One old bull: Market's record growth streak in no imminent danger

One old bull: Market's record growth streak in no imminent danger
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The bull market that began in the spring 2009 and continues today was born out of extraordinary stimulus provided by global central banks.  

Central banks slashed interest rates to zero and engaged in quantitative easing by purchasing government and mortgage backed securities, which created a wave of liquidity that flooded the world with money.  

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The objective was to create a “negative carry” for investors associated with holding short-term liquid investments, whose rates of return failed to keep pace with price inflation, this forced investors in search of yield into risker assets such as equities and corporate bonds. 

 

This dynamic shaped the start of one of the most unloved bull markets in history, as the deliberate engineering of a bull market by central banks didn’t provoke investor excitement. The combination of two trends that supported the markets rise and influenced the way investors behave and invest emerged. 

The first trend was central banks slashing interest rates to the lowest level in the history of mankind. The second was the emergence and popularity of passive investment strategies.  

With interest rates at zero, the Federal Reserve communicates to the marketplace to take risk, and ultra-low interest rate policies helped support higher equity valuations since future cash flows are discounted back to today at a low rate making them worth more in today’s money. 

The financial crisis traumatized market participants to such a degree that they all wanted to stay away from risk, including security-specific risk, industry-sector risk and manager specific risk.

They were presented with new investment vehicles known as index funds and exchange traded funds (ETFs) that involve investors purchasing a basket of securities at one time, rather than buying a specific security.  

When money flows into an ETF or index, the manager has to buy into the securities in an index in proportion to their current market capitalization regardless of price. This investment strategy introduced a massive price agnostic buyer into the marketplace.  

As long as money keeps flowing into these types of strategies, there will continue to be a lack of price discovery in the market. This flow of funds provided a massive tailwind in the early years of the bull market, and it continues today.

As the bull market aged, it received a boost in the form of counter-cyclical fiscal stimulus from the passage of the corporate tax cut, deregulation and increased fiscal spending.

The first seven years of the bull market were supported by central bank policies. Over the last two years, the market narrative appears to be one of above-trend economic growth and normalizing interest rate policy, resulting in an accommodative environment for equity investing. 

Market expansions don’t die of old age, they die because something specific killed them. There are always risks and threats to any bull market. Some signals to be mindful of is the flattening of the yield curve, the rate of change in wage and price inflation, trade tensions and equity valuations.  

The best-case scenario for the equity market is that corporate earnings rise by more than share prices and the market can continue to go higher and grow into its valuation. 

There is no reason that this bull market can’t continue unabated, but as interest rates rise and borrowing costs get more expensive this can lower profit margins.  

I don’t foresee the Fed choking off growth and inducing a recession, but after a decade of an unabated rise in asset prices, investors should be prepared for structurally lower equity returns in the future than the gains they have earned in the past. 

Jay Leonard, FRM, CAIA, is a chartered financial analyst (CFA) and SVP at Garwood Securities, a boutique institutional broker-dealer.