Bull Market at 8: What to Expect from Here?

Short answer: lower returns.

This the great lesson from the global financial crisis of 2008. Central banks have saved the financial system, not the real economy.

The best way to illustrate that point is the following chart from Goldman Sachs’s note dated March 24, 2017 (« Bull Market, 8th Birthday – Many Happy Returns? »):

Source: Goldman Sachs

In short, central banks have propelled a nice run for risky assets (high yield, equities) while the real economy (wages, inflation, real estate prices) have been laggards.

This might look like a conundrum, since corporate profits have risen sharply over the last 8 years.

But, but but… The corporate sector has preferred to invest in its own equity and not in the real economy (for instance by building new productive capacity or looking to raise the total productivity of factors).

What to expect in terms of asset classes returns ?

Source: Goldman Sachs

The short answer is: prospective returns are lower when valuation ratios are high, which is currently the case in the US.

From GS’s report:

« Our feeling is that the bull market has further to run but that there is a growing risk of a correction. This is a sentiment that we have expressed in our latest asset allocation update where we tactically reduced our 3-month equity weighting to neutral owing to elevated equity drawdown risk. Equities have had strong risk-adjusted returns in recent months, trending up with low volatility.  The S&P 500 has increased for more than a year without a 10% drawdown and has had 73 consecutive trading days with 1-month realised volatility below 10%. In fact, realised 1-month S&P 500 volatility is at 8.3%, which is the 7th percentile since 1928. Other equity markets have been more volatile but, generally since the middle of last year, equity volatility has settled at relatively low levels. As a result, risk-adjusted equity returns have been strong.

Of course low volatility does not mean a correction is imminent, but it is a reason to be more cautious about a setback at least.

There are three factors that make us more nervous short term:

  • Equity valuations are elevated and n volatility is low.
  • There is a growing risk that real bond yields will rise as the Fed is seen to be behind the curve on policy tightening given the recent easing of US financial conditions.
  • Growth momentum (the second derivative of growth) may be close to a peak. »