The stock market recently hit new all-time highs but are they going to be sustainable?
by Jurrien Timmer, Director of Global Macro, Fidelity Investments
Key takeaways
- The stock market hit new highs last week, and the history of market cycles suggests that the current bull market trend could continue for some time to come.
- In terms of the business cycle, the US economy is out of recession and into an early cycle recovery.
- In addition, the market continues to display characteristics of a secular bull market. Secular bull markets are prolonged super-cycles in which the market produces above average returns.
- Factors supporting the secular thesis include de-equitization (the number of public stocks is declining), a highly accommodative monetary policy, and a weaker dollar.
The stock market’s relentless upward march continued last week, with the S&P 500 (SPX) reaching a new all-time high of 3,508. That’s 4% above the February high of 3,394.
Nevertheless, there has been a lot of chop underneath the surface since March, with some weeks in which it is only the FANGs1 running the board while the broad market trails behind, only to be followed by the exact opposite.
It has been the battle of the “work from home” stocks (FANGs) vs. the “re-open” stocks (cyclicals/value/small caps). Case in point, 2 weeks ago the S&P 500 Index gained 0.8% to a new all-time high while all 11 sectors had more decliners than advancers. Last week, all 11 sectors had positive breadth.
The message here is that while it is true most bull markets end with narrowing breadth, that condition can persist for a very long time. For instance, the 1990s showed one example, with persistent negative breadth during the second half of the decade despite a 3-fold increase in the S&P 500.
Where are we in the cycle?
Given the above, what can we say about how far along in the cycle we are? Is it early days, like the summer of 2009 or the fall of 1998, or is it the bottom of the 9th inning like late 1999? I think it’s the former, and here’s why.
Reason 1: An early cycle bull market has only just started.
Reason 2: Not only is this likely a cyclical bull market, but I think we are also likely still in a secular bull market. A cyclical bull market typically lasts as long as the business cycle while a secular bull market may show higher than average returns for nearly 20 years.
The chart below shows the average bear market cycle since 1920. I have added averages for secular bear markets (1930s, 1970s, and 2000s) and secular bull markets (1920s, 1950s–60s, 1980s–90s). Note how the slope, magnitude, and duration of the down-cycle is completely different for secular bull markets vs. secular bear markets.
Cyclical downturns during secular bear markets are agonizingly long and deep and take a long time to unwind. But cyclical downturns during secular bull markets are fast and furious and recover very quickly.
Note how the secular bull average line rises until only a few months before the peak, falls quickly and then recovers just as quickly. We saw a mini-version of this in late 2018 when the SPX fell 20% in 3 months and was back to new highs shortly thereafter (the definition of a V). The same thing has just happened with the COVID Crash, only with more magnitude (35% from high to low).
Cyclical downturns during secular bull markets all have the same pattern: A long advance interrupted by a sharp but short-lived cyclical bear market, which then quickly recovers into the next bull market.
A particularly compelling analog is the 1998 cycle. In 1998 the effects from the Asian Flu (economic flu, that is) culminated in the Long-Term Capital Management (LTCM) hedge fund debacle in October of 1998, which produced a 22% decline in the SPX and led to 3 rate cuts by the Greenspan Fed. The market melted up from the October low into year-end and beyond, dominated by mega cap growth stocks.
True, economically speaking, a global pandemic producing the worst economic contraction in our lifetimes is not a fair analog to 1998. There wasn’t even a recession in 1998 (although there was a global manufacturing slump at the time). But in terms of price action for the SPX and the dominance of mega cap growth stocks, the analog is compelling.
One suggestion is that 2021 could end up looking like 1999: A speculative blow-off driven increasingly by retail day traders while the average long-term investor sits things out.
How do we know that we are actually in a secular bull market? Well, we don’t, because these things are unknowable in real time. But what we can do is have a thesis and test against it. If the current market environment looks like a duck, walks like a duck, and quacks like a duck, then I am going to assume that it is a duck until proven otherwise.
I first started writing about the secular bull market thesis in 2013, when the SPX made its first new all-time high after the global financial crisis (GFC), and since then pretty much everything that this market has done has confirmed as much, including the sharp recovery off the March lows.
The chart below shows the post-GFC cycle overlaid against the previous 2 secular bull markets. Right on track.
And the next chart shows the market’s real return since 1871, with a trend line on top (constructed using exponential regression). Secular bull markets typically start 50% below the trend line and end 18 years later at 100% above the trend line. We are currently 11 years in and are sitting right on the trend line. For all the bears out there calling the market a bubble, I don’t see any evidence of it in the chart below.
If we are only in the 5th inning of a secular bull market, what does that mean in terms of market leadership? Well, the 1998 analog above suggests that large-cap growth could continue to dominate, but looking at other time periods, there isn't a clear conclusion.
During the 1950s and 1960s, growth dominated until inflation increased in the 1960s. That ended the Nifty Fifty era and from there on it was all value. During the 1980s and 1990s it was more of a one-way street in terms of growth beating value. I think it all comes down to inflation from here.
What other factors could continue to drive this secular bull market?
Reason 3: If the de-equitization of the stock market continues, the supply/demand dynamic should remain favorable. (De-equitization means that the number of public stocks is declining.) The number of publicly traded equities has been cut in half since the late 1990s—peaking at 8,309 in 1996 and down to 3,853 by 2016.2
A similar and related dynamic is the ongoing shrinkage of the share count in the S&P 500, driven in large part by share buybacks.
Reason 4: Monetary policy remains ultra-accommodative and, I believe, is likely to stay that way for a number of years to come (as confirmed by the Fed’s new inflation targeting stance). It’s a “there-is-no-alternative” (TINA) world as far as the eye can see, and with the P/E ratio on the 10-year Treasury now at 143x (the inverse of 0.7%), equities at 25x trailing earnings seem like a bargain.
If the money supply keeps expanding, equities should do well alongside hard assets like gold and real estate. The big question is whether this will turn inflationary. If it does, it should put downward pressure on valuation multiples. The question then is to what degree that pressure might be offset by a risk-free rate near zero.
That answer will come down to real rates. If the Fed can pull off anything like what it did during the 1940s, i.e., absorbing a massive increase in federal debt while keeping interest rates low, then real rates should remain negative. This is again bullish for equities and hard assets.
Reason 5: A lower dollar would also be a big tailwind for the secular trend. The Fed seems to be winning the global race to the bottom, as evidenced by the weakening of the dollar against foreign currencies for about the past 4 months. When all rates everywhere are at or near zero, currency becomes the final frontier. A lower dollar is bullish for equities and hard assets.
There are always legitimate reasons to be cautious or bearish, and that’s certainly true today. We have the election, COVID, mass unemployment, US-China tensions, high valuations, etc. But when I add them all up, I am still finding more reasons to be in than out. So this week I am channeling my inner optimist by accentuating the positive.
About the expert
Jurrien Timmer is the director of global macro in Fidelity's Global Asset Allocation Division, specializing in global macro strategy and active asset allocation. He joined Fidelity in 1995 as a technical research analyst.
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