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A cause for concern over bull markets

By Ian Woodcock
Defensive positioning and the ability to look through positive market moves is becoming increasingly important in today’s investment climate, and it would seem that the elongated bull market is at odds with investor sentiment.  A lack of easy options for investors is forcing them into riskier assets, which consequently has helped cause a market bubble not truly reflective of the surrounding conditions.

While the backdrop may be very different from the cusp of the tech bubble in 2000, there remains the real possibility that valuations could revert over the coming months, albeit perhaps with a slower and more drawn out decline rather than an overnight ‘crash’

The prolonged bull market we are currently seeing continues to climb among considerable levels of investor pessimism, which is in stark contrast to the euphoria so evident in the lead up to previous market peaks.  But while many investors out there might not be feeling bullish, a lack of appetizing investment options means in many cases they feel forced to act as if they were, and invest more aggressively in search of greater returns.

Since last June’s EU referendum, the global-facing FTSE 100 index has rallied impressively, although many could argue this has been caused by a weak sterling rather than positive investor sentiment.  At the same time, fears surrounding geopolitical uncertainty and historically low interest rates have forced investors into fixed income assets in a bid for income, which has pushed bond yields down to all-time lows.  This disappearance of income from traditionally ‘safe’ assets has caused a relay race-style bid for yield, whereby investors have had to move back to higher-risk investments to achieve the desired outcome.

While the psychological backdrop to the market may feel anything other than a bubble, by traditional measures of valuation equities led by US indices are still very expensive.  For example, the cyclically-adjusted price-earnings (CAPE) ratio of the US stock market is currently at 29.4 times compared to its long-term average of 16.8 times.  This is a level that has only been reached during twice previously, during the 1920s before the Great Depression and during the dotcom bubble of 2000, so the signs are not good.  Other metrics also point towards equities being expensive. US market capitalisation measured against GDP, for instance, confirms that stocks are challenging their 2000 valuation highs.

Worryingly, economic forecaster GMO estimates a loss of value of 3.8% for US stocks for the next seven years, which is significantly greater than its predicted losses of 2% during the summer of 2007.  Looking at the accuracy of the firm’s forecasts in the past this should be a compelling reason investors to remain defensively positioned, But for younger investors, seeing the threat of change is not always easy.  Professional investors under the age of 30 have likely never experienced a testing correction or a bear market, they have enjoyed only tailwinds blown from central bank-sponsored asset inflation which might make them feel almost bullet-proof.

Given lacklustre returns from asset classes across the board – fixed income and cash in particular – the merits of investing in equities at the moment are clear.  However, catalysts for market corrections in the past have been evident for those prepared to actively seek them.  In 2007 the debt edifice was ripe for collapse and the early warnings were visible in the form of Collateralised Debt Obligation funds liquidating and Northern Rock customers queueing for their savings back.  These were signs on the road to the failure of Bear Stearns and Lehman Brothers, and while previous market highs may have been less obvious – rising interest rates usually call time on elevated and rising valuations.  So with the Federal Reserve now raising rates for the first time in over a decade the clock is ticking.

The writer is investment consultant at Chase Buchanan: ian.woodcock@chasebuchanan.com

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