Ten years ago marked the beginning of the end — the end of an extended, globally synchronized economic expansion and equity market rally that created trillions of dollars in wealth, lifted millions of people out of poverty, and fundamentally changed how global investors and corporations looked at emerging markets.
As we approach the 10-year anniversary of the last equity peak (October 2007) and the 2008–2009 financial crisis, we examine the current economic expansion and stock market rally with the benefit of hindsight, seeking to uncover lessons that can help us to anticipate risks and opportunities ahead.
Lesson No. 1: Peaks Are Often Further Away Than You Think
Equity performance is – obviously – heavily influenced by economic trends. Peaks and sustained equity declines often emerge into and during recessions. Since the late 1960s, there have been six bear markets registering a 25%-or-greater decline for the Standard & Poor’s 500, and five of these coincided with a U.S. recession. That means looking for an equity peak requires an understanding of where an economy is in the business cycle and how near the next recession might be. This is easier said than done.

Since the end of World War II, the U.S. has had 11 business cycles, with expansions lasting an average of about six years. The expansion of the 2000s was in its fourth year, and the equity “bull market” in its third, when then Federal Reserve Chairman Alan Greenspan told Congress that some local housing markets were exhibiting “froth” and that he saw signs of risky financing. He added at the time, though, that he did not see a national bubble and that the economy did not appear at risk.
About a year later, U.S. Treasury Secretary Hank Paulson noted, “When there is a lot of dry tinder out there, you never know what will light it. We have these periods every six, eight, ten years and there are plenty of excesses.” Another six months later, in March 2007, after the U.S. housing market had started its decline, then Fed Chairman Ben Bernanke testified to Congress that “the impact on the broader economy and the financial markets of the problems in the subprime markets seems likely to be contained.”

All three policy makers, supported by reams of data and armies of economists, knew there might be a problem but could not put a finger on the timing, much less the scale, of the economic or market downturn to come.

So what do we watch to try to see equity peaks and recessions on the horizon? We start with trends in economic and financial data that can shed light on the probability of a looming recession. Our short list includes labor market and housing data, business and consumer confidence, and consumer credit, among other economic metrics. It also includes financial data that can be causes and/or symptoms of economic vulnerability, such as energy prices, corporate profit margins, credit spreads, mortgage interest rates, and monetary policy variables. Backtests of our recession model have correctly “flashed red” before recessions in 1990, 2001, and 2007, although the model has not always picked up all signals adequately (it underestimated the degree of housing vulnerability in 2007). As of June this year, our proprietary model suggested only a 38% chance of a U.S. recession over the next few quarters, with some of the greatest relative risk coming from a slowing labor market. Historically, equities have been much more likely to see sustained declines when recession probability readings reached 70% or higher.

Barring some shock, the economy for now doesn’t look at risk of imminent recession, though we continue to believe we are in the later stages of this economic cycle. All else equal, our next equity peak is likely still a ways off.

A similar takeaway can be reached by looking at positioning. Equities will be relatively more vulnerable when there are more owners who could get spooked (see Lesson No. 3) and suddenly sell en masse. That was definitely the case back in 2007 and 2008: between October 2002 and October 2007, equity inflows totaled $947 billion compared to $259 billion for bonds.

The 2008–2009 equity bear market, perhaps alongside some short-lived but still-painful crises in subsequent years (the 2011 U.S. debt-ceiling standoff, the 2012 European debt crisis, and the 2015–16 oil shock), resulted in an investor base much more skeptical toward stocks. Indeed, since March 2009, when the S&P bottomed, net fund flows into bonds have far exceeded flows into stocks. This is not a “crowded” market.

While economic momentum and investor positioning both give reason for near-term calm or even optimism toward equities, valuations provide a different, somewhat more cautious message. Equities are relatively more vulnerable to whatever shock emerges at higher valuations. While one can use a number of metrics here, most today at least directionally paint a similar picture. Looking specifically at price-earnings ratios (PEs), the current global PE ratio of about 16x (as of May 31 for the MSCI All Country World Index, on a next-12-months basis) has reached its highest level post-tech bubble.
Lesson No. 2: It’s Not Just This Time But Every Time That Is Different When It Comes to Economic and Equity Cycles
While economic trends, investor positioning, and valuations are all important inputs when assessing the probability of an equity-market peak, we have to acknowledge that these metrics, in absolute terms or in a historical context, are not sufficient to form a view. Just as economies and financial markets evolve, so too do catalysts for downturns. Every cycle is different in this regard.
The 2008–2009 crisis that followed the October 2007 equity peak has been thoroughly researched and discussed. While many factors contributed to this downturn, most would agree that at least near the top of the list would be a bubble in U.S. housing, in turn exacerbated by subprime mortgages; a bullish commodity market that, along with home prices, pushed inflation higher and led central banks to tighten monetary policy; a relatively relaxed regulatory environment; and a significant increase in leverage and the use of financial derivatives that were not sufficiently understood by relevant parties.
Looking at the current economic and market backdrops, we see some forces that leave us thinking this cycle could extend substantially longer, maybe even becoming the longest expansion and equity bull market in modern times. Other factors, however, could even now be sowing the seeds for the next equity peak and descent. We have to consider both sides as we construct portfolios.
In our minds, global monetary policy today creates two-way risks for this cycle. The 2008–2009 crisis led the Fed and its global counterparts to slash interest rates and expand balance sheets to provide liquidity and credit to the global economy. While baby steps to reverse low or negative interest rates are now under way in a few countries, balance sheets remain at a cumulative record high, having more than tripled in the last decade.
While one can debate the costs and benefits of prolonged, exceptionally easy monetary policy, it does appear to have helped lift equity and credit prices, in part as investors reached for yield. With inflation remaining stubbornly low around much of the world), there is potential for this easy monetary backdrop to persist well into 2018 or longer. Central bankers are subject to the same emotional biases as the rest of us (see Lesson No. 3). Given the choice between tightening too early and threatening a recession (not a legacy many policy makers seek) or tightening too slowly and possibly creating asset-price bubbles and/or inflation, they tend to lean toward the latter.
Easy monetary policy may be helping to support equities today, but it has also contributed to some of the economy’s growing vulnerabilities. Indeed, low interest rates factor directly and indirectly into several of the potential catalysts we are watching for the next equity-market descent — sparks that could set off the “dry tinder,” as the Treasury’s Paulson described it back in 2006.
Vehicle sales. We see several structural and cyclical forces suggesting that the auto cycle could have peaked, and historically the auto cycle has coincided with the broader business cycle (i.e., autos decline dramatically in a recession before rebounding in the recovery). Sales of new automobiles in the U.S. have slowed since December, when total sales hit their highest level since 2005 at a rate of over 18 million annualized (according to WARD’s Automotive Group). In addition, an increase in defaults of subprime auto loans is leading some to fear that autos will be the next subprime crisis. However, as the overall size of the auto market is a fraction of the housing market, and the systemic risk of subprime auto loans is more limited than that of subprime housing, we do not see troubles in the auto market as comparable to the subprime housing crisis and sparking the next recession.
Retail. Our concerns around the American retail sector are not about consumers.
Household wealth hit a record high earlier this year, helped by rising home prices and equity valuations. Consumer confidence, meanwhile, is well above pre-crisis peaks, suggesting a willingness to spend. Our peak-related worry is instead tied to a technology disruption not seen in previous cycles – a rise in online shopping that is projected to increase significantly.

The ongoing and looming hit to retail profitability is starting to leave firms with no choice but to close stores. Indeed, recent months saw some companies announce large-scale store closures with corresponding reductions in workforces. We expect this traditional retail consolidation will continue, exerting a negative influence on this corner of the commercial real estate market as well as hitting the labor market. As with autos, we do not see this retail trend as big enough to trigger a recession — U.S. retail trade, at 6% of GDP, is material but does not dominate the economy.

However, companies could use a recession as an opportunity to speed up consolidation — potentially exacerbating the next downturn.
Corporate and consumer debt. Retail weakness figures prominently in the next risk we are monitoring: corporate debt levels, specifically for non-financial corporations. Regulations since the crisis forced the financial sector to reduce leverage. This is helping mask the fact that non-financial corporations have significantly added to debt on their balance sheets during this expansion. Debt of non-financial corporations as a percentage of GDP is the highest it has ever been in the period for which we have data (since 1951), at over 72%. Though this debt burden may be manageable at current low interest rates, it could quickly change as rates normalize.
With investor positioning biased toward yield-oriented fixed income and credit (see Lesson No. 1), a faster exit from any weak sector could quickly spread throughout the broader market.

Another related pocket of vulnerability is consumer debt, even with jobless claims near multi-decade lows and overall consumer debt as a percentage of income levels at its lowest since before the crisis. These upbeat headline figures, in our view, mask underlying weakness specifically for lower-income consumers or borrowers with less pristine credit. As interest rates ultimately rise, debt payments and obligations could quickly become more burdensome, eroding support for the broader economy from the all-important consumer.
Geopolitics and policy. Identifying possible sources of geopolitical risk today, including North Korea, ISIS, and Russia, among others, is fairly straightforward. Predicting when a geopolitical risk becomes a market-moving reality, and especially one significant enough to trigger a downturn, however, is nearly impossible. That said, we continue to monitor all such potential risks as closely as we can, knowing that they can be meaningful catalysts, especially if an economy is already slowing or otherwise vulnerable.

An oil supply shock is a risk we want to watch, as it could increase business and consumer uncertainty and lift inflation. Also, we are watching political developments closely this year in Europe: while benign outcomes in elections in the Netherlands and France have calmed market fears somewhat about a potential “disintegration” of Europe, the support for anti-Europe parties and risk of surprise should not be underestimated. Another area of uncertainty is within the U.S.: what actually becomes legislation and when will almost certainly shape the length and character of the current economic expansion and equity rally.
China. The 2008–2009 crisis had a profound impact on China due to its reliance on exports to consumption-heavy economies, such as the U.S. From its cyclical peak in 2007, Chinese GDP growth slowed from 15% (year on year) to 6.4% in 2009. Although its economy recovered, the pace of growth has moderated as the economy matured. Over the past couple of years, Chinese growth has averaged a little under 7% if official numbers are to be believed. It should be noted that although China represents roughly 15% of global GDP, it makes up approximately 25% of global GDP growth.

Like counterparts around the world, Chinese policy makers relied on massive fiscal stimulus to limit a demand shock at the height of the crisis. This credit expansion has continued largely unabated since, and as a result, China’s total debt-to-GDP ratio has ballooned from 162% in 2007 to 258% currently. Many investors have been expecting that China will eventually have to go through a nonperforming loan cycle to help cleanse the economy of excessive leverage. It is beyond the scope of this piece to forecast if or when that may occur, but we believe that China’s ability to stimulate growth through credit expansion is unlikely to continue without also increasing risk materially. At a minimum, the world’s second-largest economy will keep slowing; at a maximum, it will suffer a crisis that impacts the globe given increasing trade and financial links.

When we put these trends and risks together, we are left with at least two takeaways. First, the U.S. economic cycle may be getting more mature, and there are areas of vulnerability, but recession does not seem imminent. Second, we think China is playing a larger role in the current global cycle and, if a deleveraging cycle were to occur in earnest, it could be substantial enough to trigger a U.S. downturn.
Lesson No. 3: Never Underestimate the Power of Emotion
Over the last decade, thousands of pages have been filled with how emotion, and specifically greed and fear, helped shape the October 2007 peak and subsequent crisis. Testimony to Congress, depositions, and interviews with the press all show financial executives who pushed to move up various league tables, in some cases by hiring consultants who in turn recommended taking on more leverage and/or increasing business footprints in the U.S. housing market.

Corporate executives were certainly not the only parties driven by emotion. Ratings agencies faced the same desire to succeed — easing standards for credit ratings of certain securities ahead of the peak. Homeowners, taking out home equity loans or “flipping,” gladly increased their net worth. So too did retail investors, rushing into the equities in a way not seen before. Government officials happily benefited from the positive economic backdrop (in turn helped by lax regulations around mortgages) — voters were more likely to be willing to keep their representatives in office as long as wallets were expanding and they were able to buy a home (or, even better, monetize it). And as noted earlier, even as economists and policy makers started to see the beginning of the end, they were reluctant to act too fast or too harshly, as an error could undermine the economy unnecessarily. When times are good, risks tend to be downplayed.

After October 2007, however, greed was quickly replaced by fear. The breadth and depth of the crisis meant that the same fear is still felt in corners of the economy and financial markets even a decade later. Central banks, even now with the strongest labor markets in years, are hesitant to tighten too quickly, lest the recovery lose momentum. Investors, as noted earlier, have been reluctant to go back into equities (even though, since the market trough in 2009, the S&P 500 has returned about 330% on a cumulative basis, including dividends).

At the same time, there are signs that greed is making another run for it today. The extended period of ultra-low interest rates and expectations for policy to remain relatively loose has clearly contributed to the growing auto and consumer debt issues noted earlier. It has also helped to create a low-volatility environment across asset classes. Both low rates and low volatility have encouraged investors to “reach for yield,” taking on more duration and/or credit risk for a higher return. Other investors are trying to directly profit from this backdrop through volatility itself. The market in related “vol” financial products has mushroomed in recent years, creating its own risk should it quickly unwind (especially if exacerbated by algorithmic selling). Corporations, seeing low borrowing costs, are more willing to issue debt, assuming rates will not rise quickly enough to make refinancing or servicing that debt an issue.
As we look at the world today, we see an economy that is still growing and central banks that are still supportive. However, we also see cracks in the landscape — some with no historical precedent. Rather than let fear take us out too early, or greed make us reach for the last crumbs of returns in the cycle, we take an incremental approach. Higher valuations, a more mature expansion, and growing risks, in our minds, warrant small steps to moderate portfolio risk. Our goal is to slowly de-risk into the peak, so we are less reactionary when the eventual downturn emerges. Equally, we hope to be sufficiently liquid and defensive as that downturn progresses so we can add back market exposure at better levels. Simply put, we want to “sell when others are greedy and buy when others are fearful,” ideally not too early or late.
For a more in-depth analysis, please visit: www.bessemer.com - Lessons from the Peak | Quarterly Investment Perspective    

Patterson is chief investment officer with Bessemer Trust.