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3 Factors Show a Bull Market That Has Exhausted Itself


Image source: Thomas Sorenes, republished under CC BY 2.0.

U.S. stocks are slightly lower in early-afternoon trading on Wednesday, with the S&P 500 (SNPINDEX: ^GSPC) and the Dow Jones Industrial Average (DJINDICES: ^DJI) (DJINDICES: $INDU) down 0.39% and 0.33%, respectively, at 12:25 p.m. ET.

Perhaps it's the skeptic in me, but it's hard to ignore the sense that the bull market in U.S. stocks "is exhausting itself" as legendary hedge fund manager Stanley Druckenmiller warned the participants at last week's Ira Sohn Investment Conference (or perhaps "has exhausted itself" -- different outlets have printed one or the other).

Perhaps it's simply the case that Druckenmiller is a perma-bear; after all, last November, he said: "I can see myself getting very bearish, I can't see myself getting bullish."

I prefer to think of him as risk-averse, and that trait has served him and his investors well: In 30 years of managing money at Duquesne Capital Management, he did not have a single down year. Side-stepping losses was instrumental in achieving an annualized return of 30% between 1986 and 2010.

Here's an indication of the market exhaustion Druckenmiller refers to: Barring an unexpected rally, the S&P 500 will celebrate next week the one-year anniversary of its closing high of 2130.82. Since then, the index has closed within 2% of the high on 62 days: close, but no cigar.

Revenue growth has been weak 

It's not just the stock market that appears exhausted, either; it's the fundamentals that (are supposed to) underpin it, too. As JPMorgan's head of U.S. equity and quantitative strategies Dubravko Lakos-Bujas wrote in a note to clients yesterday, "While the current recovery cycle is often cited for its long duration (fourth longest since 1900), the fact that organic growth has been weak and unbalanced is often understated."

And he has the numbers to support that statement:

During this cycle (2Q07 profit cycle peak to present), revenues expanded at 2.5% [compound annual growth rate] with total cumulative growth of 24% (vs. the prior cycle at 7.8% and 66%, respectively).

While sales growth was robust in the initial years of this recovery, the steadily declining trend has been less encouraging. More recently, top-line contracted during each of the last four quarters and is expected to decline further in 1Q16 (-1.8% y/y) and 2Q16 (-1.1%). The prior recovery in comparison was more robust and consistent without any intra-cycle contraction.

Organic revenue growth has been even weaker

But even those modest numbers overstate the strength of the fundamentals, as Lakos-Bujas explains:

Further, we estimate 39% of overall sales growth was driven by M&A during this cycle compared to 16% in the prior cycle. Excluding this synthetic boost, organic revenue growth has been a dismal 1.6% CAGR or 15% cumulative (vs. 6.8% and 55% in the prior cycle).

All told, organic revenue growth has been weak, driving roughly 50% of S&P 500 earnings growth, with the rest driven by margin expansion, largely thanks to interest expense reduction from the prolonged zero interest rate policy.

This is not to mention a third factor that Druckenmiller raised just over a year ago when he remarked that "[e]very month that goes by we have more and more financial engineering." Companies have been buying back their own shares on a massive scale, goosing earnings per share.

None of this is to suggest that investors ought to abandon U.S. equities -- I think it's worth being a Buffett-style long-term optimist on the U.S. economy and betting on U.S. corporations. However, investors ought to be prepared for the possibility that returns in the near to medium term will be disappointing, and perhaps even ugly.

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