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The bears seemed to have asphyxiated the bulls and blown them to oblivion during the first half of 2018; the bulls on Wall Street, returning from their opulent, regal New Year parties, complemented by endless bottles of Moët and Chandon and gifts consisting of Rolexes and Richard Milles, were a bit smug, intoxicated by the luxuries and pleasures that were a result of a raging bull market that blew past economic expectations and sent analysts scurrying to their desks to uncover the blunder that led to their repeated demise in 2017.
The alpha of the bulls, the Dow Jones Industrial Average (DJIA), rallied a mammoth 25.08 per cent between December 30 of 2016 to December 29 of 2017, before hitting its pinnacle at an eye-watering 26,616.71 in the beginning of 2018. Unfortunately, the equity markets have never been guided with a prudent, vigilant mindset- it's guided by the glutton's insatiable appetite for more and more, an unbounded desire that transforms the greatest boons into ceaseless curses. The skilled investor or trader is not a madman crunching numbers with a calculator in his/her hands and incessantly clicking away at stock and technical analysis charts but is instead a person who can judge when the fools in the market are greedy and when they are going haywire.
Proclaimed by the Oracle of Omaha himself, every person should learn to 'be fearful when others are greedy, and greedy when others are fearful', and by the looks of 2018, skilled investors and traders are on red alert. Twenty eighteen is the double-edged sword of the equity markets and it, starting off as a derivative of the thunderous market boom in 2017 but slowly swimming into choppy waters ahead, signals the final stretch of the second longest bull market recorded in history. Yet, the majority of investors and traders alike seem to disregard the inevitable global market recession and label it a bluff- those 'gurus' are in for a wild ride, minus the fun and games and heavy on financial losses.
Examining the US equity markets from a statistical viewpoint, the current bull market which started in March of 2009, is currently 114 months or 9.5 years old; the average bull market from 1930 has lasted 97 months. Regarding the current market scenario with a generally opaque overview that has held itself consistent with equity market history, the US equity markets have definitely breached the high point of their rollercoaster ride and are scheduled for a downtrend. The average bear market that has followed a bull market has had a lifespan averaging 18 months and recorded a loss in valuation of around 40 per cent. The previous statement postulates two different lines of thought- the first being the brevity of bear markets. In comparison to the gradual yet steady financial gains offered by bull markets, the misery and financial havoc caused by the bear ends sooner; this reveals an essential principle regarding market sentiment, which is the tendency of investors and traders to quickly shift their focus to market fundamentals during recessions. The markets too often overreact to any stimuli, whether it indicates a positive or negative financial outlook, and the overreaction often materialises and manifests itself in the form of extreme market valuations on both sides of the financial spectrum. So, bear markets are almost immediately followed by a rapid increase in valuation which eliminates losses in the financial markets; however, complete recovery of the pre-recession principal amount is not achieved until about 25 months later- so buckle up for a pleasant, yet nail-biting ascent into financial recovery.
Recessions that pare market valuations by over 40 per cent on an average require 58 months for full recovery, and most investors don't have the iron heart to hold their losing positions for that span of time, and hence significant financial losses are already recorded during bear markets themselves. On the other hand, the other line of thought that can be drawn from the effect in market valuations during recessions is that market sentiment shifts to polar opposites in short amounts of time. This mercurial temperament of the market creates massive amounts of volatility during recessions which swings and oscillates prices between the upper and lower extremes, creating disastrous trading and investing environments. The increased volatility in the price action of the markets makes it significantly more difficult to exit a position; ultimately, the large portion of gullible investors are caught in the cross-fire and lose a significant portion of their portfolio throughout the recession.
The fickle, oscillating mindsets of common investors debunk one of the most recent excuses to being negligent of the oncoming recession: the market conditions seem too good and consumer confidence seems to be too high to warrant a recession. Indeed, there is no doubt that investors have correctly judged consumer sentiment as the consumer confidence index had posted a 10-year high of 101.11 in March of the current year, but investors are neglecting the scary similarities the current consumer confidence index resembles to itself back in January of 2007, when the consumer confidence index posted a new high of 100.93 after the dotcom bubble burst. A year after January, 2007, the 2008 global recession was in full swing. This draws light to an important principle in investing: higher consumer confidence sets the stage for more flowery and fastidious projections in the future, increasing the difficulty of meeting or surpassing those estimates and upping the ante for the downside.
A miss in earnings or revenue guidance or even trivial business matters can instigate a major downtrend in the prices of a security when analysts predict hefty increases in revenue, sales, profit margins, etc. General investors, a gullible breed of people, often like to jump on market bandwagons, buying when others are madly loading their portfolios with all kinds of securities and selling when the general market is; this often results in more downside than expected. In fact, drawing from examples of earnings and growth misses of the current year, there is probably no better example than Facebook common stock. Two days after releasing quarter two financial reports, Facebook had lost nearly US$ 120 billion in its market cap, a valuation decrease of over 20 per cent within two days. The drop was largely due to expected declines in profit margins and declining user growth for Facebook's social media platform as discussed in conference call of the earnings quarter by Facebook CFO David Wehner. These downsides of the earnings reports marred Facebook's attractive valuation, investments and growth numbers.
In spite of a projected pullback in profit margins from 44 per cent to about 30 per cent within the next few years, Facebook still maintains a P/E multiple of around 24, which is extremely undervalued, given the future revenue prospects in ad revenue Facebook will receive not only from Facebook.com but also from Instagram, Whatsapp and Messenger, major social-networking platforms with proliferating user growth and massive appreciation in revenue from quarter to quarter.
Several critical market valuation indicators are already flashing the overbought signal in the current year. Generally, a price to earnings multiple of 20 of the SP 500 index seems to be a historical resistance point for it as recessions seem to follow the markets rather rapidly after the P/E multiple of the SP 500 has eclipsed 20. The recent high of 24.46 in January of 2018 is yet another sombre note in the melody of the equity markets and is indicative of a recession in the near future.
Additionally, if one takes a close look at the historical chart of the P/E multiple of the SP 500, they will notice the multiple to have consolidated quite a while back, hovering around the low and mid 20s from July of 2015. A consolidation around this range will usually be followed by a downtrend of the P/E multiple, which is a result of and indicates falling security prices. A quick look at the Warren Buffet Indicator, which gages the market capitalisation of the entire US market to that of the GDP, proves that the current valuation of the equity markets is 147.6 per cent of the US GDP.
Generally, used by the traditional value investor, readings above 100 on the Warren Buffet Indicator signal an impending bear market or recession; as the Indicator has gone through the test of time, the 2008 market crash can be analysed. During that time, the core of the American Indexes, the Dow Jones Industrial Average, declined about 45 per cent and prior to the crash, the total market capitalisation of the US stock market was about 108 per cent of the then-current GDP. Of course, it is not appropriate to judge an equity market just by consulting a single indicator, but the general investor, who is currently preoccupied with the astounding growth margins of companies, should pay heed to eye-wateringly high premiums he/she is paying for any company.
Although, the human breed of investors have been sniffing lucrative deals out for centuries, the majority of them do not learn one basic lesson in investing- patience is a virtue associated with every movement in the markets. Deriving a conclusion from that, it is important to note that the market doesn't crash in a single trading day.
Lastly, a pullback in the equity market cannot be discussed without consulting the yield curve, which measures the return on long-term government bonds, commonly the US 10- year treasury note, against short-term bonds like the US 2-year note. When the difference between the yields of the two bonds is high, the general economy has a lot of room to grow and expand. However, economic growth starts to dwindle when the yield curve starts to plateau and ultimately falls, leading to a recession, when the yield curve inverts and starts its trajectory downhill. Yield curves invert when shorter term bonds pay a higher yield than longer term counterparts. Currently, the yield curve in the US is plateauing, and it is predicted that the curve will begin its downward slide as early as the middle of 2019. Yield curve inversions have historically been a sign for impending recession, and investors should be cautiously watching yield curves that are signaling the end of a glorious bull run.
Never has it been possible to augur an equity market recession, and this article is not attempting to predict the exact timeframe in which the market will begin its way down, but rather this article aims to bring sanity into the minds of many investors with investments in the US market. Plenty of hedge funds seem to already be preparing for the downturn in the markets as hedge funds like Bridgewater associates currently hold large gold reserves (gold generally moves inversely to the markets). In the end, let us hope the bull prospers and the bear withers, but let us also be mindful of the bear prowling behind the bushes.