Many things have tried to derail the eight-year-old equity bull market. They have all failed.
The surprise devaluation of the Chinese yuan, Brexit, the shocking US presidential election — they all gave it their best shot, but were ultimately stymied by optimistic investors who saw an opportunity to add to positions at discount prices.
So what will finally be able to put an end to what’s now the second-longest bull market in history?
Brad McMillan, chief investment officer of Commonwealth Financial Network in Waltham, Massachusetts, which oversees $US114 billion, has some ideas. While still positive about stocks in the short-term, he sees a reckoning on the horizon that will strike within the next two years.
In an interview with Business Insider, McMillan spoke about his bear market call, valuations, investor complacency and President Donald Trump’s lessening impact.
This interview has been edited for clarity and length.
Joe Ciolli: There’s a subset of the investment population that says the market is overvalued, but earnings growth seems to be assuaging those fears somewhat right now. When will the market start reacting to stretched valuations?
Brad McMillan: I think the tipping point is going to be a rollover in consumer confidence, which is generally preceded by a rollover in job growth. I tie it all back to the economy.
Job growth is starting to decline. While we’re still growing, you can see that getting into a trouble zone somewhere in the 12 to 24-month range, if current trends continue. That’s when a lot of the hope starts to fade, and when consumer confidence starts to drop, that’s typically what causes the turn in multiples.
Right now we’re in relatively uncharted territory. We’re at the third-highest levels of all time. But that doesn’t mean we can’t keep moving higher in the near-term. We will until something intervenes to change that.
Ciolli: So that 12 to 24-month range — is that the time frame for a 10% correction, or for something deeper, like a 20% pullback that would put us into a bear market?
McMillan: I think the bear market scenario is quite possible. The comparison of where we are to 1999 makes a lot of sense. The economic trajectory over the past seven to eight years has been remarkably similar to the 90’s. We could be headed for some stormy weather over the next couple years.
Ciolli: For the time being, it seems like every time we get weakness, people use it as an excuse to buy the dip. What do you think is the most likely tipping point for the equity bear market you foresee in the next 12 to 24 months?
McMillan: I look around and I see two major sources of risk. First of all is international economic risk. And there’s also political risk, which exists all around the world, and clearly in the US.
The Italian election is certainly something that presents a lot of risk, as is the debt ceiling debate in the US. China is not out of the woods in terms of making its economic transition. There’s a lot of debt there. I’m not sure specifically how that could happen, but it’s certainly on the list of systemic risk factors.
Markets tend to rise with improving fundamentals, which is what we’re seeing with earnings at an increasing rate. While these factors are all very positive at the moment, the pain comes when they roll over.
Ciolli: Your firm published a recent blog post that asked if market complacency has reached a peak. The VIX is pinned to the mat, but it didn’t seem like you were particularly worried. What’s your view now?
McMillan: You have to look at two things: the level of risk, and the immediacy of that risk. You can compare it to high blood pressure — if you have high blood pressure, that doesn’t mean you’re going to have a heart attack, but it does mean you should be paying attention. We see signs from this indicator that we have a couple of tough years ahead of us. We’re worried over the medium-term, but not particularly worried over the short-term.
An exogenous shock is typically going to be the trigger for some sort of market correction, but it’s not really the cause. It’s important to distinguish that. When you look at the actual causes of significant bear markets, the biggest one is a recession. I’m not really going to get worried about a killer bear market until we get a recession. That’s the first thing we need to watch for, and chances are, that’s probably 12 to 24 months away. It’s not an immediate problem.
If you’re a young person with a 30 or 40 or 50-year horizon, that’s not necessarily concerning. For older investors that are starting to draw down, it’s something they need to pay more attention to.
Ciolli: If we’d done this interview a month or two ago, we probably would have been talking about Trump the whole time. But now it seems like headlines around Trump aren’t shocking the market as much anymore. Have you noticed the same thing?
McMillan: I see that, and I agree with it. We used the Trump bump to get into a higher range for valuations, and now fundamentals have proven capable of keeping us there.
There was an enormous amount of hope in the investor class that we’d see positive policy action from a unified Republican administration. While it hasn’t really played out like that, we’ve seen fundamentals improve, particularly from an earnings perspective. Even as the air is going out of the policy expectations, you’re seeing improving fundamentals buoy the market up. That’s why you’re seeing this range-bound trading. We’re losing the policy push, but we’re getting better fundamentals, and they’re largely offsetting each other.
Ciolli: With the Trump effect now muted, earnings growth is frequently cited as the biggest driver of the ongoing stock rally. Are there any other current catalysts that you feel are underrated or underappreciated?
McMillan: One of the major justifications for valuations right now is low interest rates. There’s an expectation, certainly on the fixed-income side, that rates are going to rise. What if the stock market is predicting correctly that rates are likely to stay low for an extended period? That could certainly help buoy valuations. But the problem with it is that the expectation of lower rates is inconsistent with the expectation of faster earnings growth, which is also embedded in the market.
If the stock market is perhaps predicting faster economic growth and continued low rates through persistent central bank action, that could be one of the factors driving us up.
Also, we’re in the first synchronised global upturn since the crisis. Even before the crisis, it wasn’t that common. Europe in particular is starting to pick up. China is continuing to chug along. It could just be a recognition that, over the next few years, we’re going to have a very favourable environment. So even if we pull back a bit in the US, we’ll be pushed forward by everyone else for the first time in a long time.
Ciolli: On the subject of share gains, there’s some debate around the leadership of the stock market rally. The FANG (Facebook, Amazon, Netflix, Google) stocks have been blazing the trail, but people are divided as to whether that’s healthy. What do you think?
McMillan: If you go back through market history, there have been stocks over time that have offered growth, no matter what price you paid for them. Now we’re at a point where there are five or 10 driving performance. To some extent, what we’re seeing in the market is just a bet on a couple hyper-growth companies.
Because the indices we follow are market cap-weighted, the bigger those stocks get, the more influence they have. It’s kind of an upward spiral, which works very well on the upside, but raises risks on the downside. That’s what we need to focus on.
It’s a behaviour pattern that we typically see close to the end of market cycles, which is one more supporting indicator that the next couple years will be tough.
Ciolli: Which areas of the market do you favour, and which do you avoid?
McMillan: We’ve been looking for some time at relative international exposure. Everyone wants to be in Europe now, and we’ve been talking about that for a long time. If you look at relative valuations, Europe is quite inexpensive compared to the US. And fund flows are starting to show a shift towards international.
Here in the US, financial institutions are absolutely looking to benefit from the Fed’s policy. They already have, and they will continue to do so. I’m optimistic about financials, but less so than many commentators. We’re starting to see loan growth trail off, and we’re rather late in the cycle.
I’ve been banging the drum on consumer discretionary for some time, and it’s worked out very well. For all the bad news about retail, and for all the constrained spending, there are still opportunities in the sector. There’s a fair amount of money out there to be spent.
What you’re buying with technology is the promise of growth. Right now, most things aren’t cheap. People tend to confuse the company versus the stock. You can have an absolutely terrific company that’s going to continue to knock the cover off the ball, but if it’s overpriced, it still might not be a good investment.
Ciolli: More philosophically, what’s the best piece of advice you can give to an investor just starting out right now?
McMillan: While technical knowledge is essential, a broader knowledge base is what takes you to the next level. Read history, read literature, understand how people think, and how they have acted in the past. Markets are all about people. Technical knowledge alone is not enough.
You need to read [Edward] Gibbon’s “The History of the Decline and Fall of the Roman Empire.” Read Shakespeare. There’s more in Shakespeare about power, decision-making, ambition, and how people are blinded by their own needs that’s so incredibly applicable to the investment process. To see it in that context is something that makes it real. It’s not about the P/E ratio. Sure, you need to know that. But ultimately, it’s about the people that are investing.
If you read writing done by Warren Buffett, Charlie Munger, and Howard Marks, they obviously have the technical fundamentals in place. But what they’re focused on is how to think, how to analyse a situation and how to understand where we are in light of where we’ve been. In order to do that, you need a much broader context than the investment universe.
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