Why Bull Market 2.0 May Be Far Less Exuberant

The bull market isn't over yet, but the high for 2018 is behind us, according to widely followed investment strategist Jim Paulsen of the Leuthold Group, per a report in Barron's. Paulsen predicts that the S&P 500 Index (SPX) will close the year at 2,550, down 2.7% from the February 9 close, and 11.2% below the record high set on January 26. His reasoning: stronger economic growth means increasing inflation and higher interest rates, and higher interest rates make the current levels of stock valuations unsustainable.

Implicit in Paulsen's analysis is that, regarding stock prices, the negative impact from higher interest rates will outweigh the positive impact from higher economic growth and corporate earnings. The S&P 500 gained 1.5% on Friday, but lost 5.2% for the week, and is down by 8.8% since its record close on January 26. The 10.2% drop in the index between its closing values on January 26 and February 8 represented the fifth correction during the current bull market, per Yardeni Research Inc.

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The New World for Stocks

As Paulsen told Barron's: "we have an economy that is growing at 3% real and 5% nominal and now we have a synchronized global recovery that's happening with the unemployment rate at about 4%, which is full employment." Moreover, he said, "This new world is not compatible with price to earning ratios on the S&P 500 of 23 times trailing or 19 times forward earnings, or a 10-year Treasury yield that is 2.5% or lower." Paulsen predicts that, if the yield on the 10-Year U.S. Treasury Note moves to 3% or higher, "that would create additional havoc" in the stock market. That yield was 2.857% as of the close on Friday, per CNBC. (For more, see also: 6 Forces That May Push the Stock Market Even Lower.)

The Fed Holds Firm

The Federal Reserve appears likely to raise rates at least three times this year, according to comments by Robert Kaplan, president of the Federal Reserve Bank of Dallas, as reported by CNBC. More upward pressure on rates will come from the Fed's planned reduction of its massive balance sheet and unwinding of quantitative easing by selling off bonds or letting them mature without reinvesting the proceeds. Moreover, Kaplan indicated that the unemployment rate in the U.S. may fall below 4%, the level that normally is taken to denote full employment. This should spur increased wage inflation. "2018 will be a strong year in the United States," CNBC quotes Kaplan as saying, adding that he expects a moderate slowdown in 2019 and 2020.

Tax Cut Skeptic

Former Secretary of the U.S. Treasury Lawrence Summers, in a December 10 opinion piece printed by The Washington Post, claimed that the economy is on a "sugar high," and that "the drivers of this year's [2017's] economic strength are likely transient, and that the structural foundation of the U.S. economy is weakening." He also insisted that "tax cuts are very much the wrong prescription."

Summers fears that cutting taxes "will further starve already inadequate public investment in infrastructure, human capital and science," and that it "will likely mean further cuts in safety-net programs and cause more people to fall behind." An additional concern of his regarding tax reduction: "because it will also mean higher deficits and capital costs, it will likely crowd out as much private investment as it stimulates." 

He also asserted, "it is hard to imagine that, with 4.1% unemployment, the economy can continue creating anything like 200,000 jobs a month, given that normal growth in the labor force is about 60,000 people." Subsequent to his claim, the U.S. added 160,000 new jobs in December and 200,000 in January, per CNBC.

Long Corrections: Not Unusual

The longest bull market since 1928 lasted 4,494 calendar days from December 4, 1987 to March 24, 2000, during which time the S&P 500 gained 582%, according to data from Yardeni. The current bull market is the second-longest of this era. From its start on March 9, 2009 through February 9, 2018, it has lasted 3,259 calendar days and risen by 287%.

Paulsen's forecast suggests a long correction in the current bull market, rather than the start of a bear market, which would require a decline of 20% or more from the January 26 high, according to the commonly accepted definition. Indeed, protracted corrections in the midst of bull markets are not unusual. Yardeni counts seven in the post-1928 era that lasted 194 days or more, with the two longest having been 531 days (1976–78) and 422 days (1959–60). There are 339 days from January 26 through the end of 2018. (For more, see also: Why Stocks Won't Crash Like 1987: Goldman Sachs.)

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