The Standard & Poor’s 500 index, the Dow Jones industrial average and the Nasdaq composite continue to reach record highs, surprising investors who think a bear market is imminent. However, the combination of synchronized global growth and low inflation may keep the bear in hibernation for a longer period of time.
Although the bull market may have more room to run, a market correction may be a higher probability near-term risk.
Bear market versus correction. A bear market is a period of several months or years, typically coinciding with recessions, in which securities prices consistently fall. In contrast, a stock market correction is commonly defined as a market decline of 10 percent from its 52-week high.
[See: 7 Stocks to Buy When a Recession Hits.]
Most investors welcome a market correction during a bull market, as corrections allow the market to consolidate before moving toward higher highs. Corrections are a normal occurrence during bull markets, and the current bull market is no exception. Other than the 2011 correction caused by the downgrade of U.S. government and European government debt, corrections since the global financial crisis have been reasonably shallow and short-lived. Even the 2011 market correction was relatively brief, providing buying opportunities in a long-term bull market.
The U.S. is in its 99th month of economic expansion, the third-longest expansion in history. Although the current expansion is noteworthy for its length, it is also the weakest expansion in the last six decades, with average GDP growth of 2.1 percent.
Investors are understandably worried that the next bear market will resemble the severity of the global financial crisis and dot-com bust, though the current economic environment appears to be very different than the environment in 1999 and 2007.
Asset bubbles and excessive leverage were the culprits for the last three recessions. The dot-com bubble was caused by excessive capital spending and irrational stock market valuations in the late 1990s. Residential real estate boomed in the 2000s, and the combination of the real estate boom and excessive leverage helped to cause the global financial crisis.
The 1990 recession isn’t top of mind today, but it also had roots in financial institutions weakened by real estate excesses. In 1990, the culprit was the combination of commercial real estate and savings and loan institutions.
The next recession. Although asset bubbles or leverage-induced recessions are what many investors fear, the next recession is more likely to be caused by an overheating economy or by central bank tightening to rein in inflation. There are minimal signs of the imbalances that caused recessions in 1990, 2000 or 2008.
Capital spending remains subdued by historical standards, despite fears that a spending boom would result from the extraordinary monetary policies adopted after the global financial crisis. Housing starts are far below the peak reached in 2007, and today are rebounding from a highly depressed level. Lenders have become much more disciplined, requiring higher credit scores and more equity.
[See: How Rising Interest Rates May Affect Real Estate Investors.]
There are risks in certain subsets of the economy, including student loans, auto loans and the energy sector, but nothing that approaches the systemic magnitude of the dot-com bubble or the global financial crisis. Despite high U.S. stock market valuations, rising earnings and low inflation makes it easier for investors to accept elevated earnings multiples. Valuations may be high, but for the most part are below the irrational levels reached during the dot-com era.
Federal Reserve policy remains the most-likely catalyst for a recession that would lead to a bear market. The Fed is starting to reduce the size of its $4 trillion-plus balance sheet, and rates could rise unpredictably in response to implementation of the balance sheet reduction plan. The likely change in leadership at the Fed is another risk factor, with Janet Yellen’s term expiring early next year.
President Donald Trump has several seats on the Fed to fill, and some of the potential candidates favor a rules-based approach to monetary policy. A rules-based approach could lead to a more dramatic move upward in rates, which would increase the likelihood of a recession and bear market. Inflation is likely to “grind” higher rather than move too sharply, giving central banks the latitude to raise rates in a gradual manner. However, a spike in wage inflation or oil prices could lead to more aggressive rate hikes than expected today.
The U.S. economy recovery is in late cycle, but U.S. corporate earnings continue to grow at a brisk pace. Economic growth in much of the rest of world is still accelerating, with recent economic laggards such as Europe and Japan enjoying a long-awaited recovery.
Chinese growth was strong in the first seven months of the year, but is expected to slow moderately in the remaining months of the year. A more dramatic decline than expected in Chinese growth is a risk for investors to monitor, as is the escalating conflict over North Korea’s nuclear adventurism. Policy initiatives in the U.S. could help or hurt economic momentum. Tax cuts could provide a near-term boost, but large-scale actions to reduce global trade could jeopardize momentum.
Looking ahead. Overall, the continuation of a “Goldilocks” economy — “not too hot, not too cold” — supports a bull market that could extend well into 2018. Growth could potentially accelerate if reflationary policies such as tax reform provide a boost in the latter part of 2017. However, given the long bull market and elevated valuations in the U.S., the risk of a recession is a possibility that shouldn’t be ignored.
The bull market may not die of old age, but investors should remain vigilant about potential catalysts for an untimely demise. Overzealous policy tightening still represents the greatest threat to a pro-risk stance, but with economic data positive and inflation subdued, the Federal Reserve may have the luxury of taking a slow and steady path. As the last few years have shown, moderate growth, dovish central bank policies and low inflation have been an ideal backdrop for stock market investors.
[See: 10 Skills the Best Investors Have.]
Disclosures: Registration with the SEC should not be construed as an endorsement or an indicator of investment skill, acumen or experience. Investments in securities are not insured, protected or guaranteed and may result in loss of income and/or principal.
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Is the Bear About to Come Out of Hibernation? originally appeared on usnews.com
