Last month we covered US over-valuation, and events since demand more comment.
On many previous occasions we have highlighted something called CAPE (cyclically adjusted price earnings ratio) as an indicator of stock market value. In particular highlighting that the US stock market is completely over-the-top.
Nonetheless, it is far from a tool for fine-tuning your timing, more a warning to have your sand bags in place. This is important for us as UK-based investors because where the US goes the UK will follow, certainly in direction if not precisely in quantum.
In the last month evidence on the need for sandbags increased. The US stock market (represented by the Dow Jones index) didn’t just close higher for 12 straight days, but also reached new all time highs on each of those days.
The last time this happened was January 1987. That year, cracks only really began to appear from June, and most of us can remember what happened on Black Monday in October. Yet despite signs of excess, particularly amongst retail investors, there was much to be positive about. That cannot be said now, with the US market more expensive than 1987, and Western economies beset by vast debt, ageing population, disruptive technology, and populist political backlashes.
Rising interest rates could certainly prick this US bubble in 2017. But higher rates of some magnitude would be needed, and that seems highly unlikely from today’s perspective, when growth across much of the US economy is still anaemic.
An interesting sideshow is that President Trump appears to be taking the credit for the apparent success of the stock market since he was elected. This is very dangerous (for him) because he is setting himself up to be blamed when it goes pear-shaped.
The mania in ETFs is also a reminder of prior stock market peaks, particularly the rush into index trackers in 1999.
The irony is that buying ETFs and other forms of cheap index trackers is called “passive investing”. But there is nothing passive going on here. This is very aggressive buying of a dangerously over-valued stock market (as least in the case of the US).
How far should we take the 1987 parallel? Should we expect a Crash in 2017, as we saw in 1987, when the US market fell by more than 20% in one day? We will be producing much greater detail on 1987, updating our existing e-book history to tally with the 30th anniversary. The simple answer is we don’t know. But we should certainly be prepared for very sharp falls over a small number of days, which I will come back to in a moment.
So what about other potential shocks? The possibility of unknown unknowns is a given – but other potential shocks sit clearly in the calendar, with the French election prominent at the end of April, beginning of May. All of us have assumed that Marine Le Pen cannot win in the head-to-head second round of the French presidential election – surely more than 50% of French voters would vote for a tatty armchair in preference to Le Pen.
That is until recent days. Polls suggest the gap is closing, and that the trend is moving gradually in favour of Le Pen. As one French farmer put it “Saying you’re going to vote for Le Pen isn’t the taboo it used to be.” Though her being elected still feels like the most unlikely outcome, do keep an eye on this as this would be a much bigger shock than Brexit and Trump combined.
We can certainly see why there would be very sharp falls over a small number of days. In 1987 much was made of the role of computers in triggering selling. But that is nothing compared to today’s computer-driven high-frequency traders who dominate of day to day stock market volumes.
There is also the greater predominance of so-called asset allocators on behalf of retail investors. These include financial advisers, wealth managers and banks with discretionary portfolios and fund-of-funds. These are meant to be “the smart money”, but the reality is that many of these guys are very twitchy and prone to panic. We observed that just after the Brexit vote when this “smart money” panicked as one to sell UK property funds, realising very large losses for their investors.
So how should you respond?
A portfolio which is well diversified across a range of asset classes is a good start, where the great bulk should be deserving of your money due to well-founded longer term attractions.
Bricks and mortar property funds (those with an emphasis outside London) still stand out with yields of 4-5% – that isn’t about to change. There is a very wide range of types of bond funds – and we expect a little bounce in the months just ahead when it is clearer that interest rates can’t go up much or at all.
Stock markets offer a range of opportunities. The demand for income (and therefore income funds) is a long term feature due to ageing populations and persistent low interest rates. Value-style funds (see the latest TopFunds Guide) should ride out short term turbulence. Various markets around the globe look cheap to good value (Brazil, China, Korea, Asia generally, emerging markets generally, India). And some market tendencies are always exploitable e.g. the tendency for smaller companies to outperform the wider markets.
If anything, on marked weakness in markets we will be inclined to seek out the latter range of opportunities at even better prices. But we won’t be complacent on this – with individual clients we will discuss taking some profits where there have been outsize profits in the last 12 months or so.