Who said investing was meant to be easy. There’s a profoundly good reason why most investment sages say you should ignore the noise of markets – you simply can’t make head or tails of the conflicting signals. This is my own default model, as I tend to stay near fully invested during large parts of the market cycle. Currently, I’m probably around 95% fully invested in risky equities.
My basic default position is to stay invested through the cycle but I can’t quite still that inner voice which suggests that the next big sell-off will be the mother of all price declines. With assets very evidently inflated by QE, the turn around when it comes could be brutal. So, why not look for any signals so that one can dial down one’s risk exposure?
The problem of course with that strategy is that for the vast majority of the time, it’s a fruitless one. Your undue caution becomes incredibly painful as markets ignore the doomsters and continue to power ahead. Over the last two years I’ve bought into downside protection at least twice – on one occasion I made money, but then promptly lost nearly all these gains in the next instance. And yet I can’t quite quick the habit. With US equity markets, in particular, powering to new highs, I keep constantly looking at the pricing for downside put options – with vol low, and valuations high, leverage looks amazing.
But am I making another mistake? Shouldn’t I just ignore the signals and stay invested? Again, I come back to that nagging fear that when the next big one comes, it’ll be much bigger than the rest – if I can mitigate some of this pain, surely that’s the right thing to do?
As is often the way, currently the bears spin a good narrative, with perhaps the most powerful one based on macro. This is QE has inflated asset prices and thus its unwinding will cause huge pain. Analysts at Cross Border Capital watch these central bank balance sheets very carefully and although they think that policy-makers have vowed to tread slowly in reversing QE, “the facts that often dominant cross-border flows already appear to have peaked and that Central Banks are starting out from a much less accommodative position than widely acknowledged, must heighten systematic risks. Feeding these facts into a statistical probit model that has been informed by machine-learning techniques warns that the consequence may be a bear market in World risk assets starting in 2018. This is not yet certain, but watching the upcoming direction of cross-border flows will tell us a lot more.”
There are, of course, any number of other bear signals worth monitoring, not least that equity market valuations as measured by Robert Shiller’s CAPE measure are at near-term highs. Maybe low-interest rates make the stretched PE multiples seem less egregious, but even a Low Rates, Longer enthusiast such as myself concedes that rates are due to rise. And of course, there’s the inevitable question of politics, which looks grim in the extreme, not least because of the upsurge in ugly populism and more bellicose language. What happens if the Donald makes a mistake with North Korea?
But I also think there is what I call a ‘home bias’ at work as well. Many investors in the UK are in a grim mood because of all the obvious uncertainties lurking around, not least our dreadful local politics accompanying Brexit. Yet the raw data suggests that we in the UK are woefully out of step and that the ‘rest of the world’ is feeling much more chipper!
This week, for instance, European analysts at Morgan Stanley put out a note with the headline the “The Global Economy is booming” and is rude health. According to the MS analysts “ the latest round of data releases suggests that the global economy is in very fine fettle indeed, and potentially even accelerating to the upside. Korean exports are often held out as the most timely guide to the global economy and the latest release this week saw them growing at 35%Y, close to a record high. Elsewhere China’s PMI is up to a 5Y high, the Japan Tankan survey is at new highs and we saw big moves higher for Sweden’s PMI (to 63.7), Netherlands’ PMI (to 60) and the composite index in France….. In the US the latest round of ISM data was also very strong with Manufacturing rising to its highest level since 2004 (New Orders component up to 64.6) and the nonmanufacturing index rising to an all-time high of 59.8. The New Orders component was also very strong within the latter index (at 63), however of most interest to us was the very sharp rise in ‘Business Prices’ (to 66) which suggests significant upward pressure on US inflation in the months ahead”.
The two charts below nicely sum up this surge in optimism.
What’s the bottom line? Should we fear the Fed or is the global economy actually in fine form? Should we bias our portfolios towards domestic concerns or simply accept that the UK is a depressed outlier and that properly diversified investors should be looking externally? My gut feeling at the moment is to stay fully invested. But I still can’t keep from watching those signals….