Can the equity bull market continue on its current path?

James Quackenbush, BridgeTower Media Newswires

The U.S. stock market continues to build momentum and is currently up 16 percent for the year, with new all-time highs seeming to occur on a daily basis. This bull market is now the second most powerful in history, in terms of performance and duration, rising more than 277 percent during its 8.5 years of existence. The rampant bull market of the 1990s is the only other time period when stocks have witnessed such an epic run in performance without a correction or bear market.

The most recent leg of the bull market can be attributed to positive earnings growth, a modest increase in economic growth (as measured by gross domestic product), the potential for tax reform, and deregulation — all coupled with extremely low volatility. However, as this bull market and economy matures, monetary policy will become more restrictive as the Federal Reserve (Fed) continues to increase short-term interest rates and proceeds to wind down their balance sheet, which may ultimately disrupt this historic equity market run.

Unlike the previous years of 2015 and 2016, when gains came in the form of price earning (P/E) multiple expansion (higher valuations), this year’s earnings growth has reignited and has been the main driving force behind market performance. P/E multiples in 2015 increased from 18 to 20.6 by the end of 2016, providing stock returns of 14 percent. However, during that same time period, earnings were actually negative on the S&P 500, decreasing slightly from 112 to 108. This year, earnings growth has rebounded with two consecutive quarters of double-digit earnings growth — thanks to low interest rates and deregulation — propelling stocks higher while maintaining roughly the same P/E multiple. It is reassuring to witness actual earnings growth justifying higher stock prices rather than multiple expansion, particularly as P/E multiples are already at lofty levels.

Additionally, this year will be remembered for the inauguration of President Donald Trump, which most pundits predicted would present a volatile and challenging time for the economy and the stock market. However, volatility has been historically low and virtually nonexistent all year, even in the face of geopolitical tension in North Korea. Overall, stock returns have enjoyed a slow and steady increase while only posting eight trading days with market movements, positive or negative, of greater than one percent.

Furthermore, the VIX Index (which measures near-term volatility through option prices) has been historically low all year, currently reading approximately 9.7 on the index after registering its lowest level ever of 9.3. This is considerably below the 10 year average of the index of 20.3 and, remarkably, this year has only registered a few spikes that reached 16. This unusually low volatility has allowed stocks to march higher at a slow, methodical pace.

However, as a result of low volatility, a sense of complacency seems to have set in on investor sentiment as investors seem to think this market will only move higher. Although there are no imminent warning flags that may derail market momentum, the Fed began their path to normalization when they started increasing interest rates in December of 2015. Since then, the Fed has increased the Fed Fund rates three additional times to 1.25-1.5% range and has indicated further increases may come by the end of next year. Higher interest rates will be a restrictive force that may slow economic and earnings growth.

What is starting to signal some concern is that short-term rates have been increasing while the long-end of the yield curve, which is measured by the 10-year Treasury, has moved lower for the year, causing the yield curve to flatten. The spread between 1-year Treasury and 10-year Treasury started the year at 1.64 percent and has since narrowed to 0.90 percent as short-term rates have increased with no equivalent increase in long-term rates. This is something to monitor as the Fed continues to increase short-term rates. If there is not a corresponding move in the long-term rate, the yield curve could become flat or even inverted. Historically, an inverted yield curve has been a good indicator that the economy is slowing and a recession could be on the horizon.

While the path of least resistance is higher for stocks for now, it is getting late in this economic cycle as the Fed is well on their path to normalizing interest rates. Earnings growth has propelled stocks higher as of late but if a more restrictive Fed proceeds too aggressively, their actions could spell problems for this current bull market.

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James Quackenbush, CFA, is a senior domestic equity analyst for Karpus Investment Management, a local independent, registered investment advisor managing assets for individuals, corporations, non-profits and trustees. Offices are located at 183 Sully’s Trail, Pittsford, NY 14534, (585) 586-4680.