Swim between the flags in 2018
Every year presents opportunities and traps and while the financial press is fast filling with predictions for 2018, here we change the focus by thinking about the boundaries marked by the bull and bear cases. Think of the extremes as the flags between which you must swim.
The bulls’ case:
To begin with the economic backdrop is supportive. The global economy is described as displaying “strong”, “synchronised” growth, and ‘Goldilocks’ is the adjective attached to the economy. The US is growing at an annualised 3-4%, China is growing at over 6.7%, and the EU is set to beat expectations with robust growth of 2.3% this year.
In keeping with this growth theme, many point to high and double-digit rates of earnings growth for US corporates. Many argue that valuations are not stretched with the PE ratio for the S&P 500 at an “undemanding” 21 times.
Furthermore, with wage growth virtually non-existent for many years, commentators are suggesting inflation is dead. Some even go so far as suggest that advances in technology have simply made inflation “obsolete”. As more jobs are replaced by technology that never sleeps, takes holidays or requests superannuation, salary costs fall and wages decline, increasing the profits for companies.
The combination of economic growth, rising profits and modest, if barely existent, inflation is of course a perfect picture for equities, hence the ‘Goldilocks’ moniker.
Most surprisingly perhaps is the view that stocks remain cheap in aggregate, especially when compared to bonds. In the United States, for example, US 10-year Treasury Bonds can be purchased on a yield of 2.40%. This is equivalent to paying 42 times earnings with no growth in those earnings. Clearly, if an investor can purchase a stock on a Price-to-Earnings ratio of less than 42 times, with the benefit of earnings growth, stocks are ‘relatively’ more attractive than bonds.
Indeed, that equation, along with low inflation – suggesting rates aren’t going to rise anytime soon – is the force driving more than a little of the enthusiasm for stocks today.
Another source of optimism is what investors refer to as the ‘central bank put’. Record-low volatility suggests that there is confidence, on the part of market participants, that any setback in financial markets will be met by central bank buying of assets until stability returns. The idea that the Fed ‘has your back’ has many adherents in today’s market.
Bulls also argue that government-backed programs that encourage wealth creation, and a self-supported retirement – such as superannuation in Australia – eventually find their way into financial markets. Population growth and increases in life expectancy are also proffered as reasons to expect demand for goods and services to expand, fuelling profit growth decades hence.
With so many bullish arguments, and of course many global indices surging, the optimists make an excellent case. The issue facing investors however is that these arguments represent just one of the flags between which investors should swim.
The bears’ case:
At the other end of the beach are the negative arguments and no fair examination of the prospects and risks for 2018 would be complete without a hearing given to the bears.
Let’s begin with the bullish enthusiasm. By itself this is not a worry for investors, indeed it can be an essential ingredient to monetising an investment strategy. Enthusiasm becomes a concern only when it morphs into unbridled exuberance, when the fundamentals of the asset are thrown out in favour of the prospect of an early gain.
There are signs of exuberance. When the CEO of America Airlines, Doug Parker announced on an earnings call with analysts: “I don’t think we’re ever going to lose money again”, I wondered whether bullish enthusiasm had crossed over to irrational exuberance. When WeWork’s CEO Adam Neumann told Forbes.com in October: “no one is investing in a co-working company worth $20 billion. That doesn’t exist … our valuation and size today are much more based on our energy and spirituality than it is on a multiple of revenue”, I couldn’t help but think, ‘here we go again’.
With commentators calling “Loss the new black”, citing the market capitalisations of Uber, Snapchat, Wework and Amazon as evidence of a “new world order”, and articles with titles such as ‘Buy Everything’, ‘RIP Bears’ and ‘Congratulations Capitalism’ increasingly common, it is worth asking whether sound reasoning has been usurped by unbridled optimism.
Investors have surprisingly short memories and there is no doubt that the fear of missing out – as reflected in the pursuit of companies with zero profit such as Tesla – is replacing the fear of loss. When that happens, it is worth being cautious.
Recently, in American Consequences Dan Ferris wrote: “investors have pushed [that] reality aside and fallen in love with companies that have a great story and a soaring share price … regardless of profitability. What they don’t realise is that equity only has value if a company earns a profit. That means there’s a much higher probability than investors currently acknowledge that unprofitable highfliers might be worth … zero.”
In the last twelve months, some of the best performing stocks have been those representing companies that have generated more than a billion dollars of losses. That’s right not profits, but losses. Meanwhile, 45 companies listed on the Nasdaq 100 are now trading on P/E ratios of more than 200 times. The combined market capitalisation of Tesla, Uber and Twitter is circa US$130 billion and their combined profit is zero.
Many have pointed to the extreme level of the CAPE Shiller Ratio, a ratio created by Nobel Laureate Prof. Robert J. Shiller which compares the S&P500 index price, adjusted for inflation, to the 10-year average earnings. This month, the CAPE ratio hit 32.24. That is a high ratio. Indeed, between the year 1881 and today, the average CAPE ratio has stood at just 16.8. Moreover, it has exceeded 30 only twice before: in 1929 and in 1997-2002. Higher CAPE Ratios imply low future returns and the model has done a very good job of predicting future returns.
There is little doubt that the US stock market is characterised by a combination of very high market valuations, but it is also characterised by strong earnings growth, and very low volatility.
History however suggests that the combination of high CAPE, high earnings growth and low volatility existed before most significant corrections.
The supply side argument put forward about technological innovation rendering companies more profitable fails to acknowledge the demand side of the equation; that fewer jobs and lower wages means less customers for the products companies sell. Henry Ford broke with tradition at the turn of the last century and gave all his employees a pay rise because he realised they were the customers for his T-model car. Generational unemployment and “capping inflation for our lifetimes”, whether due to economic mismanagement or technological innovation, could produce deflation, which of course is an outcome that is as bearish for equities as rampant inflation.
Before getting too excited about the current Goldilocks economic conditions, it may pay to know that there is absolutely no correlation, in any geography, between economic growth and stock market returns. Perhaps surprisingly, if the economy is expanding at above average rates, there’s a 50% chance the stock market will do better than average and a 50% chance that it will do worse.
With respect to the ‘central bank put’, it is true that in recent history central banks have intervened following any signs of instability in markets, through measures such as ‘QE’. And while it is likely that central banks will be slow and measured, they can’t control ‘animal instincts’, which combined with record levels of margin debt against the S&P 500 will force many investors to sell even more shares as prices decline.
There are of course many other arguments put forward to suggest you should be fully invested. We agree that in the long run, being fully invested is preferred. But it is also true that the higher the price you pay the lower your return, and holding long term just means locking in a low return on a long-duration asset. Prices today are factoring in all of the bullish arguments with little room for setbacks, hiccups or speed bumps.
Those who are patient will be well rewarded for investing when there is blood in the streets. Remember, be fearful when others are greedy and be greedy when others are fearful, no matter whether you are bullish or bearish in 2018.