Question #3 for 2018: What Could Summon the Bear?

We are running a special 3-part series this week on investment themes for 2018, so we’ve asked each of our analysts to respond to the following question: 

“What would it take for the current bull market to finally come to an end in 2018?”

Jim Fink

Bull markets are nurtured by low inflation, which keeps interest rates low, and high corporate profit margins. With stock valuations historically near peak levels, any erosion of these two bullish pillars could be enough to cause a painful bear market.

A spike in energy prices would, by definition, cause inflation and since energy is one of the primary input costs of industrial companies, an energy price shock would cause corporate profit margins to plunge.

Skyrocketing oil prices caused by hostilities in the Middle East would not only cause global inflation and higher interest rates, but could also plunge China, the world’s second-largest economy and a heavy importer of Middle Eastern crude (almost 40% of its total oil consumption), into an economic recession.

It is doubtful that the rest of the world could simply shrug off a Chinese recession and keep growing without disruption. The result could be a global stagflation that causes the worst energy-induced bear market since 1973-74.

Ari Charney

The world’s central banks are preparing to take away the punch bowl. Easy-money policies have helped inflate financial assets and other rate-sensitive sectors.

Equally important, extraordinary monetary policy has helped put a floor under asset prices. The hope now is that both the U.S. and global economies are ready to stand on their own again.

While recovery in the U.S. has been modest, the expansion is about to enter its ninth year. That makes it the third-longest period of economic growth in our nation’s history. We’re obviously closer to the end of this cycle than the beginning.

Granted, interest rates in most developed-world economies remain near historically low levels, even after the recent round of rate hikes.

The Federal Reserve has done an excellent job of telegraphing its intentions to investors. That’s helped make recent rate increases a relative snooze, rather than a disruptive event.

But policymakers never really figured out why the global economy has remained so weak for so long. That makes me suspicious of their sudden optimism about a “synchronized expansion.”

While gradual monetary tightening certainly seems like a reasonable course of action, there’s a risk that the so-called experts get it wrong, once again.

Stephen Leeb

Bull markets typically end once investors see the increasing likelihood of a recession. In many cases, this comes as inflation rises if investors can’t see any way that inflation could be managed without steps that would dramatically slow growth down to recessionary levels (1% or less).

A warning sign would be if commodities started rising too rapidly. As 2008 showed, if commodities, especially ones that we need to import, rise too fast, we have the worst of all worlds: inflationary drivers that at the same time are inherently deflationary.

Continued growth in production of oil from shale would be a positive sign and would likely delay any impact from higher oil prices until 2019 or later. But a slowdown in shale and/or too sharp a rise in oil prices would clearly be negative, and these are areas that investors should be watching.

Linda McDonough

Inflation is the most dangerous threat to the joyous bull market we’ve enjoyed in the past year. Decreased trade via tariffs, taxes and a focus on domestic manufacturing will raise prices. The deflation consumers have experienced to date is a direct result of the globalization of trade. With higher barriers, prices will rise.

Of course, if inflation rises to unexpected levels, the Federal Reserve may be forced to raise interest rates faster and higher than predicted. Each creeping up of rates slices off another layer of cash that might have otherwise been poured into stocks and may keep a lid on equities markets.

Robert Rapier

There is an emerging bull market in the energy sector that is just getting started, in contrast to the long-running broader bull market. For those concerned about the longevity of the overall bull market, some rotation into the energy sector may be prudent.

Expect the energy bull market to gain strength in 2018, unless the OPEC agreement to limit production falls apart (unlikely), or the global economy slips into recession.

Scott Chan

A recession, or at least fear of one, could cause protracted weakness in the market. The most likely causes: If China’s growth slows and there are renewed fears (or at least perceptions) of debt problems in the country.

Given China’s important role in international trade and as a foreign market for many international corporations, trouble in the Middle Kingdom would impact the top and bottom lines of many companies.

Additionally, the global economy would get clobbered if inflation picks up and the Fed and foreign central banks, such as the ECB, overreact and overtighten.

Inflation would suddenly accelerate if there’s a spike in oil prices caused by major supply disruptions. For example, a coup in Saudi Arabia or some other geopolitical event could prevent a major oil exporter from selling its crude.

John Persinos

Triggers for a correction in 2018 will abound. Valuations are off the charts. The stock market is pricier now than in 1929 and in 2007. Those years heralded protracted bear markets. Around the world, there are bubbles in stocks, bonds and housing.

Years of low interest rates that spawned these asset bubbles are coming to an end. The Fed is on course for shrinking the vast amount of government securities it holds. The European Central Bank and the Bank of Japan are following the Fed’s lead.

Two other tightening cycles, one in 1999 to 2000 and another from 2004 to 2007, were followed by stock market crashes. The Fed tries to strike a balance with monetary policy, but it rarely gets it just right.

There’s a danger that rising rates will choke off the economic expansion. At the same time, the Trump administration is gutting the regulations put in place to prevent another 2008. If trouble comes, Uncle Sam won’t have many tools at its disposal.

Also worrying are extremely high debt levels in overseas countries, notably China and beleaguered European Union countries such as Italy. A major overseas bank failure could start a “domino effect” and global contagion. Potential catastrophe in the strife-torn country of Venezuela looms large.

Jim Pearce

Unexpected geopolitical conflicts aside, the single biggest risk to the U.S. bull market is a rotation out of high-multiple growth stocks into lower-multiple value plays. What might trigger that type of event is rising interest rates, which have the effect of discounting future profits at a higher rate.

Many of the growth stocks pushing the market higher are valued based on earnings assumptions several years into the future. Consequently, an acceleration in rising interest rates could reduce their current share price value by a considerable amount.

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