What’s Next for the Stock Market?

The market ructions in early Feb were a genuine 'shot-across-the-bows' - a warning to investors about the longevity of easy credit, soaring asset prices and ultra-low volatility. That's why, with markets potentially on the verge of a big reversal, we think it's prudent to hold more cash.

Those market ructions, and the associated breathless headlines, confirmed what we already have been warning you about - the cost of holding cash may soon be overshadowed by the value of its optionality.

There is value in holding cash because it provides flexibility to take advantage of lower prices. And in 2018, you may need to be nimble with your investment dollars.

Importantly, while the recent setback may not yet lead to a more serious or imminent crash, history tells us that corrections tend not to arrive without warning. Rising volatility and one or two false starts tend to precede a more serious event. The seeds of doubt about rising inflation, fiscal difficulties and higher bond yields take time to germinate.

So it's a very good time to look at some of the seeds that have been planted. You may remember Alan Greenspan, the 13th US Federal Reserve chairman between 1987 and 2006. Having presided over the US central bank for an unprecedented five terms, and coining the term "irrational exuberance" during the dotcom bubble, he is - now at 91 - regarded by many as a legend of modern finance. As an aside Nasim Taleb suggested recently in a BBC interview that Greenspan was the conductor of a great crash.

For our purposes, however, it is worth noting that Greenspan has joined other value investors, including Howard Marks, in noting investors are "at it again". In a recent interview with Bloomberg, Greenspan observed, "There are two bubbles: we have a stock market bubble, and we have a bond market bubble."

It's worth paying attention when the person who originally observed irrational exuberance, notes it again. And instances of irrational exuberance are growing in frequency. During previous bubbles, extreme examples of inexplicable behaviour were evident. "Cash boxes" - companies conducting no business activity of any description - added ".com" to their names, causing share prices to surge.

And Australia is not immune. The ASX-listed Getswift, with revenue of just $600,000 last year, was valued by the market at nearly $600 million before its recent troubles with ASIC and shareholders.

History reveals that prior to any bubble bursting, there is a tendency for unbridled enthusiasm for investing in stocks to take hold. Newspapers are full of stories of small or younger investors making millions.

The question to ask is not whether this will end - it most certainly will. The question is whether it will end in 2018 or 2019.

To help address that questions, it's worth remembering that high prices themselves aren't usually enough to trigger a rout. The market for stocks is expensive. The S&P500 total return index has risen 258.72 per cent over the nine years since December 31 20081. During this period US 10-year Treasury bond rates averaged 2.54 per cent. For the nine years prior to that period, 10-year bond rates averaged 4.23 per cent, and prior to that, 6.26 per cent. The steady decline in bond rates has been a wind at the back of asset prices.

And since the lows of 2009, even inferior companies have risen dramatically, and they've been lent billions of dollars with few covenants, rather than being pushed out of business.

That tailwind however is now easing with US 10-year bond rates having risen from a low of 1.36 per cent in mid 2016 to 2.92 per cent today.

At the beginning of the most recent nine-year period referred to above, during which the stock market rallied 258 per cent, Nobel laureate Robert Shiller's CAPE Ratio was at just 15.17 times earnings. Today, that same CAPE ratio sits at 33.6 times as I write2 - a level unseen since the DotCom boom, and not seen ever before that.

And dropping the negative earnings of 2008 from the 10 year average earnings of the CAPE ratio, and adding 10 per cent growth to the earnings number for 2018, has the CAPE ratio still at over 30 times and above all levels ever, with the exception of the dotcom boom.

When bond rates are no longer falling, and when the CAPE ratio is at historically record levels the implication is that future returns will be lower than they were in the past.

The only question of course is whether those future, lower, returns will be smooth or volatile.

For a rout to take hold, there typically needs to be a reappraisal of the major inputs that go into an asset's valuation. Those two major inputs are growth, and the cost of capital. If anything causes investors to reappraise their expectations for growth or their expectations for interest rates, high prices suddenly become unpalatable.

At present, the expectations for the input to valuations are supportive of high asset prices. Global synchronised economic growth - the IMF has just upgraded its forecast for the world to grow at 3.9 per cent - is a positive because it contributes to corporate earnings growth. Donald Trump's tax cuts are also currently viewed by the majority as providing a handy boost to profits. These factors, if they persist, and while interest rates remain relatively low, could cause the stock market to rally sharply and well above the recent highs. Of course, a sharp rally today would probably mean a sharper correction later.

But not everyone believes the growth will continue. And there is a growing chorus of commentators who point out that Donald Trump's tax cuts, at the very end of a credit boom, could force the US Fed to raise rates much faster than has hitherto been expected.

The US research firm, Capital Economics believe that, "there will be a US-led slowdown in 2019 which, along with higher US interest rates, may cause a slump in equity prices".

Again, the volatility in early February is a reminder of how seriously these warnings should be heeded. As Buffett recently noted, the light can at any time go from green to red without pausing at yellow.

The question is whether those lower returns will be smooth or accompanied by volatility? As Figures 1. and 2. show, the US S&P500's Sharpe Ratio3, when measured across most time frames, is at near record highs and at a level history shows has rarely been sustained. This suggests that even if the overvaluation, as measured by Robert Shiller's CAPE ratio doesn't lead to a correction, volatility is quite likely to pick up.

Figure 1. S&P500 Sharpe Ratio rolling 100-month periods
Figure 2. S&P500 Sharpe Ratio 12-month annualised to Dec 31, 2017

And if heightened volatility is a real risk, and prospective or implied returns are in the low single digits, don't the returns offered by cash offer a superior risk-adjusted alternative?

Some asset classes with higher risks of capital loss than cash, are now offering lower yields than cash. This is an irrational and unsustainable situation. It certainly makes sense to us, to be holding some cash, even if it means that returns are held back in the short term.

It's better to be 12 months early than 12 minutes late.

When expectations about US rates start to negatively overshadow the current optimism about growth, current high equity market valuations will be reversed, and financial instability fears will take centre stage.

It is plausible that some shock to current sentiment will occur in 2019, if not before, because a hit to growth from either China's unconstrained credit binge or an event surrounding the historic record amount of junk bond debt due to be refinanced could occur in that year. Just keep in mind stock markets cast their shadow before them, and so markets typically react well ahead of the anticipated event.

  1. The S&P500 TR Index rose 26.46% in 2009, 15.06% in 2010, 2.11% in 2011, 16% in 2012, 32.39% in 2013, 13.69% in 2014, 1.38% in 2015, 11.96% in 2016 and 21.83% in 2017.
  2. Dropping the negative earnings of 2008 from the CAPE ratio and adding 10% growth to the earnings number for 2018, has the CAPE ratio still at over 30 times and above all levels ever with the exception of the dotcom boom.
  3. The Sharpe ratio is the average return earned in excess of the risk-free rate per unit of volatility or total risk.

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