Let’s start with the easy bit! There’s no evidence that old age (i.e. duration) or high valuations are in fact a useful guide to when a bull market will end.
We’ve shown the length and strength of past bull markets in the chart below. With cumulative returns ranging from 43% to 417% over periods of time as short as eight months to as long as a decade, it’s clear that there is no reliable pattern.
Another frequent theory is that the bull market will end soon because valuations are very high, as it did with the Dot-com bubble of the 1990s when price-earnings ratios reached a lofty 28x. However when the bull markets of the late 1970s and early 1980s came to an end, price-earnings ratios were only in single digits – far from bubble levels.
Are market events better indicators?
Instead of looking for past indicators or patterns, we argue it is more useful to identify events or catalysts that can end a bull market and trigger a bear market.
Mapping the economic cycle onto asset class returns, we see that when most bull markets ended, a recession occurred within the next year. It also appears a turn in the credit cycle is another systematic bull-killer, with seven of the past eight bull markets ending around the time when the global yield curve was flat or inverted.
Though this may seem intuitive that there is this connection, there were exceptions to these occurrences, highlighting that there are often other factors at play. This means that they are not necessarily conditions for a significant equity market correction, but they certainly make it more likely to occur.
Don't stress the little things
Just as important as correctly forecasting the end of a bull market is avoiding prematurely forecasting it. Our macro mapping work shows that equities typically deliver the best risk-adjusted returns throughout the expansionary phases of the economic cycle, so ‘long equities’ should be the default position for the majority of the expansion.
Looking more closely at the period around the start of recessions, however, shows that equities tend to fall in anticipation of the recession. On average the peak in equities occurred about six months before the start of a recession.
This has several implications for investors. Assuming investors have imperfect timing skills for the start of a recession, it would be prudent to become more cautious on equities as the economic cycle progresses into its late cycle phase.
It also suggests that while the economy remains in a mid-cycle environment and recession risk is deemed to be very low, it is important not to get too stressed about things that are unlikely to change one’s view of the cycle.
Our approach to medium-term risk taking is driven by three key factors:
- the economic cycle
- valuations and
- the probability of a financial crisis.
Focusing on these factors in combination with the above analysis of how bull markets end allows us to concentrate on what really matters, ignore the noise and benefit from the bull market that started in 2009.
Adapted from "How Bulls Die...", Lars Kreckel, Fundamentals. For those interested in the original piece, please click here.