Investors are underestimating the current bull run in equities, according to Chris Beauchamp, chief market analyst at IG, who says there are few signs of weakness in the fundamentals that have driven the rally of the past decade.
Numerous commentators have warned we are entering the final stages of the market cycle and that investors should prepare for a severe correction. Earlier this year, John Chatfeild-Roberts, head of the Jupiter Merlin team, even warned that the rally had peaked in January.
However, Beauchamp said investors are being “unnecessarily bearish”.
“A Bank of America report came out earlier this week that said it sees no upside for equities in the next few months and that earnings have peaked and everything is turning down from here,” he said.
“I filed that away in my 2018 predictions folder that I keep just so I can refer to it in six months’ time, so I can see who was right and who was wrong. We’ll see.
“My suspicion is that they will be proven wrong on that front. I think things will still improve over the longer term.”
Beauchamp pointed out that while markets seemed to be characterised by a state of “irrational exuberance” – a common signal that a bull market is about to turn into a bear one – at the start of this year, the period of volatility that hit at the end of January seems to have brought everyone back down to earth.
More important than that, he said that it is earnings that have been the primary driver of the market – and that these continue to power ahead.
“Earnings in the past two years have risen faster than the index itself so there are reasons to think there is plenty of catching-up to be done in terms of stock prices, particularly of course in the US,” he explained.
“The forward P/E [price-to-earnings] of the S&P 500 was getting close to one standard deviation above the 25-year average at the start of 2018, so everything was primed for volatility and that is what we got.”
“And then obviously [share prices] have been cleared out quite remarkably and you have got a market valuation chart back towards the 25-year average, so it is not as if markets are pricing in too much growth at this point in time.”
“The consensus is currently expecting earnings to rise 18 per cent this year and 10 per cent next year. That might be too rich given the trade war outlook, but certainly valuations aren’t too aggressive.”
It is not just the bull run that is nearing a record length. The current expansion in the US has already lasted 95 months, making it the third-longest in history, and many analysts are warning that the economy is due a recession – which would derail the earnings expansion.
However, Beauchamp said that the major warning signals for a recession “are not even flashing amber, let alone red”. For example, he pointed to the shape of the yield curve, describing analysts’ obsession with this metric as one of his bugbears.
“You can see we are still quite a way away from the yield curve inverting, but even when this does happen, it doesn’t necessarily signal that a recession is due,” he explained.
“If you look at history, the yield curve tends to invert about 19 months before a recession, so we are still quite a way away on this basis. We should not assume one is just around the corner just because the gap between the 2000 and 2008 recessions and this one is getting wider.
Source: IG
“There is still plenty of time for that yield curve to invert and then we will be on watch for the next recession, but we are not on watch just yet.”
Beauchamp said a similar story is reflected across other key data points to watch out for, too.
“Unemployment claims are at multi-decade lows, going back to levels not seen since the 1970s,” he noted. “Again, they tend to rise about 11 months before the next recession, and there is no sign that they are rising on a sustained basis.
“As I think we have learned over the past five or six years, you shouldn’t predict the end of that or any trend and this one is one of the strongest out there and continues to point towards further strength in the US economy.
Source: IG
“Then the third of the Holy Trinity of US data to watch for in terms of a recession is new home sales. They decline from a peak at least two years head of a recession and these haven’t started to decline either, so all three of these should give you reinforced confidence that actually we are seeing further growth in the US.”
Source: IG
While some analysts have pointed to record levels of earnings optimism as a sign that investors may be becoming over-confident, Beauchamp said this is not necessarily something to worry about. He noted that while excessive pessimism is a good sign that a market has bottomed out, he said that optimism “can just persist and persist” and markets can continue to strengthen.
However, he said that just because he thinks the market will go higher from here, it doesn’t necessarily make it a great time to buy in.
“Things aren’t cheap, it is certainly not a bargain basement moment for the stock market,” he added.
“But overall the excess of the past few years has been worked off and if we do see a return of bullishness from investors, there is room for those valuations to expand yet further and push on, supported fundamentally by that strength in the bull market.”