When the bull becomes the bear

Dec 03, 2019
As the days of the current bull market appear numbered, investors need a strategy to see them through more volatile times.

By Cormac Lucey

The Capital Asset Pricing Model (CAPM) contends that the risk involved in buying any financial asset can be divided into diversifiable risk (which can be effectively eliminated if you spread your investments sufficiently) and non-diversifiable risk (which is the specific, non-market risk associated with the asset). Financial studies tend to focus on the non-diversifiable risk element (measured by beta), as this is a key driver of the security’s cost of equity and thus, of its cost of capital. Many market practitioners, by contrast, concentrate instead on the overall direction of the market. Get that right, and you are likely to make money even if your choice of assets is poor. Get that wrong, and even a good choice of assets may go unrewarded.

Berkshire Hathaway is an example of a great stock to have owned over recent decades – over the last 31 years, its share price has risen at a compound annual growth rate of just over 18%. But you would have suffered significant losses if you had held the stock during the last two equity bear markets: between March 1999 and February 2000, its share price dropped 44%; and between December 2007 and March 2009, it fell 47%.

What do today’s investment signals indicate about prospective equity returns? Excuse me if the following analysis is USA-centric, but in general global equity bear markets begin and end in the USA. Looking at America, there are two clear warning signs that the days of the current bull market – which commenced over a decade ago, in March 2009 – are numbered.

The first warning sign concerns the US unemployment rate. There is a clear pattern over the last half-century that US recessions and bear markets occur after a prolonged fall has brought the American unemployment rate below 5%. There is also an established relationship between the US unemployment rate and one-year equity returns: if the US unemployment rate exceeds 7%, average annual returns exceed 11%, but if the unemployment rate is below 4.5%, average returns are just 1.3%. As of September, the US unemployment rate was a mere 3.5%. The logic of this relationship is that, while lower rates of unemployment are good for workers and society, they can stoke wage inflation, business costs and thus central bank interest rates. The negative effects exert a negative influence on equity values.

The second warning comes from the yield curve. It depicts the annual rate of interest investors can get from US government bonds of differing maturities. Normally, investors get a higher rate of interest when they expose themselves to greater risk by purchasing government bonds of longer maturities. Very occasionally, we get an inverted yield curve, when the rate of interest on short-dated government bonds exceeds that on longer-dated ones. Inverted yield curves have, in the last 50 years, been unfailing warnings that a US recession will occur within 24 months. In recent months, the US yield curve has inverted.

While these two warnings strongly indicate a US equity market peak sometime within the next two years, neither signals the need to head for the exit door immediately. Indeed, some of the largest investment gains can be made towards the very end of bull markets. Citi Research maintains a Bear Market Checklist of 18 different signals. In March 2000, 17.5 of the signals were flashing red. In October 2007, it was 13. In September, just four of their 18 indicators were signalling warnings.

This suggests that investors should remain positive on equities, but they should also plan now what their investment strategy would be in a bear market. Will they reduce their equity exposure, switch entirely to bonds and cash or are they willing to short the market (and seek to profit from falling equity values)? Investors now need to shorten their investment horizon and switch from a long-term buy and hold strategy (which works wonderfully over prolonged bull markets) to a short-term tactical approach (which will be more suited to the choppy investment waters that appear to be ahead).

Cormac Lucey FCA is an economic commentator and lecturer at Chartered Accountants Ireland.