Does S&P 500 fall portend end to the bull run?
11 October 2018
Rory McPherson, head of Investment Strategy, Psigma Investment Management, looks at this week’s events on the US stock markets and whether this is the first sign of an end to the longest ever bull run.
Events this week on US stockmarkets have raised further questions over whether the bull market rally, the longest ever, will continue or whether we are due a significant correction.
Investors have been truly spoilt over the last 9.5 years and in our view it’s highly unlikely that returns will be as good over the next few years as they’ve been recently.
Markets are undeniably in a late cycle stage, but the game is not up. Granted there are more risks (more on those risks below) and the ability to be nimble and flexible is going to be key to protecting the good returns already banked.
Income needs and inflationary pressures will remain as ever and it’s our strong belief that one needs to think differently and be truly balanced in order to generate a solid and sustainable future income stream.
With the dubious honour of longest bull market ever, it is right to ask if it can continue. Our view is yes, but we’re late cycle and there are cracks appearing. Bull markets don’t die of old age and are much more prone to keel over due to excesses and sharp changes in regime; we’re beginning to see signs of both but are not there yet.
In terms of excesses, let’s first consider valuations. At 16 times forward P/E, global equity markets should be considered fair value; certainly not cheap, but nor are they eye wateringly expensive.
Even the US, which has attracted most of the attention (and returns!) does not look expensive to the point it starts to keel over.
In fact, most equity markets have had a de-rating this year as earnings have held up, with most major markets enjoying high single-digit growth rates.
This has been most pronounced in the US, where earnings are set to grow at 25% this year; helped in no small part by stimulative tax cuts.
Valuations aren’t cheap, but in and of themselves do not look like they are ready to unsettle the equity market bull.
In terms of more immediate risks, we’re mindful of a US economy that whilst currently booming, is also displaying classic late-cycle characteristics.
The US economy is now operating at full potential and is starting to create inflation; as evidenced through prices and wages. At the current trajectory this is likely to drag the rest of the world into full potential production by mid-2019 (roughly) and this in turn could cause recessionary pressures to build.
We are mindful of the flatness of the US yield curve (flattest since October ’07) which has been an excellent pre-cursor to credit drying up. Throw into the mix that the US Federal Reserve is firmly on a hiking path and one can quickly conclude that caution is warranted at this late stage of the cycle.
Choosing the right assets
Such risks warrant caution but they don’t warrant running for the hills and retreating to cash.
Clients still need income and inflation is ever present. The blend of assets to deliver on this is key and to our minds is very different to that which has worked so well and for so long (i.e. not government bonds and UK stocks).
Given the glut of cheap money we’ve enjoyed (which has raised all boats), our belief is that future returns (and future income streams) are likely to be lower. That said, we believe distributions of the order of 3% to 4% are eminently doable; just with the right asset mix.
For mid-risk clients who we run balanced mandates for, we’re looking to spread risk across 11 core asset classes with a particular focus on specialist, short-dated and smaller companies within fixed income and within markets such as Japan within equities.
Specialisation and expertise is key. As such, we’ve looked to set-up bespoke, segregated mandates with chosen bond managers where we have very close oversight of the underlying issues. Being exposed to long-dated bonds is, to our mind, incredibly risky and a risk we’re happy to avoid.
For clients where income is paramount, we’ve actually looked to carve out our fixed income exposure into a one-stop-solution. This enables clients to gain exposure to the sorts of investments which will hold up well in a rising rate environment.
Bonds which are backed by hard assets can flex their yield as rates rise and bonds such as US mortgage bonds actually do better when rates rise; no-one wants to repay their mortgage at a higher rate!
These are just two examples of how taking a different and less well-trodden approach to asset allocation can ensure the best surety of good future income and returns.
Where are we now?
Sadly in investing no one rings a bell when it’s time to get out of stock markets and shelter in cash. Based on indicators we look at, we don’t think we’re there yet but do think there’s evidence of late-cycle signs which warrant caution.
Added to this, geopolitical risks are as high as they’ve been in a generation and create further headwinds for markets.
Whilst there might be life within the old bull yet, we lean towards a cautious stance which means being very specific and targeted. This means specialist bond investments which have a good yield and taking a balanced approach within equities; at the margins favouring those assets (i.e. Japanese stocks) that provide a greater margin of safety through the cheaper price one pays for them.
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