“This is the part when I say that I don’t want ya,” is the catchy chorus of a current radio hit. No, I am not referring to the bear as titled, but to the level of our collective deception. Needless to say that I have no clue what the short-term market outcome will be, but it should strike us as cautionary that the S&P 500 has extended a more-than-1,000-day up-move without a single correction of 10% or greater. In fact, the last meaningful downturn of such magnitude dates back as far as 2011, a time when the European debt crisis and downgrade of the U.S. long-term credit rating had sparked significant volatility. Ever since, investors have been spoiled with somewhat “predictable” returns, certainly the foundation for today’s recency bias and risk complacency, especially concerning those unsuccessfully searching for income in a low-yielding market environment.
There is a different angle from which to view complacency: if 2011 events in Europe and the U.S. were serious enough to cause market turbulences, current conditions may pose equal risks. The Eurozone is not in better shape than it was three years ago. Even though funding stress in sovereign bond markets has eased substantially, subpar economic growth, a problematic labor market, and political and fiscal gridlock continue to be the norm, not the exception. Mario Draghi, the head of the European Central Bank, who gained a moment of fame with his 2012 “whatever it takes” speech, may have become disillusioned over the effectiveness of accommodative policy as a “stand-alone” solution. Recently, he offered a deal, demanding political reforms in exchange for monetary support; quite evidently maintaining the “whatever it takes” approach, albeit a desperate one.
The U.S., underneath the surface, is not entirely convincing either. Whereas conditions are far more robust when compared to the rest of the world, the price paid to support the economy and financial markets continues to be high, and heavily dependent on (future) credit and leverage. Not only has the U.S. Debt-to-GDP ratio swelled to unprecedented levels, but the Fed Balance Sheet, even when considering ongoing tapering efforts, remains in excess of $4.4 trillion, or about 25% of U.S. GDP. Consumers and investors continue to ramp-up borrowing as well: consumer debt, in the second quarter of this year, has grown at its fastest pace since 2008, and investor leverage has reached levels similar to 2000 and 2007, clearly an indication of too much optimism (or desperation as Draghi) in anticipation of future returns in capital markets.
I am not calling for the end of the bull market in equities, but it is important to keep a sharp mind when assessing risk and opportunity. Except for volatility, not a single asset class is considered cheap. This is also the flip side of the coin. Markets can continue to grind higher, given excess liquidity and negative real rates, which are typically conducive for equities, but volatility will likely adjust to the upside, making any given investment process more challenging. Asset allocators also need to stay critical with respect to valuations. Even if Europe and other non-U.S. markets are a bargain on a relative basis, a “value trap” is another risk to consider; some markets are cheap because risk outweighs the opportunity set. Investing in those markets may be best approached by applying a single-stock selection process, rather than a pure beta (i.e., index) play.
It is not comforting to anticipate volatility or even a more significant correction, but economic indicators, especially abroad, potentially lend reason to a changing market environment. The general feel-good factor needs perspective: financial conditions that come with labels such as overoptimistic, overbought, and overconfident are not usually associated with producing attractive long-term results.
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. For the rest of his blog posts, visit here. You can also follow him on Twitter @MoneyClipBlog.
