Why the Bull Market Is on Borrowed Time

Why the Bull Market Is on Borrowed Time

  • This bull market is already one of the best and longest ever.
  • The S&P 500 has hit a new all-time high on an inflation-adjusted basis.
  • Valuations now look pricey, and D.C. budget battles may be brewing.

Stocks reached a milestone this week: For the first time since the dotcom bubble, the S&P 500 has hit a new all-time high on an inflation-adjusted basis (not just a nominal one).

It took more than 14 years. That sounds terrible, but investors from the 1960s had to wait nearly 20 years for new highs. Patience has been rewarded. But what about persistence? On a number of measures, just as this bull market has taken the crown of glory, it's looking long in the tooth and vulnerable. Investors should start thinking defensively. Here's why.

For one, let's just look at longevity. This bull market is currently the fourth longest out of 23 in terms of duration and is the sixth best in terms of total percentage gain. That puts this well ahead of the average for the Dow Jones Industrial Average going back to 1897, when Grover Cleveland was president and Mark Twain famously quipped that the "report of my death was an exaggeration."

Related: Why America Voted Against Obama’s Economy

The three other bull markets that outlived the current one started in 1949, 1990, and 1921. None lasted longer than eight years. So, at the very least, this suggests the bull market will be unable to live past 2017 putting the date of the final top, conservatively, sometime in 2016.

But past is merely prologue and statistics is not destiny. There is nothing keeping the market from continuing to power higher indefinitely.

^INDU Chart

^INDU data by YCharts

And yet the evidence is building that market conditions, on a short-, medium-, and long-term basis, suggest caution is warranted.

Consider, for the short-term, the powerful market rise out of the October 15 low. The S&P 500 has yet to close below its five-day moving average — a run of consistency that hasn't been seen since the 1990s. It's been 22 straight days, if you're keeping count.

And conditions have been quiet. Too quiet. In fact, the current range on the S&P 500 is the tightest in history. Over the last six sessions the S&P 500 hasn't moved more than 0.077 percent on a closing basis. The next tightest range was in 1965 at 0.080 percent. Pretty incredible when you consider all the balls in the air right now — Ukraine, Obama vs. Republicans, the Fed ending QE3, and more — and the fact that we just saw the most volatile trading conditions in a year in the middle of October.  

Moreover, while U.S. large-caps look invincible, other asset classes are not nearly as robust. The Russell 2000 small-cap index dropped 0.8 percent on Monday for its third loss in a row — its worst streak since the middle of October — before rebounding a bit Tuesday. The iShares High-Yield Corporate Bond Fund (HYG) is down four days in a row, pushing below its 200-day moving average as junk bonds come under pressure. And the CBOE Volatility Index (VIX), Wall Street's "fear gauge," has popped back over its 200-day moving average and is up 11.9 percent from its intraday lows last Monday.

Even sector-level activity suggests caution is warranted. Utilities led the way Monday, up 1.3 percent as a group, followed by a 0.6 percent rise in consumer staples and a 0.5 percent rise in health care. Cyclicals like energy, technology, and consumer discretionary led the decliners.

Over the medium-term, valuation metrics are more than fully valued. The cyclically adjusted S&P 500 price-to-earnings ratio is at levels that have only been exceeded in the run up to the 1929, 2000, and 2007 market bubbles. Investor sentiment is extended, with mutual fund cash reserves at record lows.

Finally, it's worth mentioning that the meme that has supported this bull market — the flow of cheap money stimulus from the major central banks — is under threat in a way that hasn't been seen before. The Federal Reserve ended the QE3 bond buying stimulus in October and is set to start raising short-term rates in 2015.

The Bank of Japan has gone all in with a massive bond-and-stock buying program, only to see the government's debt-to-GDP ratio of more than 220 percent, and the recent tax hike intended to control the deficit, undercut its efforts. A snap election called by Prime Minister Shinzo Abe threatens to remove political support for the print-and-pray strategy. This week we learned that Japan has already fallen back into a technical recession.

Related: Japan Is Back in Recession. Time to Buy Japanese Stocks?

And the European Central Bank is bumping up against German recalcitrance to full-fledged sovereign bond purchases — something that may violate the ECB's founding documents and is a political nonstarter in the Fatherland — limiting its ability to respond to new economic slowdown.

The catalyst for another bout of weakness may very well be the cause of all the major stock market pullbacks we've seen since Republicans took the House in 2010: Political gamesmanship over the budget and the national debt in Washington. The August 2011 pullback, the late 2012 pullback, and the October 2013 pullback were all driven by fears over government shutdowns, debt defaults, and diminished credit ratings.

It's likely that with the GOP takeover of the Senate following the mid-term elections earlier this month, these battles will be rejoined in the weeks to come.

As a result, I continue to recommend holding a large allocation of cash to protect against the likely return of stock market volatility as we head into December and the end of the year. Although this is historically a period of seasonal strength for stocks, the specter of a budget battle cannot be overlooked at a time of rich valuations and extended sentiment. For the more aggressive, an outright position in volatility via the CBOE Volatility Index (VIX) or precious metals via the Gold Trust SPDR (GLD) looks attractive.

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