This Year, You'll Be Safer if You Swim Between the Flags
Only time will tell if a bull or bear market awaits investors in 2018. There’s plenty of ammunition for both scenarios but I think it will pay investors to look closely at the boundaries marked by the bull and bear cases, and treat them like the flags between which they must swim.
The bull case
Let’s look first at the bull case.
To begin with, the economic backdrop is supportive. The global economy is described as displaying “strong”, “synchronized” growth, and ‘Goldilocks’ is the adjective attached to the economy. The US is growing at an annualized 3-4 per cent, China is growing at over 6.7 per cent, and the EU is set to beat expectations with robust growth of 2.3 per cent this year.
In keeping with this growth theme, many point to high and double-digit rates of earnings growth for US corporates. Many argue that valuations are not stretched with the PE ratio for the S&P500 at an “undemanding” 21 times.
Furthermore, with wage growth virtually non-existent for many years, commentators are suggesting inflation is dead. Some even go so far as to suggest that advances in technology have simply made inflation “obsolete”. As more jobs are replaced by technology that never sleeps, takes holidays or requests superannuation, salary costs fall and wages decline, thus increasing the profits for companies.
The combination of economic growth, rising profits and modest, if barely existent, inflation is of course a perfect picture for equities, hence the ‘Goldilocks’ moniker.
Most surprisingly, perhaps, is the view that stocks remain cheap in aggregate, especially when compared to bonds. In the United States, for example, US 10-year Treasury Bonds can be purchased on a yield of 2.40 per cent. This is equivalent to paying 42 times earnings with no growth in those earnings. Clearly, if an investor can purchase a stock on a Price-to-Earnings ratio of less than 42 times, with the benefit of earnings growth, stocks are ‘relatively’ more attractive than bonds.
Indeed, that equation, along with low inflation - suggesting rates aren’t going to rise anytime soon - is the force driving more than a little of the enthusiasm for stocks today.
Another source of optimism is what investors refer to as the “Central bank ‘put’”. Record-low volatility suggests that there is confidence, on the part of market participants, that any setback in financial markets will be met by central bank buying of assets until stability returns. The idea that the Fed ‘has your back’ has many adherents in today’s market.
Bulls also argue that government-backed programs that encourage wealth creation, and a self-supported retirement - such as superannuation in Australia - eventually find their way into financial markets. Population growth and increases in life expectancy are also proffered as reasons to expect demand for goods and services to expand, fueling profit growth decades hence.
With so many bullish arguments, and of course many global indices surging, the optimists make an excellent case. The issue facing investors however is that these arguments represent just one of the flags between which they should swim.
The bear case
At the other end of the beach are the negative arguments, and no fair examination of the prospects and risks for 2018 would be complete without a hearing given to the bears.
Let’s begin with the bullish enthusiasm. By itself this is not a worry for investors; indeed it can be an essential ingredient to monetizing an investment strategy. Enthusiasm becomes a concern only when it morphs into unbridled exuberance, when the fundamentals of the asset are thrown out in favour of the prospect of an early gain.
"Enthusiasm becomes a concern only when it morphs into unbridled exuberance"
There are signs of exuberance. When the CEO of American Airlines, Doug Parker, announced on an earnings call with analysts, “I don’t think we’re ever going to lose money again”, I wondered whether bullish enthusiasm had crossed over to irrational exuberance. When WeWork’s CEO Adam Neumann told Forbes.com in October, "No one is investing in a co-working company worth $20 billion. That doesn't exist…Our valuation and size today are much more based on our energy and spirituality than it is on a multiple of revenue”, I couldn’t help but think, ‘here we go again’.
With commentators calling “Loss the New black”, citing the market capitalizations of Uber, Snapchat, WeWork and Amazon as evidence of a “new world order”, and articles with titles such as ‘Buy Everything’, ‘RIP Bears’ and ‘Congratulations Capitalism’ increasingly common, it is worth asking whether sound reasoning has been usurped by unbridled optimism.
Investors have surprisingly short memories and there is no doubt that the fear of missing out - as reflected in the pursuit of companies with zero profit such as Tesla - is replacing the fear of loss. When that happens, it is worth being cautious.
Recently, in American Consequences, Dan Ferris wrote,
“Investors have pushed [that] reality aside and fallen in love with companies that have a great story and a soaring share price… regardless of profitability. What they don’t realize is that equity only has value if a company earns a profit. That means there’s a much higher probability than investors currently acknowledge that unprofitable highfliers might be worth… zero.”
In the last twelve months, some of the best-performing stocks have been those representing companies that have generated more than a billion dollars of losses. That’s right - not profits, but losses. Meanwhile, forty-five companies listed on the Nasdaq 100 are now trading on P/E ratios of more than 200 times. The combined market capitalization of Tesla, Uber and Twitter is circa US$130 billion and their combined profit is… zero.
Many have pointed to the extreme level of the CAPE Shiller Ratio (CAPE), a ratio created by Nobel Laureate Prof. Robert J. Shiller which compares the S&P500 index price, adjusted for inflation, to the ten-year average earnings. This month, the CAPE ratio hit 32.24. That is a high ratio. Indeed, between the year 1881 and today, the average CAPE ratio has stood at just 16.8. Moreover, it has exceeded 30 only twice before: in 1929 and in 1997-2002. Higher CAPE ratios imply low future returns and the model has done a very good job of predicting future returns.
There is little doubt that the US stock market is characterized by a combination of very high market valuations, but it is also characterized by strong earnings growth and very low volatility.
History, however, suggests that the combination of high CAPE, high earnings growth and low volatility existed before most significant corrections.
Indeed, Shiller recently identified there have been 13 bear markets in the US since 1871. A bear market is defined as a 20 per cent correction from a high within a 12-month period. The ‘peak months’ before the bear markets occurred in 1892, 1895, 1902, 1906, 1916, 1929, 1934, 1937, 1946, 1961, 1987, 2000, and 2007. There were a couple of notorious stock-market collapses – in 1968-70 and in 1973-74 – but Shiller did not include them in his recent study because they were more protracted and gradual.
His first observation is that the average CAPE ratio was higher than average, at 22.1 in the peak months, suggesting that the CAPE does tend to rise before a bear market. For investors today, with the CAPE ratio well above average, it is valuable to note that prior to 10 of the bear markets since 1871 were preceded by an above-average CAPE ratio.
Peak months before past bear markets also tended to show high real earnings growth: 13.3 per cent per year, on average, for all 13 episodes. And “the market peak just before the biggest ever stock-market drop, in 1929-32, [recorded] 12-month real earnings growth [of] 18.3 per cent.”
Those who point to near record-low levels of volatility as protection against a bear market should heed Shiller’s observation that “stock-price volatility was lower than average in the year leading up to the peak month preceding the 13 previous US bear markets”. He adds, at “the peak month for the stock market before the 1929 crash, volatility was only 2.8 per cent.”
The supply-side argument put forward about technological innovation rendering companies more profitable fails to acknowledge the demand side of the equation: that fewer jobs and lower wages mean fewer customers for the products companies sell. Henry Ford broke with tradition at the turn of the last century and gave all his employees a pay rise because he realized they were the customers for his T-model car. Generational unemployment and “capping inflation for our lifetimes”, whether due to economic mismanagement or technological innovation, could produce deflation, which of course is an outcome that is as bearish for equities as rampant inflation.
Before getting too excited about the current Goldilocks economic conditions, it may pay to know that there is absolutely no correlation, in any geography, between economic growth and stock market returns. Perhaps surprisingly if the economy is expanding at above-average rates, there’s a 50 per cent chance the stock market will do better than average and a 50 per cent chance that it will do worse.
With respect to the Central Bank ‘Put’, it is true that in recent history central banks have intervened following any signs of instability in markets, through measures such as Quantitative Easing. And while it is likely that central banks will be slow and measured, they can’t control ‘animal instincts’, which combined with record levels of margin debt against the S&P500 will force many investors to sell even more shares as prices decline.
So, who is right?
There are of course many other arguments put forward to suggest you should be fully invested. We agree that in the long run, being fully invested is preferred. But it is also true that the higher the price you pay the lower your return, and holding long term just means locking in a low return on a long-duration asset. Prices today are factoring in all of the bullish arguments with little room for setbacks, hiccups or speed bumps.
Those who are patient will be well rewarded for investing when there is blood in the streets. Remember, be fearful when others are greedy and greedy when others are fearful, no matter whether you are bullish or bearish in 2018.
Roger Montgomery, Chief Investment Officer, Montgomery Investment Management
The Montgomery Global Funds own shares in Amazon