Recognize and Prepare For the End of the Bull Market

For more than eight years now, the U.S. stock market has climbed higher without any major interruption. Investing during bull markets can be easy money for diversified investors. But long-term investors need to be prepared for the inevitable end of the bull market and make sure they are not caught off guard when the Wall Street tide turns.

The stock market is considered to be in a bull market once it has gained 20 percent from a recent low point. In the current bull market, the low point for the Standard & Poor’s 500 index was March 9, 2009. On that date, the S&P 500 hit an intraday low of 666.79. In the eight years since, it has steadily climbed roughly 280 percent to above 2,500 for the first time without a single decline of at least 20 percent along the way.

Not only is the S&P 500 now more than 63 percent higher than its previous all-time high before the 2008 financial crisis, it is the second-longest bull market in U.S. history. The longest bull market ever lasted almost 10 years, from Oct. 11, 1990, to March 24, 2000. During that bull market, the S&P 500 gained a total of 417 percent.

Steep valuations don’t always mean it’s time to sell. Despite the huge gains and nearly unprecedented duration of the current bull market for stocks, there are few obvious signs that the rally is slowing down. In fact, 2017 has been a particularly strong year for the S&P 500, which is up nearly 15 percent through the first nine-plus months of the year.

Market bulls and bears have plenty of evidence to support their arguments. Bears say certain value metrics suggest stocks are historically expensive. The cyclically adjusted price-to-earnings ratio, which is a favorite metric of Nobel Prize-winning economist Robert Shiller, suggests stock prices are higher than any other time in history other than the dot-com bubble of 2000. Today, the S&P 500’s CAPE, which incorporates 10 years of earnings data to smooth out short-term fluctuations, stands at 31.3. Its historical average dating back to the 1880s is only 16.8.

CAPE indicates stocks are currently valued at nearly twice what they have been in the past, but even Shiller himself admitted earlier this year that high stock prices don’t necessarily mean it’s time to sell. Shiller said U.S. stocks could potentially have another 50 percent upside in coming years. The dot-com bubble is the perfect example of a time when buyers weren’t deterred by steep valuations, and the S&P 500’s CAPE soared to nearly 45.

Market bulls argue that, while stock prices may be expensive, the market shows no obvious signs of trouble. Republicans in Congress have promised aggressive corporate tax cuts that could boost earnings substantially. Despite several interest rate hikes, rates remain historically low, giving investors few alternatives to stocks. The U.S. economy is growing, inflation is near the Federal Reserve’s optimal range and the unemployment rate is the lowest it has been in 16 years.

These are the signs to watch. For now, the prudent approach to an expensive market is to expect the bull market to continue while being mindful of potential signs of trouble.

Ironically, one of the best indicators of the health of a bull market is investor skepticism. Ihor Dusaniwsky, head of research at financial analytics firm S3 Partners, says investors have been increasing their bearish bets on stocks throughout the past two years in anticipation of a stock market sell-off. “As the market climbs to new highs, investors are paying more attention to the short side of their books and making sure they have sufficient hedging positions of either ETFs or beta stocks to recoup long-side losses if the market drops,” Dusaniwsky says.

According to S3’s tracking, total domestic short interest in stocks has climbed from $767.5 billion at the end of 2015 to more than $929.2 billion as of Sept. 30, 2017. “Looking at domestic short interest balances, I wouldn’t say that the end of the bull market is near, but investors seem to be preparing their ‘go bags’ just in case,” Dusaniwsky says.

Owen Murray, director of investments for Horizon Advisors, says investors concerned about the end of the bull market should closely monitor a handful of leading economic indicators. “If we were to see some of the leading economic indicators, such as consumer sentiment or capital goods orders, begin to soften or decline, it might be time to begin to prepare for a market decline,” Murray says. “If an investor is worried that the market might be heading for a decline, they may want to trim some of their winners in the stock market and invest in short-term Treasury bonds or other high-quality fixed-income investments.”

Peace of mind comes from having a plan in place. According to Mike Loewengart, vice president of investment strategy for E-Trade, identifying stock market tops in real time can be extremely difficult. Fortunately, for long-term investors who have well-constructed, diversified investment portfolios, the most important thing to remember when the bull market ends is not to panic. “Recent record highs have extended months of investor optimism, and many rightfully are scratching their heads over just how far this bull market can run,” Loewengart says. “So what does the smart money do? They follow their investment plan, regardless of what market headlines suggest.”

The most dangerous part of the end of the bull market may not be what happens to stock prices. Instead, it may be how investors will react. It’s been eight years since investors have experienced a bear market, and the youngest generation of investors may have never done so.

It’s much easier to construct a bear market plan now, when investors have a clear head and plenty of time to make rational decisions. Good decisions are…

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