How long will the tired bull keep running?

January 9, 2018 08:58 AM

Led by Wall Street, global equity markets continued to enjoy one of their best starts in eight years. Japan’s Nikkei 225 marched to a new 26-year high after the S&P 500 and Nasdaq Composite set record closes in the previous session. In Europe, the FTSE 100 made a new high on Monday before retreating slightly to close 0.36% lower, meanwhile, the German Dax is only 1.2% shy of its all-time peak, reached in October last year.

There’s no reason not to be optimistic when global growth is expected to run above average; inflation remains muted, and U.S. tax reforms are driving up U.S. corporate profits forecasts at the fastest pace in more than a decade.

Many skeptical equity investors are not willing to call the end of the bull market, given that contrarians who challenged common market beliefs in 2017 missed the rally. However, this doesn’t necessarily mean there is no reason not to be worried.

From a valuation perspective, few can argue that stock valuations, particularly in the U.S. are overstretched, despite the upgraded earnings forecasts. When looking at the cyclically adjusted price-to-earnings multiple “CAPE”, it is currently above 33, a level last seen during the dot-com bubble. However, this indicator has been suggesting that stocks are expensive for the past two years, but there are still no signs of the bulls giving up. This is due to the low-interest rate environment, which wasn’t the case in 2000 or 1929.

The 45% rally in the S&P 500 during the past two years has driven down dividend yields to below 1.9% which is now lower than the returns on 2-year treasury notes. At the moment it appears that investors are not too worried about rising short-term interest rates, but the outlook will likely change when yields in the long term start to increase.

Today the Bank of Japan announced a reduction of buying JGBs by 20 billion yen. Although it’s considered a slight tweak in monetary policy, this may mean that further tightening is on the cards, despite BoJ’s Kuroda signaling at December’s meeting that no monetary policy tightening was imminent.

I expect to see further actions from major central banks to tighten policy through reducing stimulus and raising interest rates, as low inflation will not last forever. Such actions will likely lead to rapid appreciation in bond yields across Europe and the U.S. which could be the first signal of an equity market correction.

About the Author

Hussein Sayed is chief market strategist at FXTM.