As we have mentioned repeatedly on this blog, the change in market mood since the pivotal moment in the middle of 2016 has been staggering.
Extreme pessimism has given way to strong gains in equity markets, while the prevailing narrative has shifted from ‘secular stagnation’ to ‘synchronised global recovery.’ The magnitude and durability of positive profits news has played a key role:
As has extremely strong macro data:
With this has come much reflection and soul-searching (along with some revisionism and hindsight bias). Those who forecast a global recession have for the most part left significant gains on the table, as have those who have placed a greater emphasis on capital preservation than return generation.
When this happens it can be deeply emotionally challenging. Very difficult questions are raised: was it right to be pessimistic, but too early? Were you right, but the facts have changed? Were you wrong all along? It can actually be far more emotionally challenging to allocate capital after a rally in which we have not participated than after a crash in which we have not.
This tension has arguably been echoed in general market sentiment. Because the strength of macro and profits data has come as such a huge surprise relative to prior beliefs, the natural response has been to treat them with scepticism. It takes a great deal of emotional energy to form beliefs and then change them. Tony wrote last year how equity market behaviour had been almost a begrudging acceptance of the facts.
Has this changed?
This characterisation of market mood may be puzzling to many. It seems at odds with recent price moves and the picture of investor attitudes painted by much market commentary. After such strong gains in equity markets it is natural to ask instead whether the journey from pessimism to euphoria is complete.
So have investors converted from sceptics to true believers? And does that mean it is time to short equity markets today?
I would argue that it is not. Shocks and drawdowns are always part of the landscape but to make a bearish assessment over longer time periods requires some critical elements to be in place, many of which I contend are not applicable today.
Valuation, absolute and relative
Much has been made of elevated valuation signals in the US market, but on a global scale, valuations are not as alarming as US-centric commentary may suggest. There has indeed been a re-rating since 2016, but this is relatively modest, given the strength of earnings growth.
Figure three below shows the limited move in the world p/e ratio since 2015, while the contrast with the levels of valuation reached in 1999 is clear:
Even more importantly, value signals are always conditional on the underlying regime, and consideration of that regime is critical today.
In 1999, the case for shorting equities in the US was about as strong as it has been in my working life. Valuations were not only stretched in an absolute sense (as many argue they are now in the US), but critically investors were also happy to receive the same compensation for stock risk as they were for owning Treasuries.
The Fed Funds rate was around 5% and real yields on US 10-year Treasuries were the same as the earnings yield on the S&P 500:
The situation today is very different. Even in the US, equities offer a meaningful yield in excess of that on offer from ten-year Treasuries.
This is critical because the prevailing interest rate is a key consideration for assessing value. While many commentators point to Central Banks playing a distortionary role, it is also true that lower real interest rates reflect an underlying reality. In the late 1990s, the world was only in the early stages of delivering the low and stable inflation outcomes that many of us have subsequently become used to (that bond markets were slow to adjust to this new reality explains why the yields on offer at that time would prove to be a gift):
The relevance of real interest rates to equity valuation is debated. It forms the basis of ‘building block’ approaches to assessing valuation (as an element of the discount rate) but others believe that its relevance is wildly overstated.
My belief is that the importance of equity valuation relative to the real return on bonds should not be ignored. They are competing assets; as many acknowledge when they argue that significant increases in interest rates can pressure equity markets. It seems very likely that a return of real rates and inflation to the levels of the 1970s and 80s, without corresponding growth, would indeed pressure equity markets significantly.
A forecast of such dynamics, however, is a bold one, and not even on the radar screen for most investors at present. Over the last two decades huge monetary stimulus and three one-year periods of oil price doubling have done little to shift the chart above. Protectionism and various forms of ‘neo-nationalism‘ could change this, but today it feels extreme to make this the base case for a prediction. Without a major shift in regime, major drawdowns in equity markets, although emotionally challenging, are likely to represent buying opportunities at improved prospective returns, rather than a challenge to the long assessment that equities will outperform government bonds and cash.
What is missing from the above analysis is the very powerful role played by human emotion.
Most analysis looks for signs of excitement among investors as a contrarian indicator of bubbles, as over-optimism leads to a huge vulnerability to negative surprise. These indicators do look elevated, but are volatile. Others, as in a recent article by Robert Shiller, suggest it may be possible to look for inflection points when the language we use suggests fear that others may be about to sell their holdings.
Ultimately however, the value of quantitative attempts to use proxies for investor sentiment as an indicator of returns is debateable (see for example here and here); the clearest conclusion is that sentiment seems to reflect what investors have just experienced. As usual it seems that there is no simple model we can use to hide from making our own judgements.
My sense from meetings with clients and investors is that there has been a notable shift as discussed above. In the US in particular there is a growing move towards risk taking. Most, however, remain sceptical about the continuation of what we have just seen; much commentary today is along the lines of ‘the rest of the market is too bullish’ while volatility aversion still appears to dominate European sentiment. This is nothing like the mentality of the late 1990s when you ‘couldn’t afford not to’ be invested, we seem some way from what Aled Smith has called ‘the BBQ effect.‘
Most important, though, is to assess our own feelings. Many of us feel nervous about the nature of the current rally. It feels more uncomfortable to write a piece like this than it would to paint a bearish picture (particularly when the chance of a short-term double digit drawdown in equity markets is always present). This emotional reaction is no small part of the value misalignment between bonds and equities that has characterised the period since the financial crisis and remains in place today.