Euphoria is said to be the terminal stage of ageing bull markets. Although there are few signs of uncritical ebullience, investors are finally shedding some of their post-crisis scepticism — raising questions on just how much further markets can continue their record-breaking runs.
President Donald Trump has been happy to flaunt the S&P 500’s return of nearly 16 per cent this year. Indeed, the total return version of the flagship US equity index has now enjoyed 11 consecutive positive months, smashing past the last record run in 1995, and few would bet against the US stock market making it a 12-month streak of gains.
But the 2017 rally is a global phenomenon, with Europe, Japan and the developing world also notching up a series of long and strong runs, buoyed by evidence of synchronised global economic growth and one attracting hefty inflows.
Japan’s Nikkei 225 index has climbed 9 per cent in 2017 to a 21-year high this week; emerging markets have gained nearly 25 per cent to trade near a six-year high; and European stock markets have nearly clawed back the losses they suffered since May. The FTSE All-World index has risen 17 per cent already in 2017 to trade at a new record high this week.
”It’s a remarkable market environment,” says Jeffrey Knight, global head of investment solutions at Columbia Threadneedle. “At some point it will exhaust itself, but I don’t see any signs of that right now.”
Although renewed chatter about US tax cuts has recently reinvigorated the US equity market, the primary driver of this year’s unexpectedly positive global stock market returns is remarkably broad-based economic growth around the world, buttressing corporate profits and stirring animal spirits nearly everywhere. This comes as government bond yields remain low and a number of central banks are still buying bonds, helping suppress market volatility.
Analysts at Bank of America Merrill Lynch note that the variability of economic growth across 45 major countries is running at the lowest in at least half a century, turning a “multi-speed cacophony” into “a perfect symphony”.
And while few countries are enjoying a boom, the International Monetary Fund this week estimated that collectively the global economy is enjoying its fastest growth spurt since the post-crisis recovery in 2010, and raised its forecast for 2017-18.
“This is not bounce back from a sharp deceleration, this is an acceleration from the fairly tepid growth rates of recent years, so that’s really good news,” Maurice Obstfeld, the IMF’s chief economist, told the FT this week.
However, this budding confidence may counter-intuitively indicate that the long post-crisis stock market recovery is becoming primed for a reversal. There are a mounting number of late-cycle signals in the composition of the post-summer global equity rally that indicate that investors are finally becoming more optimistic, perhaps even euphoric.
“This is what worries me the most,” says Omar Aguilar, chief investment officer for equities at Charles Schwab Investment Management. “I think we’re at the beginning of the late cycle now.”
In a note entitled “The Perpetual Rally”, Morgan Stanley analysts note how the shares of smaller companies and cyclical industries have outperformed lately, while stock correlations are continuing to fall — all typical signs of budding positivity and a bull market entering its final years.
“While investors have at times appeared reluctant to embrace the recent rally, there is evidence from last month that risk appetites are increasing,” analysts wrote.
Other evidence, however, points towards mainstream investment managers still being nervous of the rally. A poll of fund managers responsible for investing $549bn of assets conducted by Bank of America Merrill Lynch in September showed respondents held their biggest underweight in US stocks since November 2007, while their cash holdings were above the average of the past decade. At the same time the survey showed bond holdings remained high, with the lowest level of managers cutting fixed income exposure in almost a year.
Low rates muddy the picture for those who argue shares are today egregiously expensive or, on the other hand, still reasonably valued. The S&P 500 currently trades on a price to free cash flow multiple, excluding financial companies which skew this measure, of 24 times, or the highest on this basis since 2006. Some investors, such as Warren Buffett, have pointed out that today’s valuations compared with the past must be weighted against the interest rates at the time. In 2006 the 10-year treasury yield sat at more than 5 per cent, compared with just over 2 per cent today.
Given the likelihood of central banks tightening monetary policy next year — the Federal Reserve plans to both raise rates and steadily trim its balance sheet, while the European Central Bank is expected to scale back its quantitative easing programme in 2018 — equity markets may well lose a major source of support in the form of low bond yields.
Much hinges on the global economy continuing its current synchronised growth spurt. If the fundamentals remain supportive then investors will find it easier to shrug off tighter monetary policy and a rise in long-term bond yields.
Still, some argue that the longer-term outlook for stock market returns has dimmed in tandem with valuations rising to dotcom boom era highs.
Scott Minerd, chief investment officer at Guggenheim Investments, estimates that at the current level of US stock market capitalisation versus the size of the US economy implies annualised total returns of just 0.9 per cent over the next decade — and that is even before inflation. He therefore recommends investors look overseas, but there too valuations are beginning to look punchy.
Few investors and analysts think that markets are entering the ebullient phase that typically heralds the imminent end of a bull run. As Mr Knight puts it, 2007 “felt like a party, it doesn’t feel that way now”. But the signs of investors becoming more optimistic are mounting around the world.
“I used to always be looking for insurance, but I’m not any more. That might mean we’re nearing the exhaustion point,” Mr Knight ruefully admits.
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