The annual Running of the Bulls was held in Pamplona last month, in a tradition that dates back to at least 300 years before the signing of the Buttonwood Agreement (the precursor to the New York Stock Exchange). Not to be outdone, Wednesday of last week saw a celebration of sorts for our own “running of the bulls” - the longest bull market in history for stocks, at 3,453 days and counting.
Bull markets are, somewhat ironically, defined more by what they aren’t than what they are. As long as stocks don’t drop more than 20% from a peak, the bull market keeps running. If they drop more than 20%, the bull market gets posthumously dated to the last peak and all of a sudden you’re in the middle of a bear market. Or they don’t get backdated and you have to wrap your head around having lived through a Schrodinger’s cat-esque market that was technically both bull and bear since the last market peak. Not to worry though! As of this writing the S&P 500 has surpassed the January 26th levels to reach a brand new all-time high, so this bull market still has legs. Probably.
Interestingly, despite being in the first-longest and second-best bull market for stocks ever (yay!), we are, at the exact same time, in the middle of arguably the slowest, weakest economic recovery ever. Booo.
Good news - the reconciliation is easy. They’re both true. The economic recovery has been tepid for a decade, and stocks have been red hot for a decade. It’s kind of like a some weird Gaussian gun, with the Fed acting as the neodymium magnets in the middle.
There’s a saying - “bull markets don’t die of old age”. It means that length of time is not a valid reason to be wary of stocks at the moment, despite now being at the longest ever point of the upswing in what is essentially a cyclical pattern. No, it means that, much like their brethren in Pamplona, what kills bull markets is a surgical strike between the vertebrae that pierces the heart. A strike that tends to be delivered, ironically enough, by the Fed raising interest rates, but could theoretically be caused by any number of things at the moment - the Fed, trade wars, inflation, a geopolitical crisis, an onslaught of investigatory and/or impeachment proceedings from the House after the mid-term elections... Given the run up stocks have had in a relatively soft economic recovery, we don’t believe that a full on recession is a necessary condition for this bull market to come to an end. All that is necessary is a slight shift in investor expectations.
June’s note (The Price is Right: Part 2), looked at return expectations given current market valuation levels, specifically using a pricing ratio method (P/E multiples) and a cash flow method.
Hopefully that above graph shows up for you, because a) it’s pretty cool and b) we made it for once rather than borrowing off the interwebs, and the last time we tried that it didn't work so well. The red line is corporate profit margin (left hand axis). From 1950 to roughly 1982, that profit margin (for the US economy as a whole) averaged 6%. Then from 1982-ish to 2002-ish, it averaged 5%. Since 2005-ish, it has averaged roughly 10%. Sustainable? Unlikely. Profit margins are one of the most mean-reverting data series in business. If profit margins continue declining (like they have been since 2012-ish), then there’s a better than even chance earnings will decline, and from the P/E pricing ratio methodology, P (the price of the stock market) will decline as well. It also means that g, and likely d, from the cash flow method decline, so there’s no help there.
For our socialist-leaning friends out there, we included the blue line in the chart above - it shows wages as a percentage of GDP (right hand axis). We would point out, however, that further reduction in profit margin doesn’t necessarily need to come from an uprising of the proletariat. Simply increasing trade tariffs (to say nothing of a full-blown trade war) would do the trick as well.
A less tangible threat to this bull market is investor confidence. Cash is an uncomfortable asset to be holding in the midst of the longest bull market advance in history. Partly because of that discomfort, people are willing to keep running through the streets of Pamplona, buying stocks at elevated valuations, because it feels better than sitting behind the fences watching the bulls race by. At certain times, however, holding cash is a very comfortable thing. It was very comfortable in early February of this year. It will be very comfortable again as soon as there’s another “let me just wait and see how this plays out” sentiment among investors.
Here’s what we mean - stocks, right now, are priced perfectly. And by “perfectly” we mean stocks are priced for lower interest rates and elevated profit margins to continue indefinitely. Take a look at Coca Cola - (disclaimer: we have nothing at all against Coca Cola...not only are they headquartered here in Atlanta, but they make Fanta, which is arguably the best non-root beer soda on the market today)
2007 was the height of the last bull market. Here are Coke’s financials from 2007:
Current Coke financials:
Take away from the take away: WHAT?!?!?!
But here’s the thing - if interest rates stay low forever and Coke keeps buying back shares of their own stock and profit margins stay high, then there’s nothing fundamentally wrong with those numbers. And in fact, they’re not terribly out of line with the rest of the market right now.
What happens though when investors begin to say “nah, I don’t feel like buying Coke at 82x right now...let’s just see how this plays out and maybe I’ll buy at 65x”? Adiós bull market. Or, to poorly translate an idiom, meterlo un tenedor.
Is running with the bulls a stupid idea? Probably. Would we do it anyway? Of course. Are we talking about Pamplona or the stock market? Both.
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