To Buy or Sell.... Have Investors Become Irrationally Exuberant?

That is the biggest question hanging over global financial markets. Despite tumultuous politics across much of the rich world, share prices are reaching ever loftier heights.

With the US stock market now into its 8th year of gains, it has only been this expensive twice in its history since 1881: just before the 1929 crash and at the peak of the dot-com bubble in 2000.

If you do want to get out how do you know when, because markets have defied pessimists for years? Projections that markets will fall, earnings will fall, it will all come to a sticky end really have not come true. So the big question for investors and for policymakers who are worried about the financial stability implications of another market rout, is what will make markets crash: are valuations enough, and if so when will that happen?

Sometimes you need something to go wrong. Goldman-Sachs have looked at the 13 bear markets, which we have had since the 1960s, and what usually happens is a recession: prices start to rise very quickly and the central bank pushes up interest rates to cut off inflation and that causes a downturn.

There are three reasons why investors are ignoring the alarm bells, each of them reasonable

First, investors’ exuberance comes after a long period of restraint. The S&P 500 index is up by 5.5% so far this year. In 2016 it returned less than 10%. In 2015 it fell. Contrast that with the late 1990s, when the S&P 500 returned 20% or more in five successive years. Nor have investors bet the farm on shares. A Bank of America Merrill Lynch survey of fund managers found that they held more cash than usual. Investors have a negative view on government bonds: ten-year Treasuries yield 2.5%, compared with 1.8% before Donald Trump’s election. Equities look attractive in comparison.

Second, there are indications of a pickup in the global economy. That is a big change from the start of 2016, when investors were preoccupied with the state of the Chinese economy and the threat of deflation. After a feeble performance over the past few years, with annual growth in trade volumes barely keeping pace with GDP, the signs are that global trade is picking up again. Commodity prices are 10% higher than a year ago. Even European growth forecasts have been revised higher. And if you look around the world most economies are recovering, except Venezuela.

Third, expectations of tax cuts, infrastructure spending, and deregulation from the Trump administration have invigorated animal spirits in America. In December American small-business confidence saw its biggest rise in nearly 40 years, according to the National Federation of Independent Business. Profits for firms in the S&P 500 index are expected to rise by 12% in 2017 after being squeezed during the past couple of years, partly because a low oil price hit the energy industry.

Still, many things can go wrong. President trump may not deliver the tax reform he has promised– so far he is the rare president who has not been able to sign any bill into law in eight months in office. Corporate indebtedness has been going up and the corporate bond market looks overextended and could suffer a run from investors. Central banks, still very cautious in their unwinding of QE may get it wrong and choke off the economy, although there is no sign of this happening yet.

For the time being, investors can, in essence, bet that things will be “different this time”. That is certainly possible for now but it requires a lot of faith in the long run. A reversal to the mean is likely at some time, but not just yet.

In light of this market outlook, we continue to look at individual stocks instead,looking for opportunities and bargains. These do not abound but we find some when we concentrate on individual companies, their management, business models and capacity for cash generation. While we will not be able to avoid the markets irrational movements, we will be shareholders of solid companies that should do well even in a market downturn. We have also made more use of options strategies to generate income and to pick up shares that we like on the way down.

Zurich, 08th September 2017