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from an equity market perspective. In general, real short-term rates will need to be stronglypositive before the onset of any bear market. Though an imprecise indicator, real short rates abovetwo per cent seem to have the ability to cause market damage.

Another tool investors may use to judge monetary conditions is a type of Marshallian K construct:comparing the growth of some form of money supply (like M2) to nominal gross domesticproduct (GDP). The logic is that whenever money supply growth lags nominal GDP, liquidity willbe sucked out of financial assets for real economy use. The reverse flow from the real economyinto financial assets occurs when M2 is growing faster than nominal GDP. As BCA points out, thegap between growth in M2 and in nominal GDP turned negative before almost every bear marketprior to 1980. Though this signal has been less effective in recent years, it is still something tokeep track of.

Currently, none of the three monetary indicators mentioned above shows any signs of impendingmarket stress. The yield curve is positive, real short rates are negative, and money supply growthcontinues to exceed nominal GDP. There is nothing on the monetary side that should worrymarket participants. Yes, the Fed has begun normalising monetary policy, but raising rates fromvery low levels when economic growth is improving should not trigger a bear market. Market

volatility and disruption, yes - but bear market, no.

Valuation is the other obvious indicator that judges a market's vulnerability to a bear phase.Valuation indicators, whether they are simple P/E multiples or even the cyclically adjusted P/E,have very little use for timing equity bear markets. Valuation overshoots can persist for longperiods of time. Valuations are, however, useful in determining prospective returns. Buying amarket when P/E ratios are high will generally deliver lower 10-year returns than buying whenP/Es are low. There is also a loose relationship between the extent of overvaluation and theseverity of the subsequent bear phase. While equity markets in the US are no longer cheap, theyare not at an extreme either. Current trailing P/E ratios are within 10 per cent of long-termaverages. Stocks also look very cheap if one uses any interest rate-based valuation tool, which

reflects the extent of overvaluation in fixed-income markets. As discussed, valuation is not usefulfor timing - but apart from that, except for some technology and biotechnology subsectors, broadmarket valuation does not seem to be at such an extreme as to cause worry.

Technical indicators - such as sentiment, breadth and momentum - can be important in trying tounderstand market vulnerability and are useful at market turning points. Current technical readingsare mixed - the market is above its 200-day moving average, but sentiment seems elevated withinvestment advisor bullishness and margin debt at an extreme. However, given the amount ofdiscussion that is taking place on bubble-like conditions in financial markets, it does not seem thatwe are in the midst of euphoria. Nor are equity market flows strong enough.

US equity markets will eventually have a significant bear market. All markets are eventuallycyclical, but there seems to be no reason to feel that it is imminent. A shock independent ofmonetary policy can induce a market correction, as can a serious economic recession - but the firstis not forecastable and the second seems unlikely in the short term. Most economists expect theUS economy to actually accelerate from here, not fall into another recession. A significant declinein corporate earnings can also be another trigger. However, absent a recession, despite the calls forregression to the mean in terms of profit margins, one cannot see how earnings in the US candecline enough to trigger a bear market. Recent corporate earnings have been weak, but they arenot declining.

If the US equity markets hold, that will hopefully provide an enabling backdrop for equity markets

across the world.

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The writer is at Amansa Capital

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