Why the Bull Market May Last Until 2018

The bull market in stocks is still alive and kicking and is likely to extend into 2018. But the bull's final charge won't be pretty, according to Doug Ramsey, chief investment officer at Minneapolis-based Leuthold Group, as reported by Barron's. Stocks are likely to face huge volatility as they stage one last rally before year-end and then stumble badly, falling at least 25% in 2018, he predicts. Investors should expect a correction in the next few months, a market drop of up to 10 percent, before the bull's last-gasp rally and final plunge.

Leuthold publishes widely-read studies on the markets.

"If a number of different valuation metrics were to return to their 60-year median, since the S&Ps inception in 1957, that would imply a drop in the S&P 500 to 1750, or about 25%," Ramsey told Barron's. A market technician, he notes that years ending in "7" tend to have a "strong downward bias" in the August to November period. He believes that a pullback of 6% to 8% in the S&P 500 Index (SPX) is already underway, and that the Russell 2000 Index could drop by 13% to 14%. After rebounding to new highs later in the fall, he expects the S&P 500 to close 2017 in the range of 2550 to 2600.

In recent weeks, Leuthold has reduced its maximum net equity exposure to 57%, Ramsey says in Barron's August 26 story. His company, he indicates, has its biggest bets in technology, particularly semiconductor equipment, data processors, IT consulting, and electronic manufacturing services. However, his firm does not own the FANG stocks, which are Facebook Inc. (FB), Amazon.com Inc. (AMZN), Netflix Inc. (NFLX), and Google parent Alphabet Inc. (GOOGL). They do not believe that tech sector valuations are out of hand, even including the FANGs, and see a positive in the fact that the price to cash flow ratio for the S&P tech sector has been virtually unchanged over the past four years, at a value of about 15.

The great bull market will end sometime in 2018, Ramsey predicts, but he won't speculate on when the top will be reached. Current negative indicators that he cites include a slowdown in the auto market, a cyclical peak that's approaching in single-family housing, and a slowdown in annual nonfarm payroll employment growth, which normally precedes the onset of a recession within 12 months. 

After experiencing negative real, inflation-adjusted, interest rates for eight of the last nine years, he expects that "the level at which rates begin to bite might be lower than commonly believed." Thus, if yields on the 10-Year Treasury note rise to 3% or 3.5%, he believes that income-oriented investors might begin selling high-yielding stocks, whereas bond yields of 5.5% to 6% would have been necessary in the past to prompt a similar exit from equities.

Based on market history going all the way back to 1880, a theoretic balanced portfolio that has been 60% in S&P 500 stocks and 40% in 10-Year U.S. Treasury Notes has produced an average annualized return of 8%, Ramsey says, noting that this is a common target for pension funds. In turn, that 8% breaks down into 4.1% from dividend and interest income, and 3.9% from capital appreciation, he adds. Today, however, "a record combined overvaluation" of both stocks and bonds mean that a 60/40 equity/debt portfolio is yielding only about 2.1% today. "That is inescapable investment math that challenges the bulls," he asserts, forecasting that investors will struggle to generate an average annual return of 3% to 4% over the next ten years for such a balanced portfolio.

Meanwhile, billionaire investor Warren Buffett remains positive on the equity markets. He believes that stock valuations, though high by historical standards, are far more reasonable than those on bonds right now. (For more, see also: Buffett Says Aging Bull Market Best Place to Be.)