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Will a stronger U.S. economy tame the bull market?

If interest rates do rise, there are strategies that investors can use to navigate the late stages of a bull market, analysts say


Date: September 17,2014

By almost every significant measure, the U.S. economy appears to be in full recovery mode. But what is good news for employment and household incomes can be problematic for stock markets.

In the traditional business cycle, a strong economy tames the bull market, as investors anticipate higher interest rates raising the cost of future corporate earnings.

In the current landscape, optimism about the economy is on the rise, stock prices have been climbing steadily for the past five years and interest rates have been suppressed for a decade. These metrics alone suggest the stock market is ready for a new direction.

But some professional investors remain unusually optimistic about stocks at this stage of the cycle, believing that conditions are unique.

“This bull market could end at any time. It could end in a month, or years from now. We are not following a normal business cycle,” says Jurrien Timmer, director of global macro for Fidelity Investments.

The normal boom-bust cycle swings on inflation, which leads to higher interest rates and swelling inventories. But the current cycle is unusual in that it grew out of excess debt in the financial system rather than an inventory bubble, he says.

The U.S. Federal Reserve’s resulting policy of ultra-low rates and stimulus has created “a Goldilocks environment” today, where the market is neither too hot nor too cold, Mr. Timmer says.

The economy is expanding just enough that corporate earnings aren’t in jeopardy but not to a degree that the Federal Reserve will have to intervene with tighter monetary policy (raising its key interest rate). Corporate earnings are on track to rise 8 per cent this year, compared with 5 per cent last year.

General investor sentiment is also supporting an extended bull market today. The market meltdown of 2008 and 2009 tore many people’s confidence in the capital markets. Rebuilding that faith has been a slow process, Mr. Timmer says.

“Generally, people are still very skeptical about asset prices and the market,” he says. “They are still looking over their shoulder, wondering what could go wrong. That’s not the kind of euphoric complacency you see at the top [of the cycle] when everyone wants all in.”

One traditional omen of impending rate hikes is a robust employment scene. When the U.S. economy is adding between 300,000 and 400,000 jobs a month, and wages grow at 3 per cent or more, the central bank normally intervenes to cool the economy. Those peaks are not in sight today.

The monthly job growth numbers have been erratic for both Canada and the United States in the past few years. But Robert Johnson, director of economic analysis with Morningstar, notes that in the United States the three-month average employment growth has been consistent, between 2 per cent and 2.2 per cent all the way back to 2011. Those numbers are in step with consumption growth of about 2.2 per cent and this year’s estimated GDP growth of between 2.0 per cent and 2.5 per cent, he says.

“I don’t think the party is going to end tomorrow,” Mr. Timmer says.

The Fed has signalled that it expects to increase its policy rate from zero to between 2 and 2.5 per cent over the next two years. The market is on board with that and as a result both the bond and stock markets are “well behaved,” he adds.

While it may prove too early yet to begin trimming equity holdings, some market watchers say the patterns are clear enough today that investors should be adjusting the kinds of stocks they own.

Martin Roberge, a North American analyst with Canaccord Genuity Corp., believes that the Fed will reverse its long-running stimulus course and boost its key interest rate “no later than next summer.”

Higher rates normally call for a change in investor strategy. During the current bull run, many investors have remained exceedingly cautious, favouring companies with predictable levels of earnings. Smart money will move from these defensive plays into cyclical stocks, according to Mr. Roberge.

Specifically, he is advising investors to buy stocks of companies in sectors that historically have done well at the late stage of a bull market. These include energy, industrials and technology.

On the flip side, the financial, consumer staples and utility sectors have a tendency to lag the broader market at this stage of the cycle, he says.

Mr. Roberge and colleagues analyzed how both U.S. and Canadian markets performed in the one-year leadup to a Fed rate hike for the last seven tightening cycles, beginning in 1977. The S&P 500 delivered a median gain of 16.1 per cent and the TSX posted a gain of 20.7 per cent. In fact, the TSX outperformed the S&P 500 in five out of the last seven cycles, which is one of the reasons he favours Canadian stocks over U.S. issues in the year ahead.

Drilling further into the data, energy, industrials and technology stocks outperformed the rest of the index. The odds of each of these sectors beating the rest of the market are about 57 per cent for technology and 71 per cent for energy and industrials, according to Canaccord data.

While Fidelity’s Mr. Timmer doesn’t advocate a sector strategy for investors, he does agree that conditions favour large-cap companies today and that small- to medium-cap plays have had their best run already this cycle. The Russell 2000 index of small to medium-sized companies has risen 12 per cent over the past 12 months, compared with a 21-per-cent gain for the S&P 500.

Mr. Timmer sees very little chance that the U.S. recovery will get derailed like the European and Chinese ones have. Canadian stocks will benefit from this hospitable environment, but they carry the extra risk in the form of closer ties to the Chinese economy through commodity exports, he warns.

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