A new report from the Wells Fargo Investment Institute (WFII) examins the 126-month-old economic expansion, the longest in U.S. history, along with one of the longest bull markets in the S&P500, gaining 350% in about a decade. The length of the economic expansion and the total return in the stock market have recently caused fear among investors, signaling the good times are about to end.
The report, titled "How Bull Markets End: Investment Strategies to Prepare for the Next Downturn," examines the relationship between equity bear markets and economic recessions, while carefully studying warning signs that could mean it's time for investors to start positioning for the next downturn.
"The sheer length of our current expansion has investors worrying when the bull market will turn into a bear market. We are persistently watching for cautionary signals that can predict changes in the markets, and right now the indicators we're studying don't suggest it's time to issue a storm watch," said Darrell Cronk, president of the WFII and CEO of Wealth and Investment Management at Wells Fargo. "Still, investors want to know when a storm is brewing in the economy and markets and how they should prepare for it."
A contraction in forward EPS is a significant threat to the S&P500 in the quarter ahead, and one of the main reasons why the total return on a year-over-year basis for the equity index has stalled.
Every bear market in the last five decades has seen a slump in S&P500 forward earnings. WFII notes that equity bear markets generally occur before economic downturns.
WFII notes that large-cap equities "often outperform many asset classes in the 12 months preceding a recession."
Several risk factors that investors should monitor are yield curve inversions and political disruptions domestically, but also internationally. The report said:
"Geopolitical uncertainties—such as the U.S.-China trade dispute, the growing U.S. political divide, Brexit, and tensions in the Middle East and North Korea—may disrupt the global economy. For example, prolonged negotiations for a revised trade deal between the U.S. and China have been contributing to heightened market volatility. Sustained geopolitical uncertainty could continue to dampen sentiment, potentially triggering a sustained economic downturn."
Other risk factors investors need to watch are high-yield corporate debt spreads, corporate debt levels, and Federal Reserve interest rate policy.
A predictor of turning points in the economy has been the Conference Board Leading Economic Index (LEI), which the 12-month change dips below zero before a recession in seven of the past eight cycles.
WFII lists several factors that investors want to watch that could suggest the bull-market peak maybe be imminent:
Mounting headwinds in the domestic and global economy are likely ushering in the next bear market for stocks and the economy.
S&P500 forward EPS is likely to contract in the coming quarter and might not bottom until 2Q20. The slowdown in the domestic economy continues to gain momentum and might not trough until 4Q20. This means a severe repricing event could be nearing for risk assets.
"Market volatility typically picks up leading into a downturn, and that alone can naturally cause some anxiety for investors," said Tracie McMillion, head of the global asset allocation strategy for the WFII. "Our guidance is to stay invested through the cycles, resist the impulse to react emotionally, and proactively take control of the portfolio to manage risk."
WFII is actively preparing its clients for a turning point in the economy, but more importantly, helping its client to position for the next bear market in stocks.