WHY THE BULL MARKET COULD END IN 2020 / BARRON´S MAGAZINE

Why the Bull Market Could End in 2020

By Ben Levisohn                                              

 

All of us, at some point, must confront our mortality. So, too, must investors prepare for the demise of a bull market that began in the depths of the financial crisis in 2009.

Yes, predictions of the end of this record run have been made before—and have been proved wrong.

The rally has so far seemed almost indestructible, thanks to stable economic growth and the Federal Reserve’s easy-money policy. 

But many market strategists and economists see powerful forces converging that could finally trip up the bull. For one, the economy has been juiced by the tax cuts and fiscal-spending package that Congress passed at the end of 2017—a stimulus that should last another year or so. Just as its effects are fading, the Fed will be continuing to push interest rates higher and shrinking its $4 trillion balance sheet.

Put them together and you have a drag big enough to slow the economy, while stamping a bright expiration date on the bull market: 2020.

And it isn’t just permabears who are gloomy of late. Ben Bernanke, the former chairman of the Federal Reserve, recently said that after two years of stimulus, “in 2020, Wile E. Coyote is going to go off the cliff and is going to look down.”

Even less-pessimistic economists and market watchers acknowledge that economic expansion will slow in 2020, while corporate profits, though still increasing, will do so at a slower pace than they had previously. Global economic growth could also feel the pinch if the European Central Bank begins raising interest rates toward the end of 2019, as it has suggested it might. These conditions are far different than what has existed in the bull market.

There’s no denying this one is getting long in the tooth. The average postwar bull market gained 161% over 1,821 days. This one, at 3,400 calendar days, is already the second-longest on record, lagging behind only the 4,494 days during the marathon run from 1987 through the peak of the tech bubble in March 2000. The S&P 500 has gained 302% since its bottom in March 2009, the second-longest run on record. During the 1987-2000 bull, the S&P 500 rose 582%. And while bull markets don’t die of old age, each day brings a reckoning that much closer.

“Like the human body, the market becomes less resistant to shocks and viruses the older it gets,” says Christopher Smart, head of macroeconomic and geopolitical research at asset manager Barings.

While a correction from its Jan. 26 highs has removed some of the market’s most egregious excesses, signs of investor complacency abound. The Cboe Volatility Index, also known as the VIX, remains below its long-term average around 20 times, and investors continue to put money into mutual and exchange-traded U.S. stock funds, even as they have fled other markets. And for investors betting that the diversity of their index ETFs will save them, the Leuthold Group’s chief investment strategist, Jim Paulsen, notes that the weight of defensive sectors in the S&P 500 has dropped to 15%, an all-time low. “Investors should be aware that defense has left the building,” Paulsen warns.

If nothing else, it’s time for investors to think about the types of companies they own, and to begin shifting away from the riskiest and most indebted toward those better-positioned to withstand a downturn. And while it may reduce short-term returns, there’s nothing wrong with holding a little extra cash to tamp down a portfolio’s volatility and deploy when stocks do fall. Because the market always falls, eventually.

To understand why 2020 should loom large in investors’ vision, keep in mind the reasons that the past nine years have been so good. Some might call post-financial-crisis growth in the U.S. lackluster; it has also been remarkably consistent, never climbing by more than 2.9% or by less than 1.5% in any calendar year since 2010. And inflation has been subdued, as well, creating the Goldilocks environment that was neither too hot nor too cold.

The latest fiscal stimulus—the tax cuts—changes that. Congress passed $1.5 trillion of them over a 10-year period, while also increasing spending by some $300 billion over two years. The Peterson Institute for International Economics puts the total impact at an additional 0.5% of gross domestic product by 2020.

Companies have used that cash to repurchase shares, increase dividends, buy competitors, and invest in their businesses. All of that activity looks set to have a big impact, though the question remains how big. Economists expect the U.S. economy to grow at a 2.9% clip in 2018, up from 2.3% in October. And that economic growth has also translated to a big boost in earnings projections, as corporations are expected to see profits rise by 21% in 2018 and 10% in 2019.

Like any artificial high, the good feelings won’t last forever. By the end of 2019, the last of the fiscal intoxication should have worn off, and the hangover could begin. Economists expect the U.S. economy to expand by 1.9% in 2020, and earnings to increase by 10%.

“The tax stimulus is designed to be very front-loaded in the lift it gives to economy,” Morgan Stanley chief U.S. economist Ellen Zentner says. “You have to deal with the hole on the other side.”

The stimulus, however, isn’t occurring in a vacuum. The Fed is already raising interest rates, and is doing so at a faster pace than some investors had counted on. At its current pace of a hike every three months, the federal-funds rate should hit a range of 3.25% to 3.5% by the end of 2019, up from 1.75% to 2% currently.

At the same time, the Fed is shrinking its behemoth balance sheet. That means monetary policy could be hitting its tightest levels just as the impact of the government stimulus begins to wear off.

Alan Ruskin of Deutsche Bank argues that fiscal stimulus has restored the “arc” to both the economy and the policy cycle. The arc refers to the rise above trend growth, followed by the decline back below it. The arc of economic growth is also mirrored in monetary policy, which should follow the same path as the economy strengthens, and then weakens.

That arc, however, is nowhere in sight. The Fed’s “dot plot,” which tracks where each member of the Federal Open Market Committee thinks rates will be over three years, suggests that fed funds will hit 3.25% to 3.5% before a gentle easing. The market, meanwhile, is pricing in rates hitting 2.6% at the end of 2019 and going sideways from there. Those paths are unlike any seen before. “What’s priced in has no modern monetary policy precedent,” Ruskin says.

Market indicators are also pointing toward 2020 as a year of reckoning for the stock market. Look no further than the so-called yield curve—that is, the difference in returns between short- and long-term Treasury securities.

In good times, the longer-term yield should be higher than the shorter because it means a bank can borrow at the lower short-term rate and make money lending at the higher longer-term one. When short-term yields rise above long-term ones, there’s no incentive to lend, and that “inverted yield curve” has typically preceded a recession by six to 24 months.

The yield curve hasn’t inverted yet—but it’s getting close. The two-year Treasury’s yield was at 2.524% on Friday, while the 10-year’s was at 2.844%. That 0.3195 of a percentage point difference is the narrowest since the financial crisis ended. If the Fed continues to raise rates at its current pace, the yield curve is likely to be flat by year end, says David Ader, chief macro strategist for Informa Financial Intelligence, and to invert during 2019’s first half. “That would point to recession in the second half of 2019 or early 2020,” he explains.

An inverted yield curve acts as a market signal, as well. Charlie Bilello, director of research at Pension Partners, notes that since 1956, the S&P 500 has dropped an average of eight months after an inversion of the one- and 10-year Treasury yields, though it took 21 months from an inversion in 2006 to the stock market’s peak in 2007. “That’s a long time to wait, exposing just one of the problems in using the yield curve to time your stock market exposure,” Bilello adds.

While 2020 may be pointing to the edge of a cliff, a lot could happen by 2020 that could either extend the cycle, or end it sooner.

The brewing trade war between the U.S. and its trading partners is the most obvious, as escalating tensions could negate the stimulus boost—and cause a selloff long before a recession. The S&P 500’s 2.2% decline during the past two weeks suggests that these worries are already having an impact.

On the other hand, the Fed might decide it would be better off slowing rate increases in light of global tariff turmoil. There’s even a possibility that the economy, which has survived so much since 2009, just keeps soldiering on—and lifts stocks with it.

“The bull market will last as long as the economy expands,” says Ed Yardeni, chief investment strategist at Yardeni Research. “I don’t know anything today that leads me to put a time frame on when this bull market ends.” That means stocks’ path to 2020 could be as rocky as 2018’s has been, or that equities could see one final melt-up before it all comes crashing down.

Investors need strategies to handle both potential scenarios.

The best way to do that could be to focus on high-quality stocks, says Brian Belski, BMO Capital Markets’ chief investment strategist. He defines quality stocks as those with an investment-grade credit rating, lower earnings-growth volatility than the S&P 500, higher return on equity than the median stock in the benchmark, and a larger-than-average cash position.

Such shares have performed quite well in all market periods. High-quality stocks have averaged a 13% gain annually since 1990, versus 7.7% for the S&P 500, according to Belski’s data. And they’ve fared even better in rocky markets with above-average volatility, rising an average of 4.2% annually, compared with 2.9% for the S&P.

“Our work suggests these stocks not only are well suited for volatile market periods, but also are an attractive long-term investment strategy,” Belski says. “As such, we believe it would behoove investors to focus on this sort of strategy as markets continue to digest what has become an increasingly complicated investment landscape.”

Stocks that meet Belski’s requirements include exchange-traded fund titan BlackRock (BLK), biotech giant Biogen (BIIB), Costco Wholesale (COST), and United Technologies (UTX).

In a similar vein, David Kostin, Goldman Sachs’s chief U.S. equity strategist, has been recommending stocks with strong balance sheets, which tend to outperform when the Fed is raising rates and monetary conditions tighten. That should pay off, regardless of whether the economy continues to expand at a strong pace, or if growth slows and heavily indebted companies struggle to cover their interest payments, Kostin observes.

“Strong balance-sheet stocks appear primed for outperformance whether economic growth remains strong or falters,” he explains. Stocks included in Goldman’s Strong Balance Sheet Basket include Facebook (FB), Intuitive Surgical (ISRG), Monster Beverage (MNST), and Verizon Communications (VZ).

But it also pays to remember that bear markets are inevitable—and not the worst thing that can happen, as long as an investor is prepared. The S&P 500, after all, dropped 57% from peak to trough during the financial crisis, but investors who held on through it had recovered their losses by the end of March 2013. The worst damage was suffered by those who couldn’t take the pain and sold near the bottom; they never made their money back.

For investors who may not have the fortitude to hang on through a run-of-the-mill correction, let alone a real bear market, Michael O’Keeffe, chief investment officer and head of investment strategy at Stifel, recommends holding a bit more cash. “Sell a little bit of your equities, and hold more dry powder,” he advises. “When the move occurs, you’re ready to redeploy.”

That sounds like good advice, especially now that it’s possible to get close to 2% on cash, a big increase since we last took the temperature of this bull market 10 months ago. With the market even longer in the tooth, that doesn’t look too shabby.