As usual, the opposing camps find little to agree on, and the man on the street is often left to decipher the conflicting data for himself. The recovery since the US markets bottomed in 2009 has certainly helped to rebuild many private investors’ portfolios, but has it also planted the seeds of false hope? Is it still possible that we could see another incarnation of the 2008 financial crisis play out, whereby investors once more see their portfolios turn an ugly shade of crimson?
All in all, new highs don’t necessarily mean a lot in and of themselves. After a protracted downturn, the subsequent rebound may bring fresh highs. Likewise, a period of gradual upward movement in stocks – over a period of years (rather than months) may see previous highs eclipsed. But as any casual market watcher knows, sustained upward movements in the markets are always interspaced with short to medium-term corrections of different magnitudes, and of course the occasional crash.
Yet every now and then we also see markets move sideways – sometimes for many years on end. Historically this has meant that some markets reaching new highs, are essentially at the same level they were 10-15 years – or even as much as 25 years – earlier.
While it is not always clear, there are some clues as to whether such a new rise is sustainable. Where are stocks in relation to their short-term, intermediate or secular cycles? When was the last crash or major correction? What are the current fundamentals of the market (that is, are valuations on the low side or the high side)? What other technical or fundamental indicators are screaming buy or sell?
Some studies show that every time a market reaches a new high, the following 12 months’ returns are better than the historical average. This may be true during an extended secular bull market, but considering that new highs are often seen just before every market crash, it is not a reliable barometer. An investor who follows this strategy will eventually get the timing wrong and invest very close to the peak. The Dotcom Bubble in 2000 and the Financial Crisis in 2008 are prime examples of investors being burned at the top of the market.
The pundits and talking heads on financial channels are assigned such gravitas today that it is difficult to ignore their prognostications. However, believing the TV hype that new highs point to a sure thing can end in heartbreak for inexperienced investors.
What the aforementioned studies fail to point out is that, while returns over 12 months following a new high may be attractive, the risk of a pending correction has been exacerbated considerably. So any committed “buy and hold” investor may have a good 12 months after a market high, but could then be in for some painful red ink not long thereafter.
Markets are typically prevented from perpetually making new highs by corrections, or even crashes. Equity markets have always moved in long-term cycles, typically ranging from extremely overvalued to undervalued. When shares rise over many years it is called a secular bull market. When they are falling, or are erratic, over a long time period (which is where we been since the peak in year 2000) we refer to this as a secular bear market. While some argue that markets have been making higher highs, these have been at the expense of continued lofty valuations, which must come down at some point for a new cycle to begin.
At our current point in the economic cycle, new highs certainly aren’t as attractive as they are in a secular bull market. In the entire history of US stock markets, a “buy and hold” bull market has never started at current valuation levels. An environment such as the one that existed in 1982 – the start of an 18-year period of rising markets – began from extremely low, single-digit price/earnings valuations. By contrast, the P/E Ratio of the S&P 500 Index today is 24.71.
Warren Buffet, probably the world’s most respected investor, gauges market valuations using the ratio of total US equity market capitalisation to US GDP as the gauge of where valuations stand at any given moment. At 126 per cent, it currently sits at a level which has historically pointed to overvaluation (for the mathematically inclined, 126% is 2 standard deviations above the mean). It is also nearing a level seen at previous market tops… prior to crashes.
Incidentally, this figure stood at only 35% at the beginning of the 1982 before the markets began an 18-year bull market. This valuation method indicates anything but stellar stock performance in the years ahead.
One key contributor to the bear market bounce we have seen since 2009 has been historically low interest rates. It is therefore important to ask: will we see interest rates rise? Higher rates usually exert downward pressure on markets, so all investments will almost certain see a significant correction in the event of a government rate rise.
Either way, one fact is unmistakable: this low interest rate environment is driving investors to seek returns from stocks – even at current valuations – because there is no yield (or in some cases negative yield) to be had from bonds or fixed income. How long this can continue is anyone’s guess. Could we see valuations actually reach or eclipse those seen in 2000 (151% of GDP by the “Buffet Calculation”)?
By almost any valuation methodology, stocks appear to be relatively expensive today, not cheap. And if corporate earnings begin to slow, things will begin to look even worse. But just because we have survived a historically long spell without a major correction or crash, does not necessarily mean that one is imminent.
The economic and geopolitical environment in which we find ourselves today is unique, so anything could happen. Stock markets are a strange animal, and have always proven to be excruciatingly irrational, going out of their way to do the opposite of what most rational human beings think they should.
Anything is possible. And for the time being, the markets continue to confound the so-called experts.
For more information and expert advice about investing in stock markets, email Phuket Expat Finance at firstname.lastname@example.org