The most likely path from here is that the S&P 500 hits 3,000 by year-end. This market is being led by earnings rather than a P/E [price-to-earnings] expansion, so it’s an encouraging dynamic for further gains.

While US equities have been down over the last few days, this seems like routine volatility and not a regime shift. Investors will likely see this as a buying opportunity and provide support.

The pillars of a bull market are still in place, with solid economic growth, tax cuts, confident CEOs and consumers, contained inflation and a cautious Fed. That mix creates a favourable backdrop for risky assets. Investor sentiment also remains robust.    

The next recession is likely to be Fed-driven, as inflation and economic activity eventually start to overheat and rates are aggressively pushed higher. Late 2019 will probably show some strain as wage demands pinch corporate profits. A Fed-driven recession is less lethal than the over-leveraged economy that drove the 2008 downturn.

With relatively high valuations from years of cheap financing and diligent profit management, we expect the next US bear market correction to be in the 20-25% range.