Signs of bubble trouble in equity markets have dissipated, in my view. But as the risk of a market melt-down has fallen, could the chances of a ‘melt-up’ be rising?
I have a fascination for market bubbles. They appeal to the amateur historian in me, raise interesting human interest stories about both success and destruction, and are intriguing from a behavioural perspective. How do investors continue to fall into the same kind trap over and over again and indulge in irrational exuberance?
Over the past 25 years I worked as an investor – yes I’m that old – and I have created an index that allows me to monitor whether bubbles are emerging or not. Modest as I am, I called this the Heiligenberg Index. For more detail on the construction of the index please see this blog.
The index has signalled both the 2000 and 2008 bubbles quite well and the index is clearly elevated in the first half of 2018. However, it has been declining steadily over the past year, indicating that bubble formation in the equity market is actually less far advanced than previously indicated. There are several reasons for this improvement.
They include lower valuations (higher earnings while S&P price level is at similar level than January 2018), a more accommodative Federal Reserve (Fed) and low US yields.
Before indulging in the possibility of a bullish scenario I need to start with a warning. We have written extensively about the structural long-term headwinds for equity markets like demographics, debt, income inequality, record profit margins and populism.
While these headwinds have not gone away but – perhaps before they take hold – I increasingly see the case for market ‘melt-up’ in the medium term.
This is for a number of reasons:
So how do we marry these seemingly conflicting views in the Asset Allocation team? To be honest I continue to think we should still gradually reduce equity risk as the asset class moves higher in 2019. Bubble formations happen more often than you might think, but are not the norm – more of an alternative scenario. We need to take into account that most of our moderately positive equity returns for the year, as anticipated in our Asset Allocation team outlook for 2019, have been priced by the markets in less than a quarter. With most US equity indices up more than 10% as I type and many of the positives outlined in the outlook priced, we can’t become too optimistic.
There are a few indicators that could increase the likelihood of a bubble: broad participation of the retail investor, tech companies really starting to outperform and the Fed firming up on average inflation targeting as their future framework for monetary policy. So as always one needs to be flexible.
Investor psychology may be all the rage in recent years, but by stripping away any emotional attachment to investing, we find that valuation always ends up the most important aspect for stock selection.