Six Things to Consider in the Late Innings of the Market Cycle

By Craig Fehr September 03, 2018

Father showing his son how to play baseball

We don't think the end of this bull market is imminent, but it does have a finite shelf life. In baseball parlance, we think we've entered the latter innings of the market cycle. The good news: we think there's sufficient game time left, so don’t head for the exits. At the same time, there are characteristics of the latter stages of market cycles for which you can prepare, helping you stay on track as conditions advance.

1. Checking the signs

There is no exact script for the market cycle, but the current environment is exhibiting several trends that suggest to us we are in the late phase of the expansion. The Bank of Canada (BoC) and the U.S. Federal Reserve (the Fed) are raising rates, unemployment is cyclically – as well as historically – low, and the yield curve (the difference between long-term and short-term interest rates) is flattening. These are not indicators that coincide directly with the peak, but instead often take shape as the business and market cycles begin to mature.

2. Late cycle doesn't mean too late

At 112 months, this bull market is already well-longer than average. This, in and of itself, doesn't predict its demise, and the current strength of economic and earnings fundamentals suggest this phase can be extended. For perspective on the length of late-cycle conditions, historically, it's been an average of 32 months from the first U.S. interest rate hike to the beginning of a recession. In addition, while the unemployment rate in Canada and the U.S. has recently fallen to multi-decade lows, unemployment typically trends below the measure of “full” employment for an extended period of time. And, when the yield curve (10-year rates minus 2-year) first flattens below 0.5%, it was also an average of 32 months before the expansionary cycle ended.1

3. It's not up to chance

Bull and bear markets are not random, nor do they abide by the clock. Historically, the stock market peaks an average of seven months before a recession officially starts. We think the risk of a recession in 2018 is very low, and the expansion is showing signs of extending potentially well into or beyond 2019. A recession will eventually come, and the market will peak in advance of that, but we don't think that's an imminent outcome.

4. The Fed will likely be the closer

Tighter monetary policy, most specifically from the Fed will, in our view, be the likely catalyst that ushers in a recession for Canada and the U.S. We think domestic economic imbalances will lead to slower growth in Canada versus the U.S., but eventually inflation will move above the Fed’s and BoC's comfort zone, requiring additional rate hikes and a reduction in the Fed's balance sheet holdings. Historically, tightening cycles have seen rates hiked by an average of more than 4%, with the BoC's target rate and the Fed Funds rate averaging 9.2% when the recession began – well above current levels. During this cycle, both the BoC and the Fed have hiked rates by less than 2%. While we don't think we'll reach past peak rate levels this time, we do believe there is still sufficient room before rates begin choking-off economic growth.

5. Returns can be worth staying in your seat for

This expansion/bull market is longer than average, and there is a potential for the final innings to be longer than average as well. For long-term investors, the goal is not to precisely predict or time the peak, but instead to position for the late-cycle benefits as well as the potential risks. Since 1950, the average stock market return in the final two years of a bull market was 20% per year.2 We don’t believe we’ll match those gains this time, but we do think there’s reason for investors to stay in their seats.

6. Play your position

As the cycle matures, let your primary guide be your long-term goals and your tolerance for risk. We also think there will be opportunities for prudent diversification and timely adjustments to account for shifting conditions. We think this stage of the cycle is characterized by:

  • Domestic economic momentum, driven by a tight labour market, healthy consumer spending trends and a rebound in business investment. U.S. small- and mid-cap stocks benefit from domestic demand and corporate tax cuts, while being less sensitive to global trade and currency fluctuations.
  • Gradually rising rates in response to firming inflation trends. In a rising rate environment, consider short-term bonds and GICs which face less interest rate risk.
  • Slower, but persistent global growth, supported by extended monetary policy stimulus and markets (such as Europe) that are earlier in the profit cycle.
  • Greater balance between positive fundamentals and policy risks, driving more moderate gains and higher volatility as we advance, with policy risks (trade, geopolitical, monetary) taking turns at the plate with encouraging economic and earnings data. We recommend positioning in the middle of your long-term range for equity and fixed income to account for this balance of opportunities and risks.

With these six characteristics in mind, talk with your advisor about how you can stay on track as market conditions progress.

Important Information:

Sources: 1. Federal Reserve Economic Data. 2. Morningstar Direct. Stocks represented by the total return of the S&P 500 Index.

Past performance of the markets is not a guarantee of what will happen in the future.

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