Things have been going so well that investors almost seem bored
with it. Volatility has remained
locked near all-time lows for
the better part of the year as complacency reigns supreme. Stocks
have been the best game in town for close to a decade, and many
investors are happy to sit tight and ride the wave higher.
Even those wringing their hands about the bull market have
indirectly contributed to its continued excellence. The faint
undercurrent of pessimism that's followed the rally at every turn
has helped keep it from getting overheated. And on the occasions
these skeptics have been able to spur selling, bulls have been
waiting patiently for a chance to add to positions.
With all of that considered, Morgan Stanley has taken on the
uneviable task of pinpointing what could ultimately bring about
the end of the third-longest bull market in history. For context,
the firm uses a proprietary US cycle indicator as a benchmark for
when a downturn is imminent.
Based on their research, Morgan Stanley thinks the end of the
bull market has a strong chance of happening sometime in 2018.
The firm even has a nickname for the supposed catalysts that
could push their indicator into downturn territory: the "three
x's" — which include extreme leverage build-up, exuberant
sentiment and excessive policy tightening.
Here's a deep dive into each:
While this situation may be sustainable in the near-term, since
interest rates are still locked near zero, that could soon change
with the Federal Reserve signaling multiple rate hikes by the end
of 2018. Morgan Stanley also notes that interest coverage —
or the ability to service debt — has been declining for both US
investment-grade and junk debt since 2015.
The chart below shows the ratio of debt/GDP, which has gone
sideways in the past few years, implying that companies are no
longer reducing debt burdens like they did when they were trying
to dig out of the last market crash.
Morgan Stanley doesn't think the market is too exuberant quite
yet. While one measure shows that expectations around the economy
have gotten overly optimistic, it's still lower than where it was
during the last financial crisis or the dotcom bubble.
Still, the chart below shows that US consumer confidence is the
highest it's been since 2000, including a precipitous surge since
the start of the bull market in 2009.
"We have a bit of a 'runway' to the cycle peak, but not much," a
group of Morgan Stanley strategists wrote in a recent client
note. "Over the next 12 months, our US economists expect further
hikes in excess of core inflation, which would take us to ~190bp
of cumulative hikes over 24 months, in line with the typical
end-of-cycle policy environment."
But before you start to panic, Morgan Stanley would like to
remind you that the stock market can continue to soar, even in
the final year of an expansion cycle. They point out that in the
past, the S&P 500 has rallied an
average of 15% in the last 12 months of an equity bull market.
"The final year of the bull market can still be uncomfortably
profitable," the Morgan Stanley strategists wrote. "Timing is
everything."
Extreme leverage build-up
Morgan Stanley points out that previous comparable cycles have been derailed by steep increases in a measure of US debt to gross domestic product. While the firm doesn't see conditions as dire as they were around the Great Depression or the most recent financial crisis, it notes that deleveraging has stalled.Exuberant sentiment
This next driver is one that was briefly addressed in the introduction: investor overconfidence. The thinking here is that when the market gets too cocky, it becomes blind to potential risks and therefore more susceptible to downward shocks. As Morgan Stanley puts it, when there's a "descent from thinking to feeling," that could spell trouble.Excessive policy tightening
When Morgan Stanley says that cycle downturns follow prolonged periods of monetary policy tightening, it speaks from experience. After all, the Federal Reserve persistently hiked interest rates in the periods leading up to both the dotcom bubble and the financial crisis. And while the firm doesn't see excessive tightening yet, it warns that it could be right around the corner.
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