Last year was phenomenal for the U.S. stock market. It’s had a fantastic run since the dark days of 2008. But the question on everyone’s mind is: How long can this last? And will we pay for it with another gut-wrenching crash? Here’s what our current economic situation suggests.
The Optimistic Outlook
Let’s start with the good news:
- U.S. economic growth has accelerated, and job growth remains strong.
- The recently passed Tax Cuts and Jobs Act (TCJA) seems likely to provide a further boost to the economy – at least in the short term.
- The 45 major economies tracked by the Organization for Economic Cooperation and Development (OECD) all grew in 2017, i.e. none were in a recession. All 45 are projected to keep on that growth path through 2019 (Source: Bloomberg, OECD).
- The Leading Economic Index remains positive, indicating no sign of decline in economic activity at the moment.
- Corporate earnings are growing at a double-digit clip and are expected to continue throughout 2018.
Most of these positive indicators refer to the economy in general rather than the stock market specifically; however, the two are connected. Historically, the stock market has fallen in advance of recessions. Fortunately, the likelihood of a recession seems low at the moment. This continuing (and potentially accelerating) economic growth is likely to support the stock market.
The Not-So-Good News
On the other hand, there are several reasons for concern:
- By most measures, the U.S. stock market seems to fall somewhere in the “overpriced” to “very expensive” range.
- Investors appear to be ignoring risk, either because they fear missing out on good returns or they are following an investment strategy based on relative returns. For example, some may think that stocks may be expensive, but they look better than cash at <1 percent or bonds at 2 percent.
- The government’s fiscal situation continues to deteriorate and the TCJA will likely exacerbate the issue over time.
- The Fed has indicated it will raise interest rates in 2018, which could eventually have a negative impact on the economy.
None of these negative issues are currently affecting the stock market, but they may at some point.
Corrections, Bear Markets, and Crashes (Oh My!)
So what will happen to the stock market? To answer that question we first have to establish what exactly we mean when we talk about an “end” to the rise of the stock market. Three terms are widely used when referring to drops in the stock market, and each applies to a different situation.
Correction: When the stock market falls by greater than 10 percent but less than 20 percent. Corrections are fairly common. From 1900 through 2016, a 10 percent or greater drop occurred once a year on average (Capital Research and Management Group – A History of Declines 1900 – December 2016).
Bear Market: The term used when the stock market falls by greater than 20 percent. Bear markets are less common than corrections, but still occur once every 3.5 years (Capital Research and Management Group – A History of Declines 1900 – December 2016).
Crash: There’s no official threshold for this term, but it usually refers to an abrupt and unanticipated drop, say 10 percent or more in a short period of time. Crashes are much less common than corrections or bear markets. Since 1900, there have been three major crashes in the U.S. stock market: the Crash of 1929 (-23 percent in two days), Black Monday in 1987 (-20 percent in a day), and the Crash of 2008-2009 (-20 percent within a week).
Given that it’s been two years since the last correction and roughly eight years since the last bear market, we are clearly due for a market downdraft. But there’s no sure way to determine when it will happen and what it will look like.
I like to keep in mind a quote about the stock market often attributed to noted American financier, John Pierpont Morgan. When asked what the stock market would do, he succinctly responded: “It will fluctuate.” That’s been true since it first opened and will continue to be true until it closes.
We’d all love to know when the market will drop. But history has proven that’s an impossible task. Your best bet is to accept that the market will go down at some point and invest accordingly. Keep in mind that despite corrections, bear markets, and crashes, the stock market has delivered phenomenal returns over time. In closing, here’s a quote from noted investor Peter Lynch:
"Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves."