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Market Outlook 2020: Market Fundamentals
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In the face of low interest rates around the globe, many investors have turned to higher-risk assets as sources of portfolio return. Of all sovereign bonds, 20% sport negative nominal yields and about 60% offer nominal yield less than 2% (with inflation near 2.3%). Global sovereign bonds offer a mean yield near 1.0%. Extremely low yields and abundant liquidity, fueled by the easy money policies of central banks, are feeding investor appetites for high-risk assets as sources of portfolio return. These actors have been the primary drivers of the current equity market boom.

Figure 11 compares daily bottoms to daily troughs, the fundamentals during the last 15 equity bull markets since June 1932. The median duration of the bull markets was 44 months with their mean cumulative total return at 89.6%. The current bull market (February 2009 – January 2020) has been running for 131 consecutive months—85 months longer than the median duration of all bull markets and 20 months less than the longest bull market, which lasted 151 months and ended in November 1961. The current bull has recorded a 449% total return, second only to the 807% bull ending in 1961.

Fig 11. Inflation - Bulls + Bears PEs + Factors
1The 12-month trailing (12mT) PE, the prior 12m PE on S&P 500 while the normalized P/Es reflects the mean month-end. Past performance is not indicative of future returns. Source: Federal Reserve Economic Data (FRED), calculated by Arrow.


Historically, stock market fundamentals such as price-to-earnings ratios (P/E) and dividend yield (Yld) revert to their norms (medians), which have a normalized P/E near 16 and a 3.4% Yld versus 26.7 and 2.0%, respectively, in the current bull market, putting the current valuations 70% above past bull market norms.

U.S. stocks continue to set all-time highs in 2020. However, foreign stocks are weak with global economic growth near 2.5% with U.S. Real Gross Domestic Product (RGDP) at 2.4% in 2019, down from 3.0% in 2018. Central bank policies and low interest rates have buoyed stocks and other risk assets.

Sir John Templeton wisely noted that bull markets are “born on pessimism, grow on skepticism, mature on optimism and die on euphoria.” The salient late-stage questions are: “When will the market be too optimistic and when will investor euphoria end?”

Being aware of prior bull market hysteria can be painful for investors who are not prepared. Instead, they should make independent decisions that lead to potential profits, like making sure their overall portfolio is well diversified. Remember, financial markets are always shifting between greed and fear. Historically, a declining market has always come back, regardless of how shocking the events were that drove it down.

The far-left side of Figure 11 shows 15 market declines on a month-end basis with a median duration of 17 months and their percentage declines resulting in a median -23.3% decline (all declines were greater than -20% on a day-end basis, not shown).

The lines between optimism and euphoria are blurred but, not unknowable. There is no sure-fire method for signaling a bear market. Stocks are always risky, but they are riskier at times when current fundamentals are far above market norms. Take a holistic approach, therefore—do not just look at previous bull and bear markets. Rather, define your own risks versus reward measures and then adjust your portfolio to fit your “views, needs and times” rather than the whims of euphoria and panic.

Figure 12 compares the fundamentals of the equity bull market after the last 15 bear markets. The current bull market is overvalued based on its normal P/E. At some point, all market fundamentals will revert to their means. Time and valuation alone are not enough to kill a bull market run.

The problem with this most obvious and seemingly simplistic question is that the lines between optimism and euphoria are unknown. Moreover, there is no sure variable or omniscient equation that tells us when the market is going to go down. In reality, the risks inherent in equity markets generally continue to grow until one day they randomly overpower the market into a sharp and sometimes protracted decline. So what can we do? We take a holistic approach to assessing the general stage of the market. Specifically, we look at previous bear markets, and instead of trying to find one infallible method to define their onset, we look for simple patterns that tend to repeat.

In the past, poor equity market performance has been preceded by high market valuations, investor concern about growth (as evidenced in the yield curve) and unhealthy levels of leverage. Although no single condition is an infallible predictor of equity markets, an understanding of where we are with respect to these aforementioned predictors has proven useful for enterprising investors.

In the last 25 years, the S&P 500 has experienced two bear markets and two corrections. While the tech bubble and the great recession bear markets are widely referenced by investors, the two corrections in Figure 12 surprisingly receive little attention. While the two corrections beginning in June 1998 and in March 2012 both caused quick erosion of shareholder value and raised the question of an impending bear market just like the recent periods of U.S. equity market volatility, these corrections were short-lived and were immediately followed by a continuation of the secular bull market for the S&P 500. In order to decipher the differences between each environment, we have identified four valuation metrics for the S&P 500, four U.S. Treasury yield spreads and three leverage ratios that serve as useful indicators of equity market health. These are shown in Figure 12 which compares the state of the last two bear markets based on month-end data.

Yellow indicates a value above the 70th percentile and red indicates a value above the 85th percentile for each variable.

The bear market checklist indicates that the equity markets showed signs of weakness prior to the bear markets of March 2000 and September 2007. In particular, the markets prior to the tech bubble bear market showed nine out of 11 indicators beyond their 85th percentile values and one other indicator beyond its 70th percentile value, registering a sell score of 9.5/11. In addition, the checklist shows that prior to the great financial crisis bear market, equity markets began flashing red and yellow for extreme values in each of the three categories prior to the massive drawdown. An investor using the checklist to begin exercising caution would have reduced portfolio losses in each case.

Fig 12. Bear Market Checklist
Past performance is not indicative of future returns. Source: Bloomberg, Federal Reserve Economic Data (FRED), calculated by Arrow.


We notice a similar pattern within the checklist when examining the June 1998 and March 2012 corrections. In June of 1998, the checklist flashed extreme caution with 70th and 85th percentile values flashing in each category. After the short-lived correction, the market returned to its bull market state for about 1.5 years, but indicators worsened eventually, leading to the tech bubble bear market. However, in March 2012, the S&P 500 experienced a short three-month drawdown, but returned to the secular bull market as the indicators only showed a sell signal of 1/11. Investors who reduced their exposure in fear of a pending bear market missed out on a multi-year period of double-digit equity returns.

The Arrow bear market checklist shows that we are in the middle of a June 1998 and a March 2012 situation. While risks exist in today’s market, there seems to be merit to investing in equities as late cycle returns are significant creators of investment wealth. While valuation indicators are starting to turn yellow and yield spread indicators are flashing red, leverage levels are low and our sell signals do not visually look anything like the bear market of 2000 that began only a year and a half after the correction beginning in June 1998. Instead, our bear market checklist indicates that an enterprising investor should remain invested and monitor whether or not certain indicators begin to further evolve towards a sell score of beyond 5, which would indicate a more unfavorable risk/reward trade-off.

We recommend that investors stay invested in equities, but assume a more defensive positioning. Specifically, we recommend U.S. value and international equities where valuations are more attractive, dividend yields are higher and returns are less sensitive to estimates of future growth. In our view, domestic and international value will enable investors to achieve the late-cycle returns that can be substantial while limiting exposure to fast erosions of wealth that are characteristic of equity bear markets.

Fig 12a. Bull Market Performance Fig12a-MarketOutlookPart4.jpg
Past performance is not indicative of future returns. See asset class proxy disclosure. Source: Morningstar, calculated by Arrow.

Asset Class Proxy Disclosure:
Past performance does not guarantee future results. Categories display the returns of current funds in the Morningstar category during the time period shown, subject to survivorship and/or re-categorization. Index and strategy research returns assume reinvestment of dividends, but do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and are not available for direct investment. 

Asset class proxies (in order as shown above by figure): Figure 11: SPX (S&P 500), Figure 12a: Equity (S&P 500).