Is it almost over or does the bull market have the ability to last a bit longer? What indicators should investors look at the get a sense of where we are in the cycle? Nomura’s Kevin Gaynor published a very interesting checklist and shared his views on how to assess the end of the current cycle.
According to Nomura, 3 « cherry drops » need to materialize to call the peak of the cycle, right before the downturn:
#1 is a « sustained decline in the classic long-leading indicators such as profit growth », which « correlate negatively with measures of economic slack ». Currently, measures of output gap tend to indicate that « we are moving late cycle rather than at late cycle ». Late cycle might be 12 months away, based on that metric.
Indicators to watch: corporate profitability, CEO confidence indicators, housing market activity, bear flattening yield curves, equity market returns.
#2 is « market and economic exuberance », when everybody extrapolates positive economic backdrop, ignoring negative trends forming. Risk appetite measure falls into this category and currently stands at 90% of its peak of 2007. « Moving late cycle then, but there is the potential for a move higher still », according to Gaynor.
Indicators to watch: market valuation indicators, fall in the variation across analysts’ forecasts, compression of spreads and PE multiples within sectors, herding behavior, deteriorating loan standards and credit metrics.
#3 is « accelerating inflation prompting an acceleration in monetary policy setting from loose to neutral and then tight ». Well, this « cherry is nowhere near dropping with real yields and core inflation someway below neutral ».
Indicators to watch: real yields, changes in the yield curve, inflation expectations.
The following charts illustrate the different points just made.
Conclusion from Gaynor’s note:
« In slot-machine forecast jackpot terms two cherries are close to dropping – probably within 12 months, but are dependent on the pace of growth and the supply-side reaction to that growth. However, the third is a way off yet. As a result, if this cycle is like its historical peers, it ain’t over yet. The implications are higher rates at a controlled pace and positive risk asset returns even if the total returns are less exciting than the last 12 months.
If US (and other country) fiscal policy or bank regulation (and thus loan growth) were to ease then the growth picture would be underpinned (cherry one shifts back up) and given the output gap inflation expectations increase. But risk assets need not sell off.
According to a well-known website “slots machines create the illusion of involving skill while only being a game of chance”. Calling cyclical peaks is a similar game. We are assuredly late cycle on many measures – that makes the system more vulnerable. But there are some unique circumstances – inflation being one and the immense level of monetary support this late in the cycle being the other. »