This Thursday Second Longest Equity Bull Market Reigns

This Thursday, April 28th, the U.S. equity bull market will become the second longest ever, at 2607 days old. That exceeds the 1949 to 1956 bull market of June 1949 to August 1956 by one day, a Bank of America Merrill Lynch report noted. The longest equity bull market occurred for almost a decade from October 1990 to March 2000, lasting 3452 days. Will this equity bull market challenge the record? The report notes the importance of Fed rate hikes – musing on “one and done” past performance – as it ponders “the final capitulation.”

Equity bull market: Watch for a mean reversion

Year to date global returns of the major asset groups have been strong in segments, weak in other areas.  With commodities up 8.4%, bonds 6.4%, stocks 3.3%, the weaklings of the market have been cash 0.1% and the U.S. dollar -4.2%.

“Underperforming cash has been a performance problem because investors in the past eight weeks have been awash in cash,” BAML’s Chief Investment Strategist Michael Hartnett and Investment Strategist Brian Leung observe in an April 21 Thundering Word report titled “One & Fun.”

Ultimately the BAML strategists see a mean reversion market. In the past easing policy from the U.S. Federal Reserve, European Central Bank, in China and even Saudi Arabia “has caused a big rally, the latter phases of which should see a significant decline in cash levels as well as capitulation into assets that are lagging the rally, and fatigue in assets leading the rally.” Today’s winners in the equity bull market are tomorrow’s losers.

Using index divergences from 200 day moving averages as a “decent guide” to the “oversold” versus the “overbought,” BAML notes those markets that are over-loved and under-loved. Over-bought assets that could suffer from a mean reversion effect include Brazil resources and financials, Russian financials, Canadian resources, US telcos, High Yield steel and metals. Those oversold assets include financials in Italy, Switzerland, Spain, the U.K. and Japan, as well as High Yield airlines and transportation in those regions where central bank policy remains accommodative.

That love of bank stocks and other various financials comes with a caveat. “Our bias remains cautious in light of regulation, redemptions, repression and thus we would look to add volatility exposure as Fed and investor complacency returns.”

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Fed one & done modeling

It’s no surprise that the U.S. Fed is a key contributor to the stock market rally – and potentially a key to its demise. That said, Hartnett and Leung comb through history to look for the “one & fun” phenomena.

There have been seven Fed one & done rate hiking cycles since 1926, just before the great depression. “Asset prices have responded very well to a “one & done” tightening cycle,” the report noted, citing one big caveat. Rate cuts followed some of the rate hikes with a one- to two quarter lag. “On average, an initial pull-back in risk assets gave way to a big rally in government bonds,” which was followed by a sharp recovery in equities with a particular focus on value and small-cap issues. “Results are even more impressive if we exclude the “one & done” Fed hike in 1931.”

With this in mind, BAML looks to its house analysis that points to coming Fed rate hikes in 2016 and 2017, and notice a more disappointing trend. “There have been five occasions when the Fed started a tightening cycle, paused for at least one to two quarters, and then resumed tightening,” the report noted. “Asset performance was less impressive on these five occasions.” During such periods Government bonds generally outperformed both equities and the U.S. dollar, while value stocks outperformed growth and large-cap outperformed small-cap. “Overall, asset returns were muted across-the-board bar copper, which significantly outperformed.”

Hartnett and Leung observe what they call a “fickle Fed” that is locked in a “data-dependent” state where the “postponement of US rate hikes and deeper credit-targeted QE by the ECB has worked wonders on the credit market.”

Take, for example, the new highs in the high yield auto sector and consider how the situation might turnaround. “Higher rates remain the necessary condition to engender a nasty credit unwind after an ‘era of zero rates.’ Multiple assets classes, all big beneficiaries of excess liquidity and zero rates, are likely to be penalized by higher rates…auto lending, private equity, asset gatherer, risk parity, private infrastructure, unicorn.” There is a new mantra forming, one that U.S. Senator Elizabeth Warren and Democratic hopeful Bernie Sanders might cheer but Lloyd Blankfein, under siege Monday from banking analyst Dick Bove who blamed him for a “lost decade,” might find challenging. “Hence long Main Street, short Wall Street,” the BAML report noted.