Pulling Life Support From a Bull Market on the Brink of History

Fed Rate Hike Path: Normalizing From the Zero-Bound
  • Stocks face volatility, P/E headwinds should Fed raise rates
  • Stimulus aiding S&P 500 rally toward one of the longest bulls

For a bull market in stocks that has been doubted and derided virtually from the day it began 6 1/2 years ago, the time has come to walk alone.

Barring a shock, investors are about to find out how much stocks are worth in the absence of Federal Reserve support that has helped restore $15 trillion to share values since 2009. Policy makers are poised to boost interest rates for the first time since 2006 today, ending a campaign of stimulus that helped stoke what could become the second-longest American rally on record next year.

History suggests two immediate consequences from tightening: higher volatility and lower valuations, meaning earnings and ultimately the economy are left to drive prices. Psychologically, bulls and bears will get an answer to a question that has lingered over markets: how much of the Standard & Poor’s 500 Index’s 202 percent jump since March 2009 is sustainable without stimulus?

“There is probably a large constituency that looks at this market and concludes that the Fed has been responsible for most of the rise over the last six years, and that any shift in policy means the end,” said David Joy, the Boston-based chief market strategist at Ameriprise Financial Inc., which oversees $766 billion. “The bull market can stay intact, but the pace is dependent upon just how robust the economy will be and what that means for earnings. Both are going to be modest.”

Joy said Ameriprise reduced its holdings in U.S. equities this quarter and prefers stocks in Europe and Japan, where earnings growth and central bank policies are more favorable.

Bull markets always face challenges, and anyone expecting stocks to keep rallying can find support in the market’s longer-term record. For all the frenetic gains since 2009, returns in the S&P 500 are just now getting back to historical averages when looked at over the long haul. They’re a little under 10 percent a year when measured from starting points 10, 20 or 25 years ago, data compiled by Bloomberg show.

“That’s a popular opinion that the stock market is only up because of what the Fed’s been doing, but gosh, I see an awful lot of fundamental positives of the U.S. economy that are reflective in the current level of the stock market,” said Bob Baur, chief global economist at Principal Global Investors, which oversees $333 billion. “Stocks will do fine for at least a good share of next year.”

After two years of calm, investors have spent the second half of 2015 coping with the first correction in four years and an increase in volatility that by some measures was a record. From plunging oil to emerging market turmoils and the selloff in junk bonds, anticipation of the Fed’s retreat added to anxiety that’s already pushed the Chicago Board Options Exchange Volatility Index above levels at the start of past Fed liftoffs.

More of the same is probable. The S&P 500 has become more turbulent in 10 out of the last 12 tightening cycles. In the last 70 years, daily swings in the equity benchmark index widened by 23 percent on average in the six months after the first rate hike of a cycle compared with the half year leading up to it. The number of days when the gauge rose or fell more than 1 percent climbed to 27 in the six months after from 20 in the six months prior.

While the broad market is little changed for the year, with the S&P 500 slipping 0.8 percent, violent swings have been more frequent than any time since 2011. The index has moved 1 percent or more on 67 days this year, almost double the total in 2014. At 21, the VIX is 29 percent above its average of 16.3 around the last three initial rate hikes since its inception.

Investors face one of the biggest tests of the post-crisis era as the Fed prepares to raise rates at a time when profits are in decline. Such a combination hasn’t occurred in five decades. The valuation picture doesn’t help either. At 21 times profit, the S&P 500 is trading higher than it was at the end of eight of the past 10 bull markets. History shows a contraction in equity valuations is almost inevitable.

Never before has a stock rally gone on this long without an interest-rate increase. While historically stocks fared well, with the S&P 500 rising about 2 percent over the first 12 months after the initial rate hikes, the confluence of higher valuations and weak earnings underscores the risk to a bull market that, if it lasts through April would surpass the 1949-1956 run to become the second-longest in history.

“There’s no question that the Fed’s been huge in driving the equity market forward,” Michael Purves, chief global strategist at Weeden & Co in Greenwich, Connecticut, said by phone. “How do stocks rally next year again with creepingly higher rates and a creepingly higher dollar? Good old fashion earnings growth will become a little more important this time around.”

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