Hans Redeker, Morgan Stanley’s Global Head of FX Strategy, says although equity markets may be reaching a cyclical top, that’s no guarantee the U.S. dollar will end the year higher.
An oft quoted line from celebrated fund manager Sir John Templeton stated, “Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.” Market watchers pondered the veracity of this maxim as markets soared throughout 2017. Now, rattled by some volatility, the question on many investors’ minds has been: Are we end-of-cycle euphoric?
Late-cycle doesn't necessarily mean each drawdown is 'the big one' says Cross-Asset Strategist Serena Tang.
The current bull market for U.S. equities is approaching its ninth year and if sustained until August, will be the longest running bull market in the history of the S&P 500. However, since the beginning of 2018, it appears each week has offered new potential for corrections, or even a wholesale transition to a bear market. Most recently, concerns about the effect of the U.S. Administration’s trade tariffs—and China’s response—sent markets tumbling.
So how can investors tell the difference between a bull correction and the arrival of the bear? In a recent report, Morgan Stanley Research analyzed S&P 500 trends since 1950 to identify recurring patterns in corrections and market shifts and provide investors with some historical signs that change is afoot.
Market drawdowns happen more often than most investors realize. The report notes that since 1950 there have been more than 100 instances of 5% or more S&P sell-offs, and 32 times in which the drawdown was more than 10%. Over the past century, the likelihood that the S&P is down 5% or 10% at any given point in a year has been 46% and 29%, respectively.
“Bull market corrections exhibit a very different pattern of performance than the start of bear markets,” says Morgan Stanley Cross-Asset Strategist Serena Tang. “We define a 'bull correction' as a drawdown of 10% or more, but with a recovery to the prior peak within 12 months. A 'bear market' is when stocks sell off 20% or more, with no recovery in the following 12 months.”
The current market volatility has led to speculation that each drop is the last gasp of this aging bull. However, Tang notes that additional trends—such as rising inflation and tightening monetary policy—suggest we're already near a market peak. Even so, “late-cycle doesn't necessarily mean each drawdown is ‘the big one’,” Tang says.
For investors, understanding the specific signals of a bear market transition can help them better position their portfolios. According to the Morgan Stanley report, here are some of the key market signals to watch for:
Credit spreads widen. Credit tends to be the first to 'crack', providing a bearish market signal 3-12 months in advance, with government bond yields, on average, peaking about three months before the S&P 500 and the ACWI (which tracks 85% of global investable equities).
“This is consistent with our finding that U.S. credit tends to trough about seven months before the S&P peaks,” says Wanting Low, also from Morgan Stanley’s Cross-Asset Strategy team. “In this environment, lower quality credit also begins to underperform. However, the returns are not all negative. Our research found that credit spreads often tighten up significantly right as equities peak.”
Equities rally sharply. Global equities tend to rise more steeply heading into a bear market as compared with a bull correction, with emerging market equities rallying the hardest. Within industry sectors, the report notes that tech tends to perform well late into market cycles, along with telecoms and materials. Health care, however, usually underperforms as the markets reach their top.
Bond yields rise. This is largely because of the bull market macroeconomic backdrop that spurs growth and inflation. Near the end of the market cycle, though, yields rise even faster. For example, the research shows that in the 12 months before a market peak, U.S. 10-year Treasury yields have on average widened by more than 100 basis points.
Emerging market currencies dominate. In the year before a bear market, many emerging market currencies perform strongly. Additionally, the Japanese yen tends to strengthen late in market cycles. Conversely, in a bull correction the U.S. dollar typically strengthens against emerging market currencies and the yen doesn't budge.
Commodities stay strong. In fact, they usually perform stronger going into bear markets than with a bull correction. For example, the report notes that crude oil, gold and copper have all historically witnessed double-digit increases in the 12 months before a bear market. These returns are usually several percentage points higher than returns seen before a bull market correction. Notably, as markets shift to bear territory, commodities and crude oil tend to peak before equities do.
It's impossible to predict exactly when this bull market will wane, but Morgan Stanley analysts report that we are witnessing some of the aforementioned signals. For example, the performance of U.S. equities, global discretionary and materials stocks, Japanese government bonds and copper all line up with the market being within a 12-month peak.
Other signals say otherwise. The performance of emerging markets, European equities and global staples don't suggest late-cycle activity. Credit spreads and U.S. Treasury yields are also outperforming for what would be considered typical of a late-cycle market.