In 1998, researchers at the Weizmann Institute of Science in Rehovot, Israel, showed that electrons passing through a membrane behave differently when being observed. In a similar way, investors looking for the next bear market are affecting its timing. Bear markets are typically preceded by a period of irrational exuberance, which seems a quantum leap from where the collective mood in markets is today. Traditional indicators such as the shape of the yield curve and the level of equity market valuations have proved ineffective thus far in this latest cycle; little surprise perhaps given the changing rules of the game, with risk free rates (here thinking about US Treasury Inflation Protected Securities) having declined to zero over the past 23 years. Instead of adhering to any single rule of thumb, we have preferred to stay invested on behalf of our investors and broadly diversified, to good effect in 2019.
Investors are happy to own equities at present with the US stock market regularly making new highs through last year, giving the impression that confidence is also high. But this observation ignores the fact that many investors are electing to own shares in high quality, defensive companies, which have therefore performed extremely strongly in the period since the financial crisis. Investing is about being able to distinguish between high and low quality companies, but also understanding what premium to pay for the former and here a huge discrepancy has built up between valuations on the highest and lowest quality names in the market as a result of investor unease.
Another indicator that, at first glance, appears to suggest animal spirits are alive and well in markets is the VIX index of implied volatility, which is currently 24% below its long-term average. A low reading on the VIX is often considered a sign of investor complacency. But underneath the headline index level the skew between expectations for a big upward move in stock prices versus a big downwards move is very high, suggesting that within the current low volatility regime – attributed to unusually active central bank policy, which has served to put a floor under markets – investors are still nervously looking over their shoulders.
Investors are not the only ones feeling downbeat. Global central banks continue to run extraordinarily loose monetary policy, with good reason on the most part given few signs of inflation in the system, but it is nonetheless surprising to hear the Bank of England talking about a further rate cut as recently as last week. December’s election result coincided with, or likely caused, the biggest jump in CEO confidence since before the referendum. With a clear mandate, Brexit uncertainty has been removed and it is instructive at this juncture to cast our mind back to the last time the UK was unencumbered by political (and perhaps self) doubt, pre the referendum in 2016, when it was the second best performing major economy behind the United States.
If investor fears around markets are affecting their reality, it is perhaps unsurprising that the ‘most hated bull market in history’ is also the longest (at 130 months the current bull market in the S&P 500 has passed the previous longest period of expansion that ran for nearly 10 years from October 1990). There are risks: fear itself can have a huge impact on the global economy and there are also tangible frictions in the form of trade wars, both of which have a crucial bearing on markets. We remain broadly diversified in our portfolios to help navigate short term pullbacks, but we continue to believe it is time in the markets rather than trying to time short term ups and downs, that is key in delivering on our clients’ investment outcomes. We pay close attention to the global economy and valuation opportunities, but we try to not let the noise distract us from our clients’ needs for long term real returns.