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Thomas Kloet, CEO of TMX Group, Li Fanrong, CEO of CNOOC, Kevan Cowan, President, TSX Markets and Group Head of Equities and Yang Hua, Vice Chairman of the Board of Directors of CNOOC, speak with each other prior to the launch of CNOOC on the TSX at the Toronto Stock Exchange. The China National Offshore Oil Corporation is one of the major national oil companies of China. (Philip Cheung For The Globe and Mail)
Thomas Kloet, CEO of TMX Group, Li Fanrong, CEO of CNOOC, Kevan Cowan, President, TSX Markets and Group Head of Equities and Yang Hua, Vice Chairman of the Board of Directors of CNOOC, speak with each other prior to the launch of CNOOC on the TSX at the Toronto Stock Exchange. The China National Offshore Oil Corporation is one of the major national oil companies of China. (Philip Cheung For The Globe and Mail)

Is the bull market over? Signs are not encouraging Add to ...

‘What the wise do at the beginning, fools do in the end,” according to Warren Buffett. Undoubtedly, the beginning of the bull market was early 2009. Are we now getting close to the end, or not yet? Here are 10 key questions one needs to ask to determine this:

1. Is there a surge in individual investor participation in the markets?

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A May 15 report by Credit Suisse indicated that the “retail crowd is more engaged than ever.” The average number of daily trades in individual accounts at TD Ameritrade, Charles Schwab and E*Trade, as reported by Bloomberg BusinessWeek, reached their highest levels since 2000. Given retail investors’ tendency to buy high and sell low, this is not a very reassuring sign.

2. Is there a significant increase in the use of margin debt?

Margin debt reached a record high in February, 2014, up 27 per cent from the previous year. Previous record highs in the past decade were in March, 2000, and July, 2007. This is something to be concerned about.

3. Do we witness a sharp rise in IPOs and merger activity?

Initial public offering activity rose sharply in 2013, almost doubling from the year before, reaching its highest level since 2007. While there had been relative calm between 2008 and 2013, merger activity has moved sharply to a higher gear in 2014. According to Bernstein Research, global volume activity surged 63 per cent this year, while Thomson Reuters reported an increase of 71 per cent. This is a disconcerting sign, as well.

4. Do the stock prices of low-quality companies reach new highs?

According to The Wall Street Journal, junk continues to beat quality in the United States. A $100,000 (U.S.) investment at the end of 2008 in lowest-quality stocks would have risen to $380,000 by mid-2013 versus $271,000 for the highest-quality stocks. This outperformance has continued into 2014. The Fed’s policy of keeping rates low has encouraged investors to put more money into risky investments that have the highest likelihood of going bankrupt. This is not a good sign.

5. Is the media bullish?

No. In fact, analysts and the media have started to say that the market is overvalued. On the other hand, analysts such as Tobias Levkovich, chief U.S. equity strategist at Citigroup, think markets have a 91 per cent chance of going up in the next 12 months. The evidence here is more positive than negative toward a continued bull market.

6. Is the Fed providing or withdrawing liquidity from the markets?

The Fed is in the process of slowly withdrawing liquidity from the markets. At the same time, banks are still not willing to readily open their lending facilities to businesses. This is not a positive sign.

7. Are interest rates expected to decline or rise?

Interest rates are at historically record low levels, so there is an increased chance of higher interest rates and expected return on equity in the future. This is another negative sign.

8. Are profit margins at a cyclical bottom or peak?

Corporate profits are booming because of declining commodity prices and a weak jobs market that has driven down the cost of labour. The share of U.S. GDP going to labour income is at its lowest level in 50 years. Where will profit growth come from, especially as going forward, we are likely to be in an environment of lower government spending, higher taxes and lower productivity? This is definitely not a good omen.

9. Are valuations extreme?

Neither price-to-book value nor price-to-earnings ratios are at an extreme level. Yet, 70 per cent of the S&P 500 companies are trading above the long-term average P/E of 14.8. The S&P 500 is trading at 2.71 times P/B, higher than all but five of the 28 bull markets since the mid 1920s. This is not positive.

10. What does CAPE signal about the future?

Since 1881, the Shiller P/E for the S&P 500 (and its predecessor stock averages) has averaged about 16. It is currently about 25. This is not terribly high in today’s economic environment, and is not pointing to overvaluation, assuming the earnings growth rate going forward is 7.2 per cent, i.e., comparable to its long-term historical average of 7.41 per cent, and the expected return on equity remains at the current all-time low level of 9 per cent. However, if an investor believes that we are heading into a future of higher interest rates or lower growth, then the current cyclically adjusted P/E ratio (CAPE) is indeed signalling overvaluation. Based on my views expressed above, this is another negative sign.

In total, nine out of 10 answers have a negative implication. This means that we are closer to the end than not and investors might want to begin lightening up their allocation to the equity market, especially low-quality stocks.

George Athanassakos, gathanassakos@ivey.uwo.ca, is a Professor of Finance and holds the Ben Graham Chair in Value Investing at the Richard Ivey School of Business, Western University. He is also the director of the Ben Graham Center for Value Investing.

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