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The S&P 500 has closed at a fresh all-time high 57 times so far this year, while the Nasdaq
has secured 70 new all-time high closes, shattering the 1999 record of 61. The fact that the
1999 rally was followed by a crash is making many people nervous, Daalder says.
Trying to see one coming though is not an exact science, as economists and academics
cannot even agree on what constitutes a bear market, and not all stocks have become
expensive due to the continuing bull market, he says.
“Concerns of an upcoming correction are spreading with each all-time high reached,” says
Daalder, whose multi-asset fund remains overweight on stocks. “Reading through the
various outlooks published by the major banks and institutions, the central theme is one of
cautious optimism, with a clear emphasis on the caution part.”
Lofty levels
“The valuation of US stocks has reached lofty levels, while credit spreads have declined,
regardless of the underlying deterioration of credit quality and overall leverage. Not surprisingly, more and more analysts are contemplating if, when and how the current rally
in the risky parts of the US financial markets will come to an end.”
A recent Financial Stability Review by the European Central Bank flagged the high valuation
of the US stock market, warning that any correction there would also pose a risk for the much
cheaper European stock markets. But would it trigger a bear market?
“If you want to take a crack at predicting bear markets, you first need to have a clear idea of
how to define one,” Daalder says. “Using one definition of ‘any 20% correction from the
previous peak’ sounds simple, but it raises a number of questions.”
“Strictly interpreted, this means that the Nikkei index has been in a bear market for over 27
years. Although no one will claim that the Nikkei has been a solid investment, it does not do
justice to the six 20%+ drawdowns that the index has experienced since the 1990s.”
“Another consideration may be that of inflation: the Brazilian Bovespa rose more than
1,000% in 1994, while inflation was as high as 5,000%. Most investors would qualify that as
a bear market.”
Shiller’s definition
Daalder looks at the definition of the Nobel Prize-winning economist Robert Shiller: “The
peak before a bear market, per my definition, was the most recent 12-month high, and there
should be some month in the subsequent year that is 20% lower.” This means there have
been 13 US bear markets since 1881 – the most recent one occurring during the Eurozone
crisis of 2011 – but it still doesn’t tell the whole story, Daalder warns.
“The rule that a 20% correction needs to take place within 12 months means that you are
filtering out the bear markets that take a bit longer to develop,” he says. “Additionally,
whereas Shiller uses real prices in the construction of his famous Cyclical Adjusted Price
Earnings ratio (CAPE, or Shiller PE), he sticks to a nominal approach. As a result, the 1970s
and 1980s were ‘bear-free’, even though there were some pretty nasty corrections during
that timeframe.”
Considering volatility
The fact that high valuation increases the risk of a correction is probably not a shocking
statement to make, but does low volatility add something to the mix as an early warning
signal? Shiller seems to imply so by warning that in his US analysis, “stock price volatility was
lower than average in the year leading up to the peak month preceding the 13 previous US
bear markets”. This has led some investors to draw parallels with today’s low levels of
volatility as a danger signal.
However, this is also unreliable, Daalder says.
“Record low volatility is by no means a reliable
early warning signal for spotting bear markets. Looking at the top-10 list of periods of record
low volatility, only once (in 1895) did it precede a bear market: in the other nine cases there
was no bear market sell-off. All in all, on a standalone basis, this does not appear to be a
useful tool with which to flag a bear market.”
So what about looking at the combination of valuation and volatility? The table below
attempts to do this by matching volatility levels with 12-month forward stock market returns.
“If the combination of low volatility and high valuations have historically spelt trouble, one
would expect the returns of the bottom left of the table to be lower on average than in the
rest of the table (inside the red circle). But there does not appear to be a particular low point
in that part of the matrix,” Daalder says.
“All in all, we do not think that there is much predictive value to be had by looking at the
combination of valuation and volatility. Of course, we agree with the ECB and Shiller that the
current valuation of US stocks is a cause for concern, but whether that means that we are
heading for a correction anytime soon remains to be seen.”
“The current rally has been very much momentum and liquidity driven, and so far we see
little signs that this is about to end. We therefore continue to be long on stocks, but with a
tight stop loss in place.”
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