"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."
Thus spoke Goldman Sachs strategists in their recent Global Strategy Paper, "Bear Necessities. Identifying signals for the next bear market". The 41-page report lines up the prime reasons as to why investors might be feeling antsy and uncomfortable in the present context:
1) The current bull market is already relatively long-lived and strong by the standards of history. Depending on one's definition, this bull market in US equities can be categorised as the second longest on record, as well as the second strongest on record.
2) On many measures equity markets (and other financial assets) are expensive versus history.
3) Margins (at least in the US) are at record highs, raising the prospect that they might have peaked.
4) 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 central bank policy cycle.
Offsetting these major concerns are two major sources of support:
1) The free cash flow yield is high (this is true in most equity markets). This, explains Goldman Sachs, is a direct result of companies having held back on capex.
2) Equities are cheap versus bonds. This, of course, remains the case today, and probably for a while to come.
Historical research has taught Goldman Sachs to distinguish three types of bear markets:
1. Cyclical bear markets - typically a function of rising interest rates, impending recessions and falls in profits. They are a function of the economic cycle.
2. Event-driven bear markets - triggered by a one-off ‘shock’ that does not lead to a domestic recession (such as a war, oil price shock, EM crisis or technical market dislocation).
3. Structural bear market - triggered by structural imbalances and financial bubbles. Very often there is a 'price' shock such as deflation that follows.
By splitting bear markets into these groups the strategists find that:
- Cyclical and 'event-driven' bear markets generally see price falls of around -30%, while structural ones see much large falls, of around -50%.
- Event-driven bear markets tend to be the shortest, lasting an average of 7 months, cyclical bear markets last an average of 26 months and structural bear markets last an average of three and a half years.
- Event-driven and cyclical bear markets tend to revert to their previous market highs after around 1 year, while structural bear markets take an average of 10 years to return to previous highs.
So how do we recognise a bear market? Answer: we don't. Given every bear market is different, and caused by different triggers in different contexts, it is plainly impossible to recognise one in advance. Investors who often sell too early are most times not better off than those who wait until the early phase of the ugly bear market announces itself.
As long as one manages to avoid the bulk of the downturn, being early or not matters little, suggests Goldman Sachs. A lot of the research depends on timelines and on definitions used, something the strategists readily admit. For example, they'd be inclined to include April 2011 as the starting point of a brief bear market that lasted five months and ultimately pulled back US indices by -19%.
Including that particular bear market means today's bull market is merely of average length, instead of the second longest in history. The first part of that sentence would make investors a lot less worried than the second part currently does.
The end conclusion from the report won't encourage many investors who'd like to be prepared for when the next bear market arrives: the reliability of indicators tends to be low. "Sometimes it is not a single factor or event but a combination that can contribute to a bear market. On occasion it is not even possible to identify the key trigger even after it is over."
Undeterred, the strategists have selected five indicators that have worked best together, historically, in identifying the next bear market. These five are:
1. Rising unemployment as a precursor to the next economic recession with low unemployment identified as a consistent feature prior to most bear markets
2. Rising inflation has been an important contributor to past recessions and it tends to trigger monetary tightening
3. Flat yield curve; Goldman Sachs argues a flat or inverted yield curve in combination with high asset valuations can be a useful bear market indicator
4. Momentum indicators such as ISM and PMI surveys; typically, when momentum is elevated there's but a reasonable chance the pace will deteriorate and eventually move below recession levels
5. High valuations; they never trigger a bear market in isolation, but in combination with other fundamental factors, high valuations can imply the risk for another bear market is elevated.
Combining all of the above, Goldman Sachs strategist are of the view that while the risk for the next bear market is relatively high right now, suggesting the next market correction has the potential to morph into a bear market, they remain of the view the odds favour low return over the next twelve months rather than a true blue bear market.
The key to their non-bear market outlook is the shift in inflation risk, as "without rising inflation expectations, monetary policy can stay looser with interest rates much lower and more stable than in the past".
Here's the final conclusion from the report: "The combination of higher valuations but lower prospects for interest rates and inflation volatility leads us to expect lower future returns as a central case rather than an imminent bear market. Nonetheless, should inflation expectations rise, necessitating higher interest rates, then the probability would rise that the next bear market would be sharp and, with fewer options to ease monetary policy, it would likely be long".
By Rudi Filapek-Vandyck, Editor FNArena. (VIEW LINK)
I cannot argue with the logic but I wonder if logic is useful with free market conditions so distorted.. We are in the lap of the gods ,central bankers and politicians decisions. The how when and what of their whims probably makes any prognostications useless to act on, no matter how logical the expert opinion is.