Bear necessities: are we near the top?
More than eight years into the current bull market, it is reasonable to worry that we might be near the top. Prices have been rising without a meaningful correction for much longer than in previous bull markets; indeed, only the 1990-2000 period exceeds the duration of the current phase. The scale of the gains since 2009 have also been pretty impressive - on a par with the 1982-1987 period and again only beaten by the golden age for stock market investors in the 1990s.
Goldman Sachs has done some interesting research comparing the current bull market with other similar periods. It thinks there are four reasons to be concerned. The first is the length and scale of the rise. The second is the high level of valuations, in particular in America. Thirdly, it points to high profit margins. And finally it notes that monetary policy is beginning to tighten.
The next part of its analysis distinguishes between different types of bear market to help identify their causes and see whether we are at risk of a repeat today. It finds three. First, there are cyclical bear markets which are caused by rising interest rates, impending recessions and falls in profits. Next come event-driven bears. These are triggered by outside forces such as wars, an oil price shock or emerging market crises. Finally, there are structural bear markets which are caused by imbalances and bubbles. Very often these precede a deflationary shock.
Having categorised the bears, Goldman then looked at the signals that preceded each type and calculated how reliable they were and how often they gave false positives. Perhaps unsurprisingly this is where the research gets difficult - if there were simple and reliable indicators of trouble ahead you can be sure that investors would have already found them. The bear, as we know, is a wily beast and each bear market is subtly different from those that went before.
However, more promising was when variables were put together. Here it was possible to find combinations which gave a reasonable indication of the likelihood of poor or negative returns in future. Five, in particular, seemed to work well: unemployment, inflation, the yield curve (difference between long and short bond yields), growth indicators like purchasing managers’ surveys and valuation.
The logic here is sensible. Tight labour markets tend to lead to higher inflation which in turn triggers interest rate rises and weaker growth expectations. If valuations are high at the same time then shares are clearly vulnerable to a fall as investors adjust to the changing backdrop.
So that’s the theory; what does it say about today’s market environment? Well, ranking each of the five variables against their history since 1948, Goldman created an overall 'Bear Market Indicator' score, expressed as a percentage. This is what the chart shown here tracks. There are two lines but they are variants on the same theme so just look at the general direction of the chart. As is clear, the current level is relatively high and certainly at a level that suggests the risks of a bear market are reasonably significant.
Are we close to a bull market peak?
Source: Shiller, Haver, Datastream, Bloomberg, Goldman Sachs Global Investment Research, September 2017
Past performance is not a reliable indicator of future returns. When investing in overseas markets, changes in currency exchange rates may also affect the value of an investment.
Interestingly, Goldman believes that the signal may be less of a worry than it might seem. The main reason for its confidence is the low level of inflation since the financial crisis and its belief that this is sustainable. If inflation does stay low then monetary policy too can remain looser. And this means that recession is also less likely - a cyclical bear market does not seem imminent.
Furthermore, it believes that post-crisis financial regulation has led to lower leverage among banks and companies alike. This, it says, makes a structural bear market also less likely. The third type of bear market - an event-driven one - is by its very nature unknowable.
So the bank’s conclusion is that a period of low returns is more likely than a bear market. The sting in the tail of its analysis, however, is that if inflation does rise, forcing higher interest rates, the ensuing bear market could be deep. Without the ability for central banks to ease monetary policy very far, it could also be long.
This analysis seems pretty sensible to me. In plain English it says: the longer the bull market continues the risks rise further but there is no reason to think that a downturn is imminent. The cycle could extend for a good while yet.
Which leads neatly to my second key question: how to manage risk within our portfolios?
How much cash should I hold?
My old friend Jim Slater used to say that you knew you were close to the top of a bull market when there was a prevailing belief that ‘cash is trash’. He meant that when everyone is fully invested in the market, with no cash left on the side-lines, there is only one way for it to go.
The irony, of course, is that the moment when no-one wants to hold cash is precisely the moment when investors should be putting a bigger proportion of their portfolio into the most reliable and liquid of all assets. There are two reasons for this: first, to protect the value of your investments in the event of a market correction; second, to keep some powder dry to take advantage of the buying opportunities that corrections create.
I’ve done a lot of thinking about the level of the market over the summer and while I’ve inevitably come to the unhelpful conclusion that I just don’t know if a correction is on its way, I’ve also decided that I want a slightly higher weighting in cash than usual. I’m a firm believer that trying to time the market is a mug’s game but I also don’t want to be full-invested as I watch any market setback that does come along, unable to benefit from the attractive opportunities that will naturally arise.
The amount of cash you are comfortable with will vary according to your risk appetite, your age, the level of the market and many other variables. For Slater, an active trader, it was anywhere between zero and 50%. For most long-term buy and hold investors, a range of, say, 5% to 15% might be more appropriate. It’s impossible to generalise and if you are really unsure, you should seek out qualified advice.
My over-arching mantra in investment is the importance of diversification. At the moment, a bit of cash feels like an essential part of a well-diversified, balanced portfolio.
Who’s afraid of a sideways market?
The conclusions of the Goldman Sachs research discussed above chime with some work done by my colleague Paras Anand, the chief investment officer for equities in Europe at Fidelity. He looked at periods during which markets have in the past moved sideways and analysed what those phases of overall dull markets were actually like for investors.
First, though, why might markets move sideways? The principal reason is that there are as many good reasons why they should rise as fall. The logical conclusion is that they might bounce around in the middle for an extended period. This has happened surprisingly often and in markets all around the world.
What if markets go sideways?
Source: Thomson Reuters Datastream, as at 28.9.17
Past performance is not a reliable indicator of future returns. When investing in overseas markets, changes in currency exchange rates may also affect the value of an investment. For full 5 year performance figures please see Market Data.
Why might markets not rise further? First, because they have already re-rated to quite high valuations. Second, because corporate profits are under pressure from price competition and disruptive technologies. And, third, because wage growth is likely to squeeze margins.
Looking now at why they might not need to fall from here: first, because valuations are not excessive, especially when compared with other assets; second, because while government and personal debts remain high, companies are broadly speaking in good health. If prices were to fall then industrial buyers might emerge to take advantage.
Now the interesting bit. If markets do move sideways does this mean that investors’ returns are also disappointing? Not necessarily, Anand thinks. The reason for this is that while very few companies make outsize returns over short periods like one year in a sideways market, a surprisingly large proportion do over longer periods. The average over, say, a three year period is made up of a good number of reasonably large risers and as many fallers.
So, in a recent sideways market in the UK between 2013 and 2016, while just 3% of companies rose by 75% or more over any one year period, over three years the proportion rose to nearly 30%. So who’s afraid of a sideways market? All it means is that you, or your fund manager, need to roll up your sleeves to find the winners and avoid the losers. Go active management!
Time to rethink home bias?
And finally, where in the world to invest in today’s environment? I’ll look at the main geographical regions separately later in this report. But I wanted to dwell briefly on an interesting element of asset allocation that I suspect could hold many investors back in the period ahead.
Home bias is the tendency for investors to hold more of their portfolio in shares listed in their local market than they should on the basis of that market’s contribution to the overall global market. In the case of the UK, which represents less than a tenth of the value of the total global equity market, many investors hold a much bigger proportion in UK-listed shares.
It’s easy to see why they would. They are familiar with the companies quoted here, and the managers too. Investing overseas feels a bit more risky. But I’d suggest that the risks globally are more skewed towards the UK today than they have been for some time. The long, slow Brexit negotiation will cast a long shadow over the UK economy for several years to come. Sterling is weak, inflation high, consumer confidence shaky. It just feels like a good time to pare back your exposure to the home market.
Look at the Investment Management Association’s statistics and you can see investors’ vulnerability to UK underperformance. Of the roughly £600bn held in retail equity funds in Britain, around £250bn is in UK shares and only £60bn in Europe and £50bn in the US. That feels wrong.