For the first few years after the 2008 financial crisis, I often only had one slide with me at presentations and this was it:
The chart shows the trend line since 1849 of the US stockmarket (the unbroken diagonal line above) increasing by 6.2% per annum (after inflation). It demonstrates that the compounding effect of investing in equities is good for your wealth; the challenge is staying the journey as it can be very bumpy. On the chart there are dotted lines representing one standard deviation away from the trend line. When the index crosses these lines, and this doesn’t happen often, we need to pay attention to our asset allocation.
My message at the start of this decade was to own US equities and revisit that call when the US stockmarket was close to the upper dotted line – and here we are! A further 15% increase in the US market in the next six months and we will clear the upper dotted line. My first thought at that point will be that our long-run expectations for real US equity returns, say for the next ten years, should be under 6%. This is not reflected in pension fund assumptions today.
Given the strong performance of equities you may well be receiving warning messages about stretched US equity valuations. I have read these messages and partly agree with the analysis, but not the conclusions.
My view differs in three areas:
Firstly, a lot of the valuation metrics are accounting measures. If we look at cashflow production and cash return on capital the US really stands out. So on a cashflow yield basis there is not a lot, if anything to choose between the US, Japan, Europe and emerging markets. They all offer just over 4% cashflow yields and importantly this looks good relative to bonds.
Secondly, investors are really starting to discriminate between new economy and old economy stocks. New economy companies have powerful network effects that act as strong barriers to entry and until regulators or society forces changes, these companies will beat the fade. Furthermore, the US market is much more concentrated than in the past, which allows very large corporations to sustain higher profits. These are important factors that need to be considered when comparing countries to the US.
Finally, valuation is not a good timing indicator unless you are measuring over several years. Expensive is good, until it isn’t. We need to monitor crowd behaviour and their emotions for timing; our colleagues on the M&G Episode team often remind us that asset prices move the most when people change how they feel about owning them.
After making a lot of money, people get emotional and in what I term ‘the BBQ effect’ they want to share these feelings – this causes those who have missed out to be jealous. It should therefore be no surprise that at market ‘tops’, a large proportion of the population, when asked, expects further gains. The opposite is also true at market lows. This is why the returns that investors actually earn lag the marketing promise of the asset class.
With this in mind it is worth taking note of the levels of optimism that we currently see.
The University of Michigan has been carrying out consumer surveys for more than 70 years. Each month, over 500 people are extensively interviewed and since 2002, one of the questions asked is: ‘What is the probability that the stockmarket will go up over the next year?’
The latest survey showed that 46% of respondents thought there was more than a 75% chance of the market being higher in a year’s time – this number has never been higher. Meanwhile, 21% of respondents (‘the pessimists’) see a 75% or greater chance of the market being lower in a year’s time. This is a big improvement from January 2016, when the number was 36%. The percentage of respondents expecting a drop in the stockmarket has been lower seven times before and I would expect it to fall from here. The gap between the ‘optimists’ and ‘pessimists’ is 25%. Just before the 2008 financial crisis it was 27%. This is just one survey, but the message is clear it is time to tread carefully.
Akin to this thinking is the logic that cyclical stocks should be bought when their relative valuations are depressed alongside readings of weak economic activity. This has really been the story since the start of 2016. When cyclical valuations get stretched and we see peak cyclical momentum in the economy we should be concerned. With that in mind, your email inboxes are probably starting to reflect talk of synchronous growth and above-trend profit growth.
This is clearly visible in the Purchasing Managers’ Index (PMI), an indicator of the economic health of the manufacturing sector. The PMI is based on five major indicators: new orders, inventory levels, production, supplier deliveries and the employment environment. As at the end of October the global PMI hit a six-year high. Furthermore, growth is very broad based with 91% of countries in expansion, slightly down from a near-decade high of 94% in September. Ned Davis Research has looked at these two indicators and the historical data shows the median time from a peak in the PMI and a peak in breadth to a recession, is 14 and 9 months respectively.
Currently, a recession looks like a very low probability but when this good news gets extrapolated into prices pay attention to the changing rhetoric, as at that time I believe we will be above the upper dotted line and when risk is forgotten it is greatest. It is also worth remembering that euphoria does not need to imply higher pricing of risky assets but may be accomplished by falling, currently perceived, safe assets and rising yields.
All of this makes a daunting task for savers in planning for retirement and in diversifying risk.
I suggest you all ‘have your ears to the ground’ at any social event you attend for the BBQ effect as 2018 is shaping up to be an interesting year.