Turbulence in the stock market can get old fast. But investors may need to get used to the bumpy ride.
Smart Take
Wall Street is delivering a real scare this October. The Nasdaq is on track for the worst month since January 2016. The Dow swung wildly on Tuesday, plunging more than 500 points before racing back.
Bank of America Merrill Lynch is warning clients that the roller coaster ride could last awhile – perhaps through 2021.
“Expect a long bout of volatility,” Bank of America strategists led by Savita Subramanian wrote in a report published on Sunday.
Bank of America keeps a running tally of “signposts” that signal looming bear market. The bad news is that 14 of these 19 indicators, or 74%, have been triggered. Two more were toppled earlier this month: the VIX volatility index (VIX) climbed above 20 and a growing number of Americans expect stocks to go up.
The recent market mayhem has been sparked by a variety of factors that all speak to an underlying theme: Investors are contemplating the eventual demise of the bull market. The bull run, which began in March 2009, is now the longest in American history.
Wall Street has been forced to confront the threat posed by the US-China trade war. The outbreak of tariffs threatens to slow the world’s two largest economies and eat into record-high profit margins.
The recent spike in 10-year Treasury yields raised worries about higher borrowing costs. And it reminded Wall Street that the Federal Reserve has in the past raised interest rates faster than the economy can handle them.
Investors are also fretting that the good times for Corporate America can’t last forever. Lackluster profits and guidance from the likes of Caterpillar (CAT) and 3M (MMM) on Tuesday triggered worries about a slowdown in earnings growth.
“If US companies can’t blow away the numbers when domestic GDP is growing at +3%, when exactly will they?” Nicholas Colas, co-founder of DataTrek Research, wrote to clients.
Bear market warning lights flashing
Investors may be bearish, but a bear market may not be in the cards just yet.
Some bear market warning lights, mostly concerning market sentiment, have not yet been lit. For instance, Bank of America sees little evidence of the investor “euphoria” that overheats the market. Also, banks have not broadly tightened lending conditions.
The good news is that Bank of America said that previous market tops were preceded by a higher percentage of bear market signposts being triggered. Four of the past seven bull markets peaked with 100% of the indicators being triggered.
Bank of America found that it has taken the S&P 500 21 months on average to peak when a similar percentage of signposts were toppled.
“History says we’ve got 21 months,” the analysts wrote.
Michael Arone, chief investment strategist at State Street Global Advisors, isn’t willing to throw in the towel on the market either.
“I think there are still a few more quarters in this bull market yet,” he said.
Are earnings fears overdone?
High volatility does not mean stocks have to go down.
Consider the 1993 to 1998 period when the VIX climbed from 15 to around 25. The S&P 500 generated annualized total returns (including dividends) of 22% over that span, Bank of America said.
One major concern that has emerged is that corporate profit growth will decelerate later this year and early next. Peak earnings growth could be triggered by a slower economy and the fading impact of the tax cuts.
However, Bank of America isn’t worried because the S&P 500 has posted roughly average returns in the three and six months following peak profit growth.
Many Wall Street pros won’t be willing to call the end of the bull market until a closely watched recession predictor goes negative. The yield curve – the difference between long and short-term Treasury rates – has inverted before every recession since in the past 60 years, according to the San Francisco Federal Reserve.
Although the yield curve has flattened in recent months, it has yet to go negative.
“That tells me we’ve got a ways to go,” said Andrew Slimmon, senior portfolio manager at Morgan Stanley Investment Management.
Even after the yield curve goes to zero, the stock market doesn’t peak for more than a year, Slimmon said.
“This is just a correction within a bull market,” he said.
