Is the US bull market ending ... or just beginning?

Many investors are fearful that a bear market is overdue, given that the S&P 500 has more than tripled over the last seven years without once suffering a 20 per cent decline. But is it possible the bear market has already come and gone?

The question may seem facetious; the US market had ‘only’ fallen 15 per cent when it bottomed in early February. Technically, that’s a correction, not a bear market, which is commonly referred to as a decline of 20 per cent or more.

To many investors, however, it certainly felt like a bear market.

The average stock suffered a peak-to-trough decline of 34 per cent between last May’s all-time highs and February’s market bottom.

Furthermore, it’s been more than a year since US stocks made new highs. Investors’ patience has been tested for some time now; the large-cap S&P 500 has essentially gone nowhere over the last 18 months, while the small-cap Russell 2000 index has been flat since the end of 2013.

"Have we corrected through time, rather than through price," asked Ritholtz Wealth Management chief executive Josh Brown recently, "enough to spark the next leg higher for the bull?"

The market mood in recent months, says Brown, has been "bottom-esque", with weary investors seemingly worn down by trying market conditions. Although stocks advanced in May to within touching distance of new highs, US equity funds nevertheless suffered outflows of $13.7 billion, their largest monthly outflow since September. Global equity funds have also seen heavy outflows, so much that a contrarian 'buy' signal is on the verge of being triggered, says Bank of America Merrill Lynch strategist Michael Hartnett.

The lack of enthusiasm for equities is confirmed by sentiment surveys such as the weekly poll carried out by the American Association of Individual Investors (AAII). In mid-May, just one in five investors described themselves as bullish. By the end of the month, that percentage had slid further, to 17.8 per cent – the lowest reading in 11 years.

That means the “despondency ratio”, to use the term used by Schaeffer’s Investment Research to describe the number of investors who describe themselves as bearish or neutral, was over 80 per cent – a level seen just once since March 2009’s major market bottom.

A superficial analysis of index returns would suggest investors have little reason to be despondent. After all, the S&P 500 suffered an abrupt double-digit plunge last August but soon reclaimed those losses, while the wave of selling seen in the first six weeks of 2016 was similarly short-lived.

Actual index returns don’t tell the full story, however.

As noted earlier, the average stock endured a 34 per cent decline. Furthermore, the selling was underway long before index stress became apparent. At the May 2015 peak, 12 per cent of stocks were in individual bear markets. By July, 19 per cent of stocks were in bear markets, despite the fact that the S&P 500 had barely budged.

In November, the index was again nearing May’s high but 23 per cent of stocks were in bear markets. At the end of 2015, following another rally that had brought the index close to May’s peak, 30 per cent of stocks had fallen into bear markets. By the first week of January, almost half of stocks were in bear markets.

Accordingly, one could argue the heavy selling that followed over the next four weeks should not be seen as a brief corrective episode, but rather as the climax to a stealth bear market that had begun eight months earlier.

If so, the implications are potentially encouraging for bulls; instead of this being an ageing bull living on borrowed time, the excess may already have been wrung out of the system, setting the scene for another run higher. The obvious fundamental catalyst would be an improvement in corporate earnings, which have declined over the last year; any improvement on this front could convince underinvested fund managers to put their cash to work (fund manager surveys show cash levels have been well above historical norms for most of the last year).

Whether economic fundamentals actually improve remains to be seen, but the technical situation is certainly looking brighter. Market breadth has been poor for much of the last year; strength among a select number of large-cap stocks had masked weakness in small-cap and mid-cap sectors, with more and more stocks falling into individual bear markets.

In recent months, however, most stocks have been advancing, with large-cap stocks like Apple lagging behind. An equal-weighted version of the S&P 500, which represents the average stock in the index, has gained 5 per cent this year, approximately twice as much as the market-capitalisation weighted S&P 500.

Doubtless, bears might respond by saying that a 15 per cent peak-to-trough decline remains a correction, not a true bear market. Additionally, it’s worth noting the market action since last year’s highs has been distinctly unlike a bear market in various ways. For example, the investor mood towards the end of bear markets tends to be one of revulsion, resulting in stocks going on sale.

Even at February’s bottom, however, stocks looked richly valued relative to history. Indeed, the earnings recession of the last year meant there was little change in valuation multiples during that time.

Secondly, bull market peaks are associated with investor euphoria, but sentiment was muted even before markets topped out last year. If the May 2015 highs marked a bull market top, it will have been an atypical one.

Thirdly, while sentiment surveys have been bearish over the last year, AAII surveys also show that equity allocations have been above their historical average throughout that time. Investors may have had little faith in stock markets, but rock-bottom interest rates meant the TINA trade – There Is No Alternative – remains alive and well. Long-term market bottoms, needless to say, tend not to be associated with above-average equity allocations.

Finally, JPMorgan analysis shows past bear markets have been associated with predictable fundamental triggers.

Eight of the last 10 bear markets were accompanied by recessions; extreme valuations were present on five occasions; aggressive Federal Reserve tightening and commodity spikes occurred in four occasions.

One could argue markets have been overvalued over the last year, but the other catalysts were noticeably absent. Again, this would indicate the last year has been a mere corrective episode, not a bear market.

Identifying market environments appears easy in hindsight. Everyone knows that markets were incredibly expensive at the peak of the dotcom bubble in 2000, setting the scene for the two-and-a-half-year bear market that followed. The halving in equity prices over that period was followed by the 2003-07 liquidity-fuelled boom, which ended when the global financial crisis eventually erupted. By March 2009, valuations hit once-in-a-generation lows; those valuations, coupled with unprecedented monetary stimulus, helped usher in a multi-year bull market.

In reality, it's not that easy. Former Federal Reserve chairman Alan Greenspan famously complained of "irrational exuberance" in 1996 – four years before the bubble burst. Similarly, it appeared stocks bottomed in the wake of the September 2001 attacks, only for the bear market to last another year. When stocks began to tumble in 2008, the initial consensus was that a run-of-the-mill market correction was in store; when stocks roared higher in 2009, everyone debated if it was a mere bear market rally.

Bull and bear market cycles can be difficult to reliably identify. Should one date the bull market of recent years to 2009 or to autumn 2011, following the S&P 500’s 19.4 per cent decline? Did markets peak last May? If so, did the bear market bottom out in February? Or was the bounce of recent months no more than a bear market rally?

Coherent arguments can be made for all the above scenarios. Unfortunately for investors, market bottoms and tops are only ever obvious in hindsight.