Since the “Great Recession” of 2008, investors have generally experienced positive returns from their investment portfolios. Now, over ten years later, equity markets have seen a switch from steady growth to higher volatility. The question of everyone’s mind: Is the longest bull market over?
Let’s take a look at the US market, the largest in world, and examples of indicators which could predict the answer to this question. Snapshots of the S&P 500, a stock-market index of the largest 500 companies trading on the New York Stock Exchange and NASDAQ, illustrate the progression of the US economy:
Source: Google Finance
Source: Google Finance
The first image outlines the length of the current bull run, the second image shows that, over the course of the last year, the S&P 500 index has declined. Although it is true that not all investors have a large exposure to the US (or even large-cap US equities), two things are becoming increasingly worrisome: investments globally becoming increasingly correlated, and several indicators showing that perhaps the economy is due for a correction.
Correlation Across Asset Types is Increasing
Typically, correlation figures are looked at to diversify risks within a portfolio. By holding investments that are uncorrelated, risk is better diversified away – a factor that will make one investment drop may not make another drop. Historically, at times of large market crashes, there is a saying that everything “correlates to one.” This implies that, if everyone is fearing the end of the world, there’s nowhere to hide and most portfolios will experience a decline, regardless of how well diversified they are.
When looking at markets globally (US, UK, China, Japan etc.), correlations between each specific country’s market are substantially higher when looking at the last five years, than the period spanning the last fifteen years. This can be attributed to companies becoming increasingly global and spreading their revenue sources across multiple countries. With investments moving more and more in a similar fashion, a slowdown in one market could affect another market’s returns.
What are the Indicators of an Economic Slowdown?
When trying to determine where markets could go next, it helps to look at leading indicators. Leading indicators are “economic factors that change before the rest of the economy begins to go in a particular direction.” They are studied carefully by policy makers and economists to try and predict where the economy and markets will trend in the near future. Although there is an abundance of leading indicators, we will look at three examples, and see why they indicate less-than-ideal market conditions in the near future.
Leading Indicator 1 – South Korean Exports
The first leading indicator we will discuss is South Korean Exports:
The above chart shows the relationship between South Korean exports, and global earnings-per-share (of companies). Visually, the correlation (relationship) since 1993 looks positive, meaning that the performance of global earnings follows the pattern of South Korean exports. This chart paints an unfavourable picture for global earnings to come, as South Korean exports have been on a decline. And, if global earnings begin to experience declines, this could be a substantial economic factor leading to weaker investment returns.
Leading Indicator 2 – Inverted Yield Curve
Another important leading indicator that economists look at is the yield curve. The yield curve is typically upward sloping: as a debt instrument has a longer term to maturity, you can expect it to also come with a greater yield. When the yield curve inverts, it means that yields for shorter-term debt instruments (i.e. one-year debt) are higher than for longer-term debt instruments (i.e. five-year debt) of the same credit quality. “Historically, inversions of the yield curve have preceded many of the U.S. recessions [and] due to this historical correlation, the yield curve is often seen as an accurate forecast of the turning points of the business cycle.
Recently we have seen a partial inversion, as the “U.S. Treasury yield curve just inverted for the first time in more than a decade:”
Note that the “yield spread” in the above graph means the difference between three and five-year U.S. treasuries (a positive spread on the y-axis means that the longer-term treasuries have a higher yield). As mentioned before, the inversion of yields has historically been a good indicator of impeding U.S. recessions.
Leading Indicator 3 – Household Wealth to Income Ratio
A final indicator of headwinds going forward is the U.S. household wealth to income ratio. “The main driver of financial well-being of U.S. households today is wealth, not income… [the] problem with this is that wealth depends on the ups and downs of asset prices, and therefore a bear market can deliver a hard blow to household wealth. If consumers feel poorer because of declining wealth, it will likely decrease consumption – a key ingredient for an economic slowdown. The wealth-to-income ratio tends to run high before a recession, and the below figure shows that it is at a twelve-year high:
Source: Federal Reserve Bank of St. Louis
While we are seeing increased volatility, coupled with increasingly correlated global assets and worrisome leading economic indicators, it is important to keep in mind that there are a large number of analysts worldwide that still believe markets have room to run. When it comes to your personal investments, it makes sense to be more cautious, given that we are in one of the longest bull markets of all time.
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