Equity markets experienced a bit of a “wobble” over the past weeks but directing life from beach chairs and BBQ stations, the investment crowd is in a relaxed state of mind making plans to be “all in.” Too many investors have missed the significant rise in equity markets and every little dip appears to be bought and, consequently, short-lived. Such a quasi-self-fulfilling prophecy is typically paired with an overestimation of future returns and investors may be too casual in leading the debate of whether stocks have reached cautionary levels or not.
From a technical perspective, U.S. equities (as measured by the S&P 500) are at a crossroads: in evaluating the period of gains leading into the dotcom bubble up to current market levels, equities have risen in a steady up-trending channel, even when taking into account the major “fallout” of 2008/2009.
With the S&P 500 now trading above this channel, it will be essential to understand if economic conditions can support higher prices (i.e., a continued “breakout”), or if investors should prepare for more significant corrections to come. The Japanese market, in the aftermath of the big deflationary bust of 1989, has experienced twelve major bull and bear cycles, both of which were significant, with gains and corrections ranging, on average, from -48% to +75%. Translated to home conditions, a more profound downturn may not be unusual or even constitute a change of the uptrend.
Valuation measures are mixed and subject to selective misconceptions. With interest rates kept artificially low as a result of continued accommodative monetary policy, methods to assess the relative value of equities over alternative allocation choices are flawed. The “garbage in – garbage out” rule must be applied. To make things more complicated, from a behavioral perspective, investors continue to reach for returns in stocks, mainly in anticipation of low-to-zero income on “safer” interest-bearing investment choices. The flip side of this new reality is that the change in investor behavior to accept unwanted or even unjustified risk (later when considering suitability) will not change fundamental investment principals: the price paid for an asset is simply a claim on future cash flows and the premium paid will only reduce the long-term return of a given investment.
Last, there is the “smart money,” which may provide guidance in an uncertain investment environment - but beware of the label “smart.” The vast rise of Smart Beta ETFs, which claim to hold “better” stocks as the result of rules-based screening, may just be another gimmick. Their inherent claim to “heal” the inadequacy of traditional ETFs could make this “smart choice” rather “un-smart,” as common ETFs may be ill-constructed to begin with (a debate for another time). An Index that is designed to measure the flow of Smart Money (SMI), or “emotional crowd buying,” does not hold the answers either. Whereas the SMI has worked over the long run (just like traditional valuation models), investors would have given up substantial returns when the index took a “deep dive” earlier this year while equity markets continued to rise significantly in relative comparison.
Given the declining reliability of traditional methods to assess allocation choices, we are investing in uncharted territory. If we can agree that asset prices and low volatility readings are where they are first and foremost due to accommodative central bank policy, we must also consider that the reduction in monetary support may be one of the biggest risks to market outcomes in the short-to-medium term. Rather than investing with a “recency bias” (allocating to assets that have performed well) or looking for “smart” choices, investors are better served by applying a framework of risk rather than capital budgeting. Building portfolios around the forecasting of correlations and volatility (risk) is just one of those concepts. Until we embrace new methods to make more reliable asset allocation choices, this equity market will keep its label as “the most unloved bull of all time.”
Matthias Paul Kuhlmey is a Partner and Head of Global Investment Solutions (GIS) at HighTower Advisors. He serves as wealth manager to High Net Worth and Ultra-High Net Worth Individuals, Family Offices, and Institutions.
