Hitting a turning point

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At the end of the year, it is always difficult to avoid an avalanche of reports looking back on the performance of the markets during the past 12 months. There are also plenty of predictions being forecasted about the upcoming year, which vary from the more plausible scenarios to wild theories about various extreme events that could occur in the near future. 2017 is now over, and it has proven to be a very fruitful year for everyone who was long in the equity market. The table below shows that this strong performance was geographically very broadly supported. All major economies have known a positive trend, and apart from a few exceptions, these are all in the double digits with some of them reaching as high as a 50% gain. The graph depicting the market performance from the past 6 years further supports this view, with all regions having known a rather steady upwards trend in 2017. This trend, however, is not something new from the past year. Apart from a weaker 2015 and the situation in the UK, all developed economies have known an extended period of market gains. Especially in the largest market, the US, the advance in the S&P 500 is now the second-longest on record without a drop of at least 20%. Unfortunately, conventional wisdom about cyclical behavior does steer us in the direction of raising questions about how long this bull market can last. The last time a bull market ended, at the end of 2007, the market capitalization went down around 50% in the subsequent year-and-a-half. Bull markets don’t just start growing bearish because of their age, so it is interesting to compare the current situation with 10 years ago. This article outlines some similarities and differences between today and the end of 2007 to find out whether we should brace ourselves for a potentially bumpy 2018 or not.

First of all, looking at relative valuations in the stock market, we can see that today’s prices are very high from a historical perspective and quite similar to the prices in the beginning of 2007. The graph displaying the cyclically adjusted price to earnings ratio, which compares current share prices with the earnings over the past 10 years for the US stock market, shows that valuations of equity today have become higher than they were at their last peak. The current level is only surpassed during the build-up to the dotcom bubble and the years at the end of the 1920s, before the great depression. This observation logically coincides with the fact that several different sources mention low levels of cash holdings in investors’ inventories. According to data compiled by INTL FCStone, the cash balance of equity mutual funds was at an all-time low of 3.3% at the end of 2017, while Morgan Stanley CFO Jonathan Pruzan also said that cash in wealthy clients’ accounts are at their lowest level. Citigroup and Bank of America Merrill Lynch highlighted similar evolutions in the past year. This shows that a high proportion of the available capital is invested in the market, which explains the high valuations. In 2007, prior to the bear market, investors had made comparable choices concerning their cash holdings. The danger this entails is that there is not enough investible cash left to support a demand that can further increase the current price levels, and that prices will consequently start to drop when some of the funds invested in equity need to be made available for other purposes. The evolution in cash holdings can also be viewed from a different angle, as it shows that the market participants are not in a very risk-averse state today.  Investors don’t act too concerned about potential destabilizing factors such as the North Korean missiles, turmoil in the Middle East or political uncertainty in the US, just like they were not too impressed by the threat of a pandemic or a crash in the Chinese economy a decade ago. This might indicate a general feeling of overconfidence in the market as is often observed before a major downturn.

Of course, the situation today is not exactly the same as it was in 2007. There are also some striking differences comparing both markets. It is interesting to point out that more than 70% of the S&P 500 stocks were advancing in the past months, meaning that the current bull market is very broadly supported. As the graph below shows, the breadth of the market today is much higher than before the last two market downturns, when this figure was only around 50%. This provides some support for the view that the current stock market just reflects a solid economic outlook, which would indeed benefit a broad range of companies, instead of leading us to assume that some parts of the market are experiencing an irrational overvaluation. Another difference is today’s monetary environment. Interest rates are much lower than in 2007, which gives investors more incentive of allocating their funds to equities instead of holding a bigger proportion in cash. The opportunity cost of not having the funds in cash becomes much lower in this environment. So it is argued that part of the reason investors allocate funds to equities today is just a lack of alternative options, where a decade ago there was a more widespread enthusiasm for financial assets in general, highlighted by the fact that the proportion of US adults owning stocks decreased from 65% in 2007 to more around 50% in 2016. Lastly, the rise of passive investing also results in a somewhat different environment compared to a decade ago. The share of passively managed assets in US markets has doubled, which means that a different dynamic can be expected when it comes to a market turning bearish. 

As mentioned above, stocks receive a high valuation today and most of investors’ funds are invested in the market, which makes the market today resemble a market that is about to come down. However, the lower enthusiasm from retail investors and breadth of the market are factors that do not point in the direction of a bubble that is about to burst. A danger that does exist in the current environment however, is that the large proportion of passive invested funds will exacerbate the effect of a downturn. With fewer shares to trade, because more are stuck in ETF’s and index funds, smaller trades could cause bigger price swings because of a lack of liquidity. To support this, Bank of America found that the average volatility of the 100 stocks with biggest passive ownership tripled to 45 percent above the rest of the market in the six months ending in May 2017. To try and draw parallels with 2007, we have to take into account that the crisis then was preceded by a spectacular growth in debt secured by property assets. There was an overconfidence in the stability of property prices which made lenders starting to neglect credit risk, driving prices up even further before they came down hard. This triggered a domino effect in other markets and caused the stock market to lose half of its value in the aftermath. A possible reason for a downturn today could be found in the actions from the largest central banks, which are trying to find their way back to a more normal monetary environment. The scaling down of their balance sheets could mean a supply of assets that makes the bond market go down, with a logical domino effect in other markets as a consequence. Policymakers are of course well aware of the dangers this poses, so we shouldn’t expect them to take any rash actions; however, today’s markets do remain an environment in which a certain amount of caution is advised.

Sources: Pension Partners, MSCI, CNBC, online data Robert Shiller (econ.yale.edu), business insider, world economic forum, the economist


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