While rustling through old research notes, we happened upon a report from the highly regarded Bank Credit Analyst or as it is better known BCA research. The title “Timing the next bear market”. This report, written in January 2014. The opening line refers to the appropriateness of assessing the likelihood of the end to the US equity rally.
The report highlights themes they view are the leading indicators for an impending bear market. Their definition of which is an index decline of more than 15% lasting for three months. We will use these themes to compare what leading indicators are currently predicting.
The first theme is the monetary conditions. Tighter monetary conditions eventually lead to a slowdown in economic growth. Monetary conditions have tightened this year in the US, mainly as a result of a higher USD. Real Fed funds rates suggest that US monetary policy is now restrictive, having been accommodative for the past ten years. But not to the degree that has caused economic recessions in the past.
Next valuation, we won’t spend too much time on that one as it is not a good indicator. Valuations of US equities may look a tad rich at present. One thing that can be acknowledged is the richer the valuation, the higher the risk of reduced returns in the future.
Technical indicators, momentum weakening is one. Measures of euphoria another. We saw what euphoria did to the stock market in early 2018. Looking at recent fund flows, and anecdotal evidence from the AAII retail investor survey and the CNN greed fear index. Investors do not appear euphoric at present. Their last one father time, stock markets are cyclical but tend not to die just from old age, in our view.
Monetary signals BCA favours the yield curve. They prefer the gap between the three and five-year maturity. At present, the gap is two basis points in yield, close to but not yet inverted. The other measure they monitor is real short rates. The difference between the return on short interest rates and the current rate of inflation. That is currently around zero. Historically interest rates tend to be several points above inflation leading into a downturn.
According to BCA, Leading Indicators do a good job of signalling recessions it’s not so good at giving a warning of bear markets. The current OECD leading indicator is now its lowest since 2008. Historically, at the current level, stock markets offer short term losses but recover within a year. Let us say the jury is out on this one.
BCA conclude that monetary conditions are the best leading indicator. In a nutshell, what the Federal Reserve do with interest rates. We would add in the oil price as another factor. Spikes in the oil price invariably lead to economic recessions. Another is the US consumer; at present, the US consumer continues to spend. The trade war could pose a problem for the Fed as it pushes up prices and restricts growth. Not an easy environment to set monetary policy in. If possible, the central banks appear to be keen to avoid an economic recession at this time. For those who are of interest, BCA concluded at the end of their report in 2014; monetary conditions suggested the bull run to continue. They were right.