The latest TopFunds Guide is available now. Do email back for your copy.  Below we cover the growing conflict over the market outlook, “Battle For Supremacy: Puritans vs Cavaliers”

Even if you didn’t study the English Civil War, you’ll recall the stereotypical images of dour fire and brimstone Puritans dressed all in black, and smiling, foppish Cavaliers.

So it is in markets now. The dour Puritans believe the end is nigh. The colourful Cavaliers are proclaiming an extraordinary bull market ahead. Let’s explore the arguments

The Litany Of Lunacy – The Puritan Case

Previously we have set out the three key ingredients that help you identify an overvalued market which are:

Over-valuation: From similar bouts of overvaluation through history the falls in the US stock market have averaged 46%. And you don’t have to go far to sniff 1999 madness. On the takeover of WhatsApp it was valued at $350 million per employee – doubtless they are each worth every penny!

Or take Tesla. It has sold only 27,000 of its electronic cars since its 2010 birth, yet is valued at $31 billion. This is a greater market value than born-again General Motors, which sells 27,000 cars every day.

Over-confidence: Over confidence is beautifully caught by something called VIX, reflecting the price of US equity options, and expected volatility. Earlier in May it fell to an all-time low, and the Wall Street Journal celebrated with the headline “The Death of Volatility” and said “Fear has left the building”.

The wonderful parallel is with the BusinessWeek headline of August 1979, which proclaimed “The Death of Equities”. Guess what happened next?  The greatest bull market in stock market history. What might happen now? It is too glib to suggest the greatest volatility in stock market history. But whatever happens, it seems highly unlikely to be a comfortable ride – though the Puritans would put it much more strongly than that.

Easy money: In a nutshell money is plentiful (due to quantitative easing or money printing) and it is cheap e.g. at the lowest levels since 1694 in the UK. This always ends in tears, and “tapering” represents the beginning of the end as the moneyprinting exercise draws to a close.

These three elements focus on a “state of instability”, as we call it, prevailing in stock markets. But problems are more widespread. Japan is undoubtedly on a knife edge. Abenomics appears to be faltering which means that the most indebted nation in the world only has one choice – even more debt!

Analysts might not agree on the outlook for developed economies, but the consensus remains alarmed about the debt bubble in China.  Yields on high yield corporate bonds (junk bonds) are hitting historic lows just as the quality is noticeably deteriorating – more complacency.

Much of what passes for volume in stock markets is actually machines talking to machines, what is called High Frequency Trading. Markets can fall precipitously if there is a sudden shock of some kind, and this trading dries up, or reverses.  Corporate bonds have a similar problem. In 2008/9 some corporate bond funds fell more than 30% when buyers at any price disappeared. This bond market is even more vulnerable now.

Party Like It’s 1998 – The Cavalier Case

To be fair to the Cavaliers, on the whole they’re not saying the world’s problems are solved – the fact is debt levels are somewhat higher than in 2007/8.

To counter-balance tapering in the US interest rates will stay low for some time to come, as central banks know the global economy remains very fragile. Yes rates might edge up, (UK’s Mark Carney has already told us to expect this) but this will be measured, with rates remaining very low by historical standards.

The Cavaliers say that the valuation method used by the Puritans (cyclically-adjusted price earnings ratio, or CAPE) is at best a blunt instrument.  More sensitive measures suggest the markets are merely at historical averages. As such there is plenty of upside, they say.

In particular, the amount of money washing around the globe, and looking for a home, is growing and could grow substantially more.  This money is derived from various sources.  Money-printing by the US, quantitative easing – QE, has been a huge mover of asset prices around the globe, but it is not alone.

Much more Japanese QE could come, much finding its way overseas. In the interim cash rich Japanese companies and consumers will be drawn to better opportunities overseas, which will be given a kick by the yen falling in value.  The Chinese are huge savers, and a proposal to remove exchange controls could trigger considerable flows of private money out of China.  There is also a savings glut in Germany. And many consumers around the world prefer to save rather than increase spending, so their cash has to go somewhere.

The team at Pimco, one of the worlds largest bond fund managers, acknowledges the global debt levels, but see this as a positive, at least for the next three to five years.  Increasing debt levels globally will restrain growth, which will hold back inflation, and prevent any sharp rise in interest rates (as this would increase the debt interest burden). Thus a stability of sorts is established – just what investors crave.

Going forward returns from equities and bonds might not excite, but will still be more than adequate in a low interest world, suggest Pimco.

Lombard Street Research go much further. They do not believe stock markets are overvalued now, and see Anglo Saxon markets as the major beneficiary of excess global savings and cash flowing out of Japan, Germany and China.  Like 1998, they see another couple of years of markets bubbling higher, with the possibility of extreme bubble conditions if China reforms more quickly than expected and allows cash to exit overseas. They do not suggest these bubble conditions are ideal – but find it difficult to see what will prevent such bubbles unfolding.

What Should You Do?

  • Be aware of the downside risks in particular
  • A bubbly peak soon will merely make the falls bigger later on
  • Buy where there is obvious value e.g. Asia, UK commercial property
  • Buy where long term demand is clear e.g. equity income
  • Buy where political and reform trends are favourable e.g. India

NB the latest TopFunds Guide is out now, and covers the above and much more. Email now for your copy