On Thursday, just as the S&P hit its latest all time high, the broad US equity index surpassed the 266% increase recorded during the 1949 to 1956 bull market from its March 2009 "generational lows", in the process becoming the 3rd strongest bull market - artificial and central bank-driven as it may be - in history.
It also prompted Citi to calculate the odds of an imminent market correction (one starting in the next 3 months) at 45%.
At the very same time that Citi was calculating the probability of the next crash, Goldman was doing the exact same analysis, and while we thought Citi's take of the immediate future was gloomy, Goldman's is downright apocalyptic because as the bank's global equities strategist Peter Oppenheimer writes in his recent "Bear Necessities" report, Goldman's Bear Market Risk Indicator has recently shot up to 67%, prompting Goldman to ask, rhetorically, "should we be worried now?"
The simple answer, as shown in the chart below, is a resounding yes because the last two times Goldman's bear market risk indicator was here, was just before the dot com bubble and just before the global financial crisis of 2008.
What happened next is vividly familiar to most except the current generation of 2-some year old hedge fund managers who have yet to see a 20% (or even 10%) correction.
Back to Goldman, this is how the world's biggest incubator of central bankers explains the above startling observation:
To be sure, the last thing Goldman wants to do is cause a wholesale selling panic (we assume), and predictably Oppenheimer immediately rushes to mitigate the dire implication of the above chart, writing that "if we exclude valuation from the index, the level falls into the low 60% category. On historical relationships this would imply a 50/50 probability of a bear market in the next 12 months. The chances of a bear market are still high (based on the historical relationships) over the next 2 years, but remember that at any point in time the chances over 2 years can go up."
Not satisified with that footnote, and perhaps concerned about the flood of phone calls on Monday by worried clients demanding an explanation for this startkly realistic take, Oppenheimer doubles down and explains that while Goldman's Bear Market Risk Indicator is currently at 67% and this would suggest that the risk of a bear market is high, "there are three reasons to worry less than in the past.
- First, inflation has played an important part in rising bear market risks in past cycles. Structural factors may be keeping inflation lower than in the past, and central bank forward guidance is reducing interest rate volatility and the term premium. Without monetary policy tightening much, concerns about a looming recession – and therefore risks of a ‘cyclical’ bear market – are lower.
- Second, financial imbalances and leverage in the banking system have been reduced post the financial crisis. This makes a structural bear market less likely than in the past.
- Third, valuation is currently the most stretched of the factors in the Indicator. This is largely a function of very loose monetary policy and bond yields. Excluding valuation (the grey line in Exhibit 1) reduces the level of the Indicator to a more comfortable level.
Well, it really reduces it to a level that is about 5% lower... and still on par with other pre great-crash levels.
With that background in mind, here are some additional warnings from Goldman on what may be an imminent 20-50% market crash correction:
Bear markets are inevitable: the question is not if, but rather when, the next one will occur. The problem is that, while bear markets are very obvious with the benefit of hindsight, they are very difficult to identify in real time. Many corrections turn out to be short-lived and relatively benign, and it is difficult to know in the middle of a correction if it will be short-lived or turn into a full bear market. Some factors tend to lead bear markets but they also have a tendency to provide false signals at other times. Some are more reliable but can reach worrying levels a year or more before a bear market. While it is not possible to find factors that give a reliable signal prior to the precise peak of a market, it is reassuring that it is less important to pinpoint the peak than to avoid a long bear market. Being a little too early, or even a little too late matters less than recognising the signals that avoid the longer decline.
Being a little early or a little late matters less than avoiding the longer decline
There are two reasons for this. First, while the final 3 months of the bull market (using US data as a proxy) tends to be a rise of 7%, the first 3 months of the decline is a rather similar amount (Exhibit 4). If you miss the peak but sell after the first 3 months, you are roughly at the same position as the investor who sold 3 months before the peak. The bigger issue is avoiding the further 20-25% of declines that often follow.
Next, Goldman reminds its clients that even if it is right, and a crash is imminent, they still have a chance to sell during the so-called "bear market bounce."
Bear markets do not tend to occur in straight lines. There is nearly always a bounce after the initial decline, providing investors with another opportunity to reduce risks if there are sufficient signals at the time to suggest a further decline is likely. The profile of the average bear market (starting in the post-war period and using US data) is shown in Exhibit 5. It shows an average profile, with the range of experiences in the blue shaded area. However, this is an oversimplification because the period over which the bounce occurs does vary, and sometimes the market has a correction and then a rally even before the actual peak (1987 and 2007 are examples). On most other occasions the market correction comes after the peak; this tends to be followed by a bounce as the market recovers towards the peak before reversing again. But the common factor in all cases is that, with the exception of 1998, a correction and bounce can be clearly observed.
This brings us to the current, "most unloved" of bull markets. This is what Goldman had to say about it:
Since the 2007 financial crisis, fears of recession and secondary bear markets and corrections have never been far away; for much of the past few years investors have struggled to shake off the shadow of the global financial crisis and the great recession. This has meant that the current bull market is likely the least ‘loved’ and in many ways the most unusual in history. The current upswing in equity prices is already among the longest and strongest in history, and many investors are clearly wondering how much longer it can last. This reflects both the very unusual nature of the economic and stock market recovery of recent years (plagued by weak economic and profit growth and persistent fears relating to the financial system), as well as the unprecedented role played by policy adjustments (and QE) adopted to soften its impact.
While Goldman goes into significant detail next, laying out the current risk factors, below we summarize the four main reasons why Goldman believes investors are focusing on the increasing risk of a bear market:
- The current bull market is already relatively long-lived and strong by the standards of history.
- On many measures equity markets (and other financial assets) are expensive versus history.
- Margins (at least in the US) are at record highs, raising the prospect that they might have peaked.
- After years of extraordinarily low interest rates and QE, which have driven and supported financial returns, we may be close to a turn in the policy cycle.
To underscore the last point, Goldman also adds one of our favorite charts, the one showing that while there has been virtually no inflation (and for commodities, there has been deflation) for the real economy, asset prices are currently going from one bubble to the next, in short: the Fed has blown constant financial asset bubbles, even if its impact on the broader, "real economy" has been non-existent. To wit:
The long economic cycle that we have been enjoying is, in part, a reflection of loose monetary conditions and low interest rates. Exhibit 17 is a simple but effective way to demonstrate this effect. Taking data back to 2009, the start of the period of extraordinary monetary policy, we can see a very big difference between ‘prices’ in the real economy – measures of wages, consumer price inflation, house prices, commodities – and asset prices. Also shown here is the long-run average nominal GDP growth and nominal GDP growth over this period for the US and Europe (in red). Financial assets have significantly outstripped both nominal GDP growth and inflation in the real economy, largely as a result of rates staying low.
Next Goldman goes into great detail looking at overlapping patterns in historical bear markets, which we look in greater length tomorrow, but these can be summarized as follows: Bear markets typically fall into one of three categories, dictated by the cause of their onset – cyclical, event driven and structural. Each has their own unique characteristics such as severity and longevity:
- Cyclical bear markets are the most common and a function of the economic cycle. They typically see prices fall by ~30%, last an average of 26 months and take four years to recover to the previous peak.
- Event-driven bear markets are typically the result of an exogenous shock, such as war. They are not typically associated with a domestic recession and are both the least severe and shortest type of bear market with falls of 26% over seven months, and on average take 11 months to regain these losses.
- Structural bear markets are caused by structural imbalances and financial bubbles, and are typically the most severe. They can result in market prices halving, typically last around three and a half years, and take a full decade to return to previous highs.
What Goldman is really saying here is that while a bear market is now not only inevitable, but imminent, the only question is how sharp and how prolonged it will be. More on that in a later post.
The next question is what are the triggers? Goldman has examined over 40 variables around bear markets...
... and identified the five factors that, in combination, provide a reasonable guide to bear market risk: valuation, ISM (growth momentum), unemployment, inflation and the yield curve.
Together, these generate the bank's Bear Market Risk Indicator which is currently flashing red.
While no single indicator is reliable on its own, the combination of these five seems to provide a reasonable signal for future bear market risk. All of these variables are related. Tight labour markets are typically associated with higher inflation expectations. These, in turn, tend to tighten policy and weaken expectations of future growth. High valuations, at the same time, leave equities vulnerable to de-rating if growth expectations deteriorate or the discount rate rises, or, worse still, both of these occur together.
To aggregate these variables in a signal indicator we took each variable and calculated its percentile relative to its history since 1948. For the yield curve and unemployment we took the lowest percentiles relative to history, while for the other indicators we took the highest (see Exhibit 37). We then took the average of these.
Putting it all together, Oppenheimer writes that "our aggregate Bear Market Risk Indicator shows the average of these factors. Historically, when the Indicator rises above 60% it is a good signal to investors to turn cautious, or at the very least recognise that a correction followed by a rally is more likely to be followed by a bear market than when these indicators are low. By the same token, when the Indicator is very low, below 40% (as was the case in 1975, 1982 and 2009), investors should see any market weakness as an opportunity to buy."
Of course, the last bit was superfluous, as currently the indicator it not only not very low, but is where it was back in 2000 and again back in 2007...
That said, since the world's largest investment bank can not credibly say a crash is imminent without then being blamed by millions of investors (and its own clients) for starting a panic and being scapegoated as the catalyst that launched what will be the biggest crash in market history, it has to hedge, and sure enough it does just that:
... we believe there are three potentially mitigating factors: (1) structurally lower inflation, (2) a lack of financial imbalances or excessive leverage in the financial system, and (3) valuation is the most stretched of the five indicators. This is largely a function of very loose monetary policy and bond yields; excluding valuation reduces the level of the indicator to a more comfortable level. Consequently, we conclude thatan extended period of low returns is more likely than an imminent bear market.
Indeed, having sketched out the future, and the fact that what comes next is ugly for market bulls, Goldman does the prudent thing and backs off, letting someone else be the fall guy for what happens next, whether that someone is the Fed itself by tightening into a recession as Deutsche Bank hinted earlier, or Donald Trump himself, whose honeymoon with the S&P500 has lasted far, far longer than most would have imagined...