The factors underpinning the bull market in US stocks, in one chart

  • The bull market in US stocks has now been going for nine years.
  • Capital Economics says both earnings growth and valuations have driven stocks to a more than four-fold increase.
  • It forecasts tighter monetary policy from the US Federal Reserve will slow the US economy sharply in the coming years, creating downside risks for prices.

US stocks ripped higher on Friday, fuelled by a smaller-than-expected lift in US average hourly earnings growth in February while helped to allay investor fears that the US Fed could lift interest rates as much as four times this year as some had begun to speculate.

The S&P 500 index soared by 1.74%, trimming its decline from the record-high of 2,872.9 points set in late January to just 3%.

After falling nearly 12% from peak to trough it’s now rallied 10%, leaving its gains from March 9, 2009 — the nadir of the global financial crisis — at 318%.

For a bull market that celebrated its ninth birthday during the session, it’s somewhat remarkable, if not a little predictable, that the markets gains on Friday were yet again propelled by expectations for less-tight monetary policy settings from the Fed.

“A key reason why the S&P 500 has fared so well is the health of the US economy, which began to recover in the middle of 2009 and has not looked back since,” says John Higgins, Economist at Capital Economics.

“The rest of the world has also been gradually on the mend, especially in the past couple of years. This has provided an extra boost to the multinational companies that dominate the index, many of whom have also been buying back their equity.”

With easy monetary policy settings from the Fed and other major central banks helping to keep borrowing costs depressed in the post GFC era, Higgins says this has not only helped to boost asset valuations but also US corporate earnings, too.

“The upshot [from an improving global economy] is that the more-than-fourfold rise in the S&P 500 over the past nine years has been largely fuelled by growth in earnings per share (EPS),” Higgins says, pointing to the chart below.

Source: Capital Economics

“Indeed, about 11 percentage points (pp) of the near-17% annual average increase in the index can be attributed to expected growth in EPS, with only 5-6pp to an increase in its valuation.”

While markets cheered the lower-than-expected increase in US average hourly earnings in February, taking it as a sign that Fed will maintain its slow and steady schedule for lifting official interest rates, Higgins says that with US labour market conditions already so tight, the risks are that inflation, rather than economic growth, will lift in the period ahead.

“The economy is now close to full employment, so stronger demand at this stage of the business cycle is more likely to boost inflation than output,” he says.

“This, in turn, will probably mean considerably more monetary tightening, which should ultimately weigh on activity. Indeed, we think that the economy will slow sharply in 2019 and 2020.”

And with so much good news already priced in, Higgins says that creates downside risks for stocks in the period ahead.

“The last two recessions in the US were accompanied by deep bear markets,” he says.

“While we are not explicitly forecasting a recession, we wouldn’t rule out a mild one.

“This is a key reason why our forecast is that the S&P 500 will end 2019 at 2,300, which is more than 15% below its level now.”

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