Have we climbed the ‘wall of worry’? Or: How I learned to stop worrying and love the boom
One of the most common clichés of the last couple of years is the idea that we have been in ‘the most hated bull market in history.” Today attitudes are shifting
Dave wrote in summer 2016 about a pivotal moment in investor psychology and asset pricing: a capitulation in any sense that that the global economy would return to ‘normal’ and arguably a peak in investor desire for safety, drawdown protection, and ‘uncorrelated’ returns.
These conditions set us up for the market behaviour we have seen since: strong returns from risk assets and, crucially, a cost to seeking safety.
Today the world feels very different. In Q4 there were more signs that investors are looking forward to the possible returns that could be generated rather than looking first and foremost to preserve capital in the short term. Within the space of 12 months we have gone from a condition of deep despair to one where markets are being described by some as euphoric.
This was borne out in Q4. Risks assets (with the exception of European equity markets) generally delivered strong positive returns. The S&P managed to finish the calendar year having delivered positive (total) returns in every single month, and a significant increase in the price of a number of commodities was supportive for equities and currencies in the emerging world. Spreads on US high yield corporate bonds reached their lowest levels since 2014.
So, are markets euphoric and should we care?
Intuitively it makes sense that if investors are very optimistic about the future – and this is embedded in prices – then they are vulnerable to disappointment. It is why we have the phrase ‘priced for perfection’ (which is the opposite concept to a ‘margin of safety’).
Dave wrote in November about how it can be difficult to gauge sentiment mechanistically. Experience is more important. Those who were around in the tech bubble say that the environment then was more like Bitcoin today: it became a topic of discussion at parties, a source of bragging rights, and drew those who had never invested before into the market.
The stock market does not ‘feel’ like this today, in fact the consensus seems to be one of deep concern and scepticism. There seems to be more commentary suggesting that everyone else is euphoric than commentary which is optimistic itself. It is common, as in Jeremy Grantham’s recent note from GMO, to see ‘dual time horizon’ outlooks along the lines of: ‘the market will go up for a little bit more but is overvalued and so must ultimately fall below where it is today.’
This echoes much commentary on Bitcoin (‘I think it is a bubble, but I wouldn’t short it’) and is a common human reaction when our expectations have been confounded by price. When the world doesn’t conform to our beliefs, our first reaction is to think it is temporary.
Peak euphoria on the other hand arises when the consensus comes to believe in the new narrative. Consider how those calling a stock market bubble in the late 1990s ultimately came to be laughed at before the crash came, or how those who had been speaking about bond bubbles were far less vocal by the middle of 2016.
The elephant in the room
Ultimately, calling the sentiment of the entire market is subjective. At best we can only have some general sense, and experience is vital to this. Moreover, you don’t need euphoria for a market to crash, as 2008 illustrated. This is why we must not lose sight of valuation.
From this perspective, the most important story of Q4 is arguably the continued rise in two-year Treasury yields.
In so far as these yields represent a risk-free rate they are crucial as a bedrock for the valuation of all assets. In 2017 rising rates did not pressure other assets, even at the long end of the US yield curve.
This is because, although investors have been confronted by the reality of strong macro-economic data, there is still a belief that rates will have to stay lower over the long term, and that Treasuries can play a diversifying role in a portfolio.
This may be because there is a view that the ‘goldilocks’ scenario of strong growth and low inflation that characterised 2017 will persist. However, I would contend that it also reflects a belief that strong data around the world is temporary. The ‘secular stagnation’ thesis has been tested but not abandoned.
Market sentiment is changing quickly, but the signs of euphoria we have already seen are still tempered by this scepticism about the longer term. This is reflected in the shape of the yield curve and the levels of equity risk premia around the world. If a belief that global growth is more sustainable does take hold then there could be opposing forces at work: we could well see euphoria intensify but also increase in cash rates begin to pressure those assets that have been the most direct beneficiaries of the low rate environment. Investors will have to be dynamic and selective in responding to these dynamics.