Ok, so Goldman’s “Bull/Bear Market Risk Indicator” is sitting at its highest level since 1969, and because that sounds scary and also some semblance of authoritative, I guess it means I’ve got to feature it.
MarketWatch got ahold of the note that contains the latest update and analysis around this indicator and they ran a feature story on it today, but just for the sake of accuracy, the note was actually published on September 4 and the charts and excerpts MarketWatch cites are from a 54-page strategy paper called “Making Cents: The Cycle & the Return of Low Returns”.
It’s by Peter Oppenheimer and Sharon Bell, and they pen these lengthy strategy papers every so often. This latest installment is number 30. Here’s the chart:
(Goldman)
We’ve been over this before in these pages, most recently in March, when the indicator was sitting at 71%. Here’s a short history of this thing, excerpted from that linked post:
Back in September, Goldman built themselves a bull/bear indicator that rolls up several variables in an effort to effectively divine something about the risk of imminent turning points. Ultimately, they “discovered” that “many bull market peaks were associated with a combination of conditions based on 5 factors”:
- the labor market,
- growth momentum,
- valuation,
- term structure of the yield curve and
- inflation
There’s nothing particularly novel about their approach, but then again, there’s nothing particularly novel about anyone’s approach to trying to time markets and/or identify peaks because to the extent you actually discovered something that was truly unique and/or infallible, no one would know about it because you’d just build an algo based on it, hit “go”, and retire to the Swiss Alps.
Here are the latest readings on those five factors:
(Goldman)
So that’s what you’re looking at in the visual, and here it is plotted with 5-year forward returns:
(Goldman)
The color that accompanies the visual echoes some of the commentary that usually comes along with the bank’s updated analysis of the cycle.
“Rising valuations and a tight labour market (at least in the US) have contributed to a sharp rise in our Bull/Bear indicator [and] typically, high valuations — or an extended level of this index — imply the risk of a bear market or a period of low returns over the next 5 years”, the bank writes, describing the second chart shown above.
They go on to note the obvious, which is that in the absence of a sharp downturn in the U.S. economy, a bear market is less likely than it would be were economic activity to slam into reverse. Here’s Oppenheimer:
Bear markets are not common without recessions or a sharp reversal of financial imbalances. Given low inflation and a more stable Phillips curve, our economists think that a recession is unlikely in the near term. This may have been the weakest US economic cycle in 60 years but it is likely to be the longest. Also, financial imbalances have moderated over the past decade. Much of the debt has been transferred to the public sector or central banks’ balance sheets.
Goldman goes on to remind you that it’s not uncommon to see a “fat and flat” dynamic characterized by wide swings in an otherwise sideways market environment.
(Goldman)
That said, the continual suppression of the term premium (i.e., deterrent to bear steepening) and solid growth might mean this time looks more “skinny and flat”:
But to get the large swings, we would likely need to see bigger rises in term premia or slower growth than we currently forecast. A more likely alternative would be a ‘Skinny & Flat‘ market: a period of low returns in a narrow trading range.
How concerned should you be about an imminent bear market? Well, not all that concerned, Goldman figures (as alluded to above). To wit:
The indicator is at levels which have historically preceded a bear market. Should we take this seriously? It’s always risky to argue that this time is different but there are two most likely scenarios when we think of equity returns over the next 3-5 years.
1) A cathartic bear market across financial markets. This has been the typical pattern when this indicator has reached such lofty levels in the past. It would be most likely triggered by rising interest rates (and higher inflation), reversing the common factor that has fuelled financial asset valuations and returns over recent years or a sharper than expected decline in growth. Such a bear market could then ‘re-base’ valuations to a level where a new strong recovery cycle can emerge.
2) A long period of relatively low returns across financial assets. This would imply a period of low returns without a clear trend in the market.
There are a number of factors the bank cites for asserting that the latter is more likely than the former, including i) structural factors weighing on inflation and thereby allowing DM central banks to avoid tightening policy too dramatically, ii) the idea that while valuations and the labor market are pretty stretched, the other components of the indicator aren’t so lofty, iii) low macro volatility, and iv) the onboarding of financial imbalances to central bank balance sheets (as opposed to private sector leverage).
The bottom line here is that investors should exercise some common sense. You’ve logged triple-digit returns since 2009, so in all likelihood, you should expect that to moderate going forward.
That’s it, I’m done with this one.
