Leaning Against the Wind


There has been a great deal of excitement in the markets since the US elections late last fall, but in my experience, changes in presidential administrations have never extended or accelerated an aging business cycle. As the current expansion nears its eighth birthday, it’s important to note that the average business cycle lasts five years and the longest cycle in history lasted 10. Global growth has accelerated modestly in recent months, but we’re seeing few signs that this upturn is anything more than a momentary uptick in a cycle replete with fits and starts. Here in the United States, we see faltering real income growth, eroding profit margins and soft signals from some forward economic indicators. Against this backdrop, I feel it is important for investors to think about the importance of conserving principal should the cycle come to an abrupt end.

Do we think the nearly eight-year rise in equity prices and valuations is justified? Most decidedly, yes. Since March 2009, the S&P 500 Index has had a total return of approximately 250%, driven by two primary factors: First, super-easy global monetary policy in the wake of the banking crisis, which drove down returns on safe assets to the point where risky assets became a much more compelling proposition than is typical. Second, expanding profit margins — margins have been running 80%–90% higher during this cycle than their long-term average — and improving cash flows

However, both these pillars are starting to erode. Central banks are becoming less accommodative. The US Federal Reserve is in the midst of a tightening cycle, and pressure is building on the European Central Bank and others to taper their quantitative easing programs. Profit margins are eroding too as the pushback against globalization prompts multinational firms to cut back on their use of cheap overseas labor. Furthermore, higher costs of capital are being felt as interest rates rise. While weak capital expenditures have kept profit margins robust, they also reduce future productivity growth. Once rock-solid corporate balance sheets have weakened of late as debt as a percentage of assets and debt as a multiple of available cash flow have both risen to levels last seen before the peak of the US housing cycle in 2007. These factors call into question the ability of companies to increase profits enough to justify today’s lofty valuations.

While there could be more stock gains ahead, an investor’s entry point has a significant influence on subsequent returns. Entering the market at today’s S&P 500 price/earnings multiple of 21 times previous 12-month earnings gives investors little cushion should the present market ebullience fade, especially when one considers that the 40-year average P/E multiple is closer to 16 times. Small-cap and value stocks are even pricier, approaching all-time-high price/earnings multiples. History suggests that subsequent returns have been weak when shares are purchased at higher-than-average multiples. Further, since the end of World War II, the average price decline from the stock market’s peak during a recession is 24%, according to Ned Davis Research, and is sometimes much worse. For example, during the global financial crisis, the S&P 500 declined nearly 57% before bottoming in March 2009.

As noted at the outset, the market began to rally this fall as the global economic outlook brightened, and the rally intensified with the election of a new president who promised a reflationary policy mix of tax cuts, infrastructure spending and regulatory reforms. Among my greatest concerns is that the market is now priced for perfection and is ignoring myriad risks while embracing the reflation narrative. President Trump’s agenda faces the reality that Washington moves slowly in the best of times and not at all in the worst. Even once legislation is passed, it can take months or years to launch infrastructure projects — given extensive permitting and environmental processes — which dilutes their stimulatory economic effects. With congressional elections every two years, the new president, realistically, only has about an eighteen-month legislative window to get his top priorities enacted before representatives begin focusing on their reelection campaigns, bogging the system down further. Markets seem to be working under the assumption that significant economic stimulus will be felt this year. I think it will be later and smaller than the markets have priced in.

Lastly, predicting the demise of business cycles is tricky, but here are the warning signs I look for, and all are now evident to varying degrees:

  1. Decaying profit margins and profit share of GDP
  2. A marked increase in mergers and acquisitions
  3. A rise in interest rates
  4. A strong US dollar
  5. A “story” that justifies extending the market’s advance despite deteriorating fundamentals
  6. A lack of private sector investment
  7. A significant increase in corporate and consumer credit

While I can’t predict whether the market will rise or fall in 2017, investors may want to focus on capital preservation given current historically high valuations. Hard-won gains have been achieved during this extraordinary cycle, but further near-term gains may prove hard to come by.

James T. Swanson, CFA is the chief investment strategist of MFS Investment Management.

The views expressed are those of James Swanson and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation or solicitation or as investment advice from the Advisor.