Stock market hits record highs – is a bear market coming?

• When stocks hit record highs, the first thing lots of investors do is get worried.
• But what if you could find reliable indicators of when stock prices are likely to fall?
• Citigroup investment strategist Robert Buckland has just what you’re looking for.
• He maintains a bear market checklist that includes 18 key data points. Here’s what they say now.

With the stock market now up more than 25 percent since its late 2018 low point, many investors are wondering what’s next. Is this as good as it will get, and will the coming move be downward? Some even worry that a bear market — a 20 percent drop from the recent highs, which the S&P 500 came close to in December — will shortly follow, taking down 401(k) accounts and hard-earned savings.

There’s good reason to worry, too. While the U.S. has remained a global bright spot (posting a 3.2 percent annualized growth rate in the last quarter), economies in other countries remain sluggish or are slowing. Diminishing global growth could drag down the U.S. also. Plus, although the Federal Reserve is now signaling a halt in its rate hiking, it has raised interest rates nine times since December 2015. At some point, those higher rates become the gravitational force that pulls down stock prices.

Stock market signposts 

Wouldn’t it be good to have a list of signals that if flashing red would warn you of an oncoming fall in stock prices? Citigroup investment strategist Robert Buckland has you covered. He maintains a bear market checklist that includes 18 key data points. When they hit certain levels, they indicate a bull market has ended and a bear market will begin. His measures include valuation, sentiment, corporate behavior and credit markets.

Buckland’s checklist has done a good job of signaling stock market turns: Almost all 18 measures were flashing red before the stock market fall in 2000. Before the market collapse in 2008 and 2009, 12 of the 18 were clearly signaling a bear market.

What’s this list telling Buckland today? Just two are now indicating a global bear market, and four others are showing caution — a score that’s not even a quarter of what it was in 2000 and 2007. The red-flashing indicators are the debt-to-earnings ratio (showing signs of distress on corporate balance sheets) and the yield curve’s flattening (when short-term interest rates are nearly the same as long-term interest rates).

For Wall Street, the bear market warning is a little higher due to higher U.S. stock prices compared to earnings — the price-earnings ratio. But this is still signaling a low probability that the U.S. stock market turns into a bear at the current time.

The price-earnings ratio

Let’s look at the p-e ratio, which is a measure of a company’s stock price relative to its earnings. The p-e ratio for S&P 500 based on forward, or estimated, earnings for the next 12 months, is about 16.99. The historical range for the forward p-e ratio is about 15.5 to 17. So by this measure, stock prices are in the high end of their range. They would have to fall by about 9 percent to bring the S&P 500’s forward p-e ratio back to the lower end of the historical range.

However, during most memorable stock market bubble in recent times — the dot-com bubble of 1999 — the forward p-e ratio stood at nearly 34 for the S&P 500. Compared to that extreme, we’re clearly a long way from bubble-level stock prices.

The S&P 500 dividend yield

Let’s look at another stock market measure called the S&P 500 dividend yield. It measures the annual dividend income investors receive from the S&P stocks. In the past 12 months, they returned about 1.9 percent in dividends. At the dot-com era peak in January 2000, the dividend yield was only about 1.17 percent.

It’s instructive to compare the dividend yield to the yield on the 10-year U.S. Treasury bond, which is often referred to as the “risk-free” rate of return. Today, the 10-year T-bond yields about 2.5 percent. That’s not much more than the income an investor could reap from owning an S&P 500 index mutual fund, when dividends are included.

Back in September 2000, 10-year T-bonds were yielding about 6.66 percent versus 1.17 for stocks. If you decided to sell stocks back then (at the top of the market), you could have reinvested the proceeds into T-bonds that guaranteed to pay you an income of over 6.6 percent on the reinvested proceeds. And if you held those T-bonds for 10 years, until maturity, you wouldn’t risk losing any of the money you invested.

Back then it was clear that bonds provided a compelling option versus stocks in terms of risk and return. But now, earning 2.5 percent annually on 10-year T-bonds over the next 10 years isn’t a compelling long-term option, especially with the Fed signaling it’s in no hurry to hike rates anytime soon. This scenario makes the case that stocks, not bonds and cash, are the best options now for long-term investors.

The S&P 500 earnings yield

Yet another measure to monitor is the S&P 500 earnings yield. This is simply the inverse of the p-e ratio. It’s the earnings of the S&P 500 divided by the index’s price. It’s a measure of the real earnings per share. You can think of it as the percentage income you would receive if 100 percent of the income from all S&P 500 stocks were distributed to shareholders.

It currently stands at about 5.8 percent, which is over twice the interest rate on the 10-year T-bond. Back in 2000, the earnings yield was just 3.04 percent, and the 10-year T-bond yielded 6.6 percent. The earnings yield got you less than half what a 10-year T-bond would.

“Buy the next dip”

Taken together, some measures show stocks are on the high end of their price range, but more say stocks are the best option for long-term investors. Overall, few signs are barking that a bear market is just around the corner. Said Buckland of his indicator list’s current message: “It’s telling investors to buy the next dip, just as it told them to buy the last one.”