10 Jan Market Commentary
As I write I am observing headlines indicating individual stock markets around the global are hitting 9 – 10 year highs, or in many cases, all-time highs. Global economic growth is strong and, for the most part, synchronised. Geo-political issues appear less pressing than this time last year. Inflation remains under control. Emergency monetary accommodation is slowly being withdrawn. Market volatility is near record lows.
It has taken us a long time to get here. Since the unpleasantness of 2008/09, recovery has been fitful, uncertain and lacked confidence. For several years markets have been concerned about the sustainability and longevity of the recovery. Given the depth of the downturn and trajectory of the recover to date, this has probably been reasonable, in hindsight.
The trepidation and hesitancy of recent years has been effectively dispelled. We are now experiencing a good old fashioned bull market. The most overvalued of major stock markets is the U.S. Records are being broken on a daily basis. While company earnings have supported this strength, the market is extrapolating earnings growth ad infinitum. This supportive environment has spread to Europe, where the cycle is perhaps some years behind that of the U.S. Emerging markets are also being supported by this virtuous cycle. Good times.
We maintain the view that long term asset market returns are mean reverting. Long term earnings growth, valuations and other key metrics always over/under shoot, but they always revert to long term averages. However, the timeframe in which this occurs can vary widely. We are perhaps finally seeing some ‘mean reversion’ in residential property prices, but this has taken a very long time to occur. Financial markets tend to revert more quickly, a reflection of the relative ease of transacting and liquidity.
Variations from long term averages reflect the impact ‘non-rational’ behavioural. I specifically use this term instead of ‘irrational’ because it separates normative human behaviour (what should be) from actual human behaviour (what is). Evolution inclines us to balance emotive and rational impulses. Both are necessary to function effectively, but it is clear that emotive impulses become more prominent as we diverge from long term averages. Put simply, our ‘fear & greed’ impulses increase as markets rise and fall.
Managing these impulses is the hard part. In the current environment ‘fear of missing out’ is a natural reaction to headlines individuals becoming Bitcoin millionaires etc. In the words of J P Morgan “nothing so undermines your financial judgement as the sight of your neighbour getting rich”. Part of our job is helping you to manage reactions that may be hazardous to your long term wealth.
There are few specific threats to current market conditions. The slow winding back of central bank accommodations are intended to proceed at such a pace that markets can factor this into long term assumptions, and economic growth is strengthening. Nevertheless, there are a number of indicators suggesting we are towards the latter part of the market cycle. These include:
- Increased leverage – U.S. margin lending is near record levels. Corporate bonds spreads are thin at both the investment grade and high yield level.
- Increased corporate actions – mergers and acquisitions, Westfield, 20th Century Fox etc. (It is also interesting that these two examples come from magnates that have historically been builders of empires).
- Increased interest in ‘exotic’ assets – artworks, cryptocurrencies, non-conventional industries (symptomatic of too much money chasing diminishing returns).
- Further to the last point, less interest in the quality of company earnings and more interest in ‘potential’. Not unlike the ‘dot-com’ boom.
- Lack of fear – volatility indices are near historic lows.
- A narrowing in the breadth of market components making record highs – U.S. markets have mainly been driven by tech stocks i.e. Facebook, Amazon, Apple, Netflix, Google (FAANG stocks. You should always be concerned when a new acronym is created).
The catalyst for a market downturn is always a little different. It concerns me that we cannot identify a specific source of weakness, but this is the nature of markets. If it wasn’t a surprise it would already be priced in, relatively to the probability of the event.
The key question is what do we do now? While U. S. markets are particularly overvalued, the same cannot be said for markets like Australia. While our market is at 10 year highs, they remain some way off all-time highs, and forward return estimates remain reasonable. Nevertheless, we know if the U.S. market corrects there will be a short term impact on the Australian market.
No one can pick a market top or bottom. Anyone claiming to do so suffers from the illusion of control, correlating a random call with a random market event. Markets will reach a tipping point, before which you are too early and after which is too late. If you had of sold out of markets in 1996, following Alan Greenspan’s ‘irrational exuberance’ statement, you would have missed nearly four years of exceptional market returns. Returns in 2006/07 were strong despite signs the U.S. housing market was already in decline.
Our asset allocation processes are designed to fit the returns you need with the risks you are willing to tolerate. Higher risk has been rewarded over the past year or so, and may continue to do so in 2018. However, a market correction of perhaps 10% – 20% is likely in the next 12 – 18 months, so you will need to be prepared for an impact on your portfolio. I stress, this may follow further strong gains within this timeframe, and I do not pretend to have any predictive super power. As J M Keynes once remarked “markets can stay irrational longer than one can stay solvent”.
In the interim, we will continue our review process, analysing the various markets, managers and investments to identify where risk can be mitigated. What we will not do is make a binary call to be in or out of a market. This would require a second heroic call on when to re-enter that market in due course and would, effectively, be a gamble. This is not what we do. What we will do is try to ensure any downturn has only a temporary impact on your portfolio and remained focussed on your long term objectives.
Sometimes you need to stand back to stand out.
David Graham CIMA® CFP® SSA™ – 10th January 2018