Investors are reaping many blessings from the super bull market over the last six years. Every since the financial crisis ended in 2009, stocks have exploded higher. Remember, just six short years ago the Dow Jones Industrial Average was trading below 7000. It is higher by just under 300% since the 2009 low point. Fortunes are being made by traders and long term investors riding the price rocket stock market higher.
Everyday I wake up hoping this historic and explosive bull market never ends. However, I know that all good things must eventually come to an end. Long-term bullish periods in the stock market are no exception to this universal rule.
Financial markets always overshoot reasonable price valuations. Overshooting occurs both on the upside and the downside. This is because markets are driven by expectations of the future rather than the reality of the present. The expectations are often over euphoric or over-pessimistic resulting in extreme price moves in both directions.
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The question right now is whether or not this bull market has overshot and will soon be correcting.
There are very cogent arguments on both sides of the fence. However, right now, the argument is stronger from the bearish camp.
There are both technical and fundamental reasons that support the bearish, price has over shoot argument. However, before we get started, it is critical to understand that a bear market is not a bad thing. Tremendous profits can be made on the downside just like on the upside. In fact, many times, money is made faster on the downside than on the upside. This is because the fear of losing profits is usually a stronger force than the greed of making profits.
In addition, another benefit of a falling market is that many stocks will be available to purchase at a discount. This is how fortunes are created in the stock market, buying at discounted prices.
First let’s look at the technical picture of the most popular stock market barometer, the Dow Jones Industrial Average.
There is no question that the Dow Jones Industrial Average has been in a massive upward trend over the last several years as depicted on this daily chart. However, note that price is over 3300 points above the 200 day simple moving average. Meaning this market barometer is wildly overextended by any measure. Remember, the 200 day simple moving average is the average price over the last 200 trading sessions. It is what defines an uptrend from a down trend.
If the average is sloping upward and the price bars are above it, technical analysts consider the market to be in an uptrend. If price breaks below the 200 day simple moving average, technical analysts consider this a change in trend, meaning a new dominant trend is is the place.
Most importantly, the 200 day simple moving average is what many institutional and hedge funds use to enter and exit very long term and large market positions. Meaning this works to make the technical indicator a self-fulfilling prophecy at the very least.
Most analysts define a bear market as a drop of 20% or more from the high price. In this case, it would require a drop of approximately 3600 DJIA points to create an actual bear market. 3600 points means the price would be just below the 200 day simple moving average prior to an actual bear market being declared. No matter how you look at it, that’s a long, long way down to create an actual bear stock market. In other words, it will not take an actual bear market to create billions in losses during a pullback.
In other words, it will only require a small technical aberration from the current highs to create large losses for the average buy and hold investor.
Meanwhile, take a close look at the Bollinger Bands on the above daily DJIA chart. Every time price approaches the top band; it gets knocked back down to the channel. Right now, the DJIA price only has a little ways to go to hit the top band once again. I view this as, at the very least, stocks are due for a short-term pullback.
While technical analysis can be very useful for describing the condition of the market, as well as timing the details of entry and exits, it isn’t what drives the market. A good way to think about it is that technical analysis is the map; fundamental analysis is the territory. You need to know the territory for the map to make sense.
Now, let’s look at the three fundamental drivers of the bull market that seem to be coming to an end.
Driver 1: Interest Rates
There is little doubt that there is a strong correlation between interest rates and stock prices. Back in the 1970’s, when the stock market barely moved, interest rates were in the double digits. No one would have ever believed that rates would fall to near zero over the next four decades. Obviously, interest rates have been kept artificially low since the financial crisis of 2007-2008. This action by the Federal Reserve has truly super-charged the stock market over the last six years. Not to mention, the slow rate decline since the highs. Now, the economic paradigm has changed. The Fed no longer has to keep rates low to juice the economy. The economy has been jumped started by the ultra low rates and it’s time for rates to start climbing. While no one knows for certain when this process will start in earnest, it is generally believed that this will be the year rates start to climb. Take away the impetus of ultra low rates and it can easily create an insurmountable headwind for the stock market bulls.
Driver 2: Earnings Per Share Growth Rates Vs Aggregate Earnings
Earnings per share have grown at a massive scale over the last several decades. The primary reason for this is stock buyback programs. You see, corporate executives are compensated by stock performance. The fewer number of shares outstanding for a company, the higher the stock price. The buyback programs lift the EPS, however, do little to lift actual aggregate earnings.
How long share buyback programs can continue as an aging investor population demands more and more income is questionable, which brings us to the third fundamental factor.
Driver 3: Aging Investors
There is no question that the population is getting older. Studies have shown the average stock investor is in his or her forties. As the population shifts to older, many investors look toward bonds as a safer alternative to equities. The aging investor population will likely lose interest in the stock market and shift its assets to the income producing bond market. Those in the 60 to 69 age bracket are the primary buyers of bonds and this age group has begun to outnumber the 40-49 year old stock buyers.
The Key Takeaway
Clearly no one knows for certain when the bull market will start to shift bearish. The technical picture plus three fundamental drivers create four compelling indications that the bull market will soon be ending. The overall shifting from bullish to bearish should not cause fear for prepared investors. The benefits include the ability to purchase stock at a discount and the very profitable opportunity to make money from the downside just like the upside. Finally, always remember, no matter what happens to the overall market, there are always individual stocks that will outperform for bullish leaning investors.