- U.S. stock markets have performed well, but valuations are increasingly stretched.
- High stock valuations are supported by possible tax reform and the notion that interest rates will remain low for a long period of time. If interest rates continue to rise or tax reform fails, U.S. stocks could stumble.
- Rising interest rates along with decreasing levels of central bank support from the Federal Reserve, European Central Bank and the Bank of Japan will likely lower broader market liquidity levels for the remainder of 2017 and into 2018.
- Central banks are now publicly asking themselves whether they’re more concerned with high asset prices or low inflation levels. How the Federal Reserve and the ECB answer that question via the speed and severity of interest rates hikes and tightening financial conditions will likely drive near-term market performance.
- Staying invested, given the paltry alternatives, is vital. However, a cautious outlook and positioning is warranted given premium valuations and potential near-term road bumps.
Increasing Risk Appetites
“Be fearful when others are greedy and greedy when others are fearful.” - Warren Buffett
As you know, we have experienced almost nine years of relatively uninterrupted growth in the U.S. stock market (and the 3rd longest business cycle expansion on record). We believe many investors are taking on increasingly more portfolio risk at a point in the business cycle when history and prudence would suggest that the opposite course of action, temporarily reducing risk levels, is the best path to achieving positive long-term returns.
The increasing risk appetite amongst the investing public can be viewed a number of different ways, but a basket of simple metrics show that investors are unequivocally more excited about future investment returns than they were even a year ago.
Wells Fargo/Gallup’s most recent U.S. Investor and Retirement Optimism index is at levels not seen since the roaring dot.com bubble. Household stock exposure is close to 2008 levels, again only surpassed by the market peak in 2000. In fact, more than half of all U.S. household financial assets are now invested in the markets, up from a ~30% historical average. Cash allocations are at dot.com era lows. The Investor Intelligence sentiment index (also known as the Bulls-to-Bears ratio) is at a post-1987 high. Personal savings rates, which surged upward for a brief period following the financial crisis, have drifted back to pre-crisis levels.
Consumer confidence, which recently reached December 2000 levels, is another curious statistic that one would think should be a positive for markets. It’s consumers who drive the economy and if they’re optimistic they’re likely to spend more, right? But there’s a lot of data that supports the notion that consumer confidence is actually a lagging indicator because it’s typically after folks buy their big ticket items that they report confidence about the future. After all, the reason they made a purchase decision on a car or new washing machine was because they felt confident about the future in the first place.
So eclipsing the December 2000 consumer confidence levels sounds great on the surface, but when you recall the fact that the dot.com meltdown and bear market that lasted two years had actually already started a few months earlier in October of 2000, it signals that investor caution is warranted.
No matter how you slice it, investors are optimistic and think the good times will keep rolling. In isolation, any of these statistics would be considered with a grain of salt. But together they paint a picture of general optimism which is likely priced into markets to a large degree. Unfortunately, investors tend to be most optimistic about stocks after they’ve done well (and future returns are likely lower than in the recent past) and become pessimistic only after they fall (when there’s actually less risk and future returns are likely higher).
In short, investors are growing more concerned with the return on their capital than the return of their capital.
We believe that staying cautiously positioned in the near future will give us the ability to capture greater prospective returns should volatility pick up.
Buying Into Market Hype
To illustrate just how easy it is to get sucked into the buy-at-any-price mentality, let’s look at comments made by Mad Money host and former hedge fund manager Jim Cramer.
Almost a decade ago to the day, on Halloween of 2007, in the 5th year of a bull market Cramer said “You should be buying things and accept that they are overvalued, but accept that they're going to keep going higher. I know that sounds irresponsible, but that's how you make the money. Right now, up is down, left is right, peace is war."
That’s how many investors feel today; most professional investors will freely admit the stock market is expensive, but those same managers believe they simply have to be invested out of fear of missing out on the next uptick. But it’s when we all collectively “buy in” and believe that stocks will always outperform everything all the time that things tend to go off the rails. When Cramer made his buy-at-any-cost comment, it reflected the sentiment of the time. Unfortunately the U.S. stock market had already peaked a few weeks before his statement en route to losing 54% of its value in the next 17 months. What had worked leading into his Halloween call, buying overvalued stocks and watching them go up, stopped working almost overnight.
We don’t mean to pick on Cramer. He seems like a generous, kind-hearted individual and has been a great financial communicator to the masses. But these market musings that encouraged folks to buy overvalued companies simply because they may go up a bit further at the top of a market cycle point out a glaringly obvious investment truth: the more you pay for an asset, no matter how great it is, the lower return you receive. A great company can be a risky investment if purchased at too high a price. Conversely, a middling company may be a wonderful investment if purchased at a bargain price.
Instead of losing half their life savings in less than a year and a half, clients who were with us from 2007-2009 will remember seeing very stable portfolio values. We saw heady optimism bubbling up and became more defensive in order to protect capital. We didn’t call the downturn on a dime, but we feared losing our clients’ hard-earned life savings far more than missing out on the last uptick in the stock market. While we don’t see the same level of excesses in markets today that the housing market displayed in the months leading into 2008, we do see the same “buying X always works” mentality. Back then, it was houses. Today, it’s large cap U.S. stocks.
From an emotional or psychological perspective, becoming more conservative and stepping back on risk taking is hard to do when the recent trend in prices has been up and taking ever more risk has been rewarding. It’s like leaving a party in full swing at 10 o’clock at night: if the party rages on you may miss the crescendo of the night, but the next morning you’re almost certainly more likely to feel better than those that fully participated in revelry of the night before.
Rising Interest Rates vs. Stock Markets
Perhaps the single most important consideration to investors today, especially when viewed in the context of high stock valuations, is an increasingly aggressive Federal Reserve. Jerome Powell has been nominated for Fed Chairman but, if confirmed, he is largely expected to continue Janet Yellen’s policy style. Even accounting for a potential replacement of the Fed Chair, a December interest rate hike is viewed as an 92% probability by the markets. If the Federal Reserve hikes rates in December and continues hiking in 2018, stock investors should take note. When the Federal Reserve starts hiking rates, they rarely stop until the economy hits a recession. In fact, 11 of the last 13 recessions have been caused by Fed tightening cycles just like the one we’re currently in.
In the 101st month of the economic expansion the Federal Reserve is increasingly antsy to return the economy to “normal”. This means higher interest rates over time. The only factor that has kept them from moving interest rates successively higher has been persistently low inflation. Now that inflation seems to be nudging upwards (even though it’s still very low), the Fed has the green light to raise interest rates.
In addition to the Fed charting a course for higher rates in the coming years, other central banks around the world are now repeatedly and very publicly questioning whether fighting low inflation is more important than popping asset bubbles before they grow too large. If they come to view ebullient stock markets as a bigger economic risk than low inflation, they may ramp up the pace of financial tightening. To this effect, the European Central Bank, led by Mario Draghi, recently signalled their intentions to slowly pull the punch bowl away from markets.
In summary, we remain optimistic on the U.S. and global economy but believe caution is warranted in portfolio positioning given the extreme optimism priced into markets and rising interest rates. Furthermore, we believe the asset allocation and security selection decisions made on behalf of our clients will weather downturns particularly well and we continue to prioritize downside protection when making new investment decisions.