The US bull run still has some running to do

The current US equity bull market appears to be defying history as it is already a third longer than the average duration of its predecessors.

But some indicators suggest that it has further to run and that we may only be three-quarters through the current upcycle. Potential catalysts for the end of the bull market and the start of a bear market include a US recession, global monetary tightening or a valuation overshoot

The US equity market is relevant to investors across the world, not only because global funds tend to be heavily invested, but because it influences sentiment for all equity markets.

Over the past 50 years, the trough-to-peak phase of the US equity cycle has averaged 66 months, but this bull market has been running for 91 months, with equities gaining 215 per cent in that time.

Milestones already passed include a peak in both the pace of economic growth, as measured by the ISM manufacturing index, and corporate margins, as well as the start of monetary tightening. And with the output gap moving towards positive territory, wage growth is accelerating.

However, other indicators have yet to flash red, and suggest that we are now entering a late phase of the cycle, with scope for equities to gain a further 10-20 per cent before a major peak.

Valuations are stretched but not yet extreme, while monetary policy is much more accommodative than has historically been the case at this point in the cycle.

Cumulative US GDP growth over the term of this equity bull market totals just 15 per cent, still far short of the typical 30-40 per cent in each of the previous three upswings. Lead indicators and US jobless claims suggest very low risk of recession over the next six months.

This is particularly important given that US and global equities continue to be influenced by the outlook for the US economy in general and the jobs market in particular.

The bottom line is that, as long as the US economy remains on a firm footing, equities should continue to rise.

At this point, monetary conditions remain easy in the US and elsewhere in the developed world, supporting the economy and pointing to upside potential for global equities in the next six to 12 months.

And even if the Federal Reserve hikes benchmark interest rates again in December — as widely expected — rates will still be well below levels that have historically triggered a significant market correction or a recession.

So what factors could trigger a recession? There is no obvious candidate, but a further decline in investment spending due to falling corporate profitability or rising bond yields is more likely than a sharp consumer retrenchment.

Next year could see central banks outside the US begin to drain some of the liquidity they have lavished on markets. Alongside the likely tightening by the Fed, there is the potential for a scaling back of quantitative easing in the Eurozone, as well as reduced liquidity injections in Japan and China.

In addition, equities are starting to look overvalued and overbought in absolute terms, especially in the US but that does not mean they will go into reversal.

At the moment, the US price-to-book ratio is only marginally above the long-term trend, suggesting that stocks could still climb as much as 15-20 per cent before reaching “peak” valuation and generating a strong “sell” signal.

Sentiment is also relatively subdued. ICI data shows that the cumulative inflows into US equity funds, relative to bonds, are back to levels seen in 1994, suggesting that there is still significant pent-up demand for equities in the medium term.

One potential warning sign is the boom in M&A activity, a strong indicator of overheating in the market as it is fuelled by a combination of ultra-easy financial conditions and corporate exuberance.

Globally, M&A volumes hit a record high of $ 1.8 trillion (Dh6.6 trillion) in the final quarter of 2015, and historically such peaks have often preceded turning points in both equities and the economy.

So, what next? We believe we have entered a late phase in the cycle — but we are not at the end yet. Equities typically crest ahead of a recession, so investors need to find early warning signals in order to correctly time a strategic change in asset allocation.

Reducing equity exposure too early can be costly, as many investors discovered in 1999 in the run-up to the bursting of the dot.com bubble.

And we must acknowledge that some arguments for a longer cycle are also valid — fiscal stimulus may lead to an equity bubble and prolong the economic recovery.

So far only a handful of key business cycle indicators — liquidity conditions, valuation, and sentiment — have reached levels that have historically been consistent with the US economy contracting within three to six months.

The same indicators suggest that global equities have a circa 10-20 per cent upside left to run — and the probability of a major market peak by the end of next year is rising.

The writer is chief strategist at Pictet Asset Management.