Markets can get too exuberant

US indices are hitting a series of new all-time highs as optimism builds – but markets appear to be pricing in perfection.

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  1. Garry White

The recent all-time highs in the S&P 500 this week mean it has now hit more records this year than it did in 2018. There may even be more to come.

However, it was at this time last year that an equity market sell-off gathered steam, with the usual “Santa Claus” rally failing to materialise. The S&P 500 lost about 11% in the final six weeks of 2018, prompting concern that the post-financial crisis bull market was coming to an end.

This year, however, things are different. Despite the fact that the S&P 500 is already up by almost a quarter in 2019 new signs of optimism have entered the market. The bulls are now in charge, but there’s a danger this euphoric positioning contains more than a touch of hubris. Caution is required.

Buy, buy, buy

Investors really are going on an equity-buying frenzy. The latest Bank of America Merrill Lynch (BofA ML) fund managers’ survey showed that cash levels at professional investors have shrunk significantly in a matter of weeks. In the October survey, fund managers held an average of 5% of their assets in cash – this is now 4.2%. This marks the biggest monthly drop since the election of Donald Trump in November 2016 and means cash levels are at the lowest level since June 2013.

So, what is justifying the resurgence of the bull?

There are heightened hopes that some form of trade resolution could be at hand, even though President Trump dangled the threat of new tariffs this week should China fail to comply with his demands. The president needs a buoyant stock market for next year’s re-election campaign, so obviously he will strike some form of deal to keep the stock market on the right course, the bulls argue.

However, the BofA ML survey took place in the first week of November, when trade optimism was at its highest as positive briefings trickled out from Beijing. Things are now looking a little shakier, although it is something of a fool’s errand to try and get inside the mind of Donald Trump.

Bankers are adding fuel

Central banks worldwide are also supporting markets – and there is no sign that the era of easy money is coming to an end. This is another bull point, with many declaring that the chance of a global recession next year has been avoided. But how credible were these claims that a global recession was likely anyway?

Consensus forecasts for GDP growth had never factored in a recession, it was more below-trend growth. The US is still expected to grow at around 2%, China just below 6%. So, this argument is overcooked too. Not much has actually changed.  

Conventional market wisdom tells us that fear and greed are the two main drivers of markets. Greed feeds the bulls and fear propels the bears. However, if you believe the BofA ML survey, then these two emotions have now combined – and this is what is sending US equity markets to record highs.

Oh no, it’s FOMO

A fear of missing out – or FOMO in trendy parlance – is what is driving investors from the sidelines, according to the survey’s authors. “The bulls are back... global recession concerns vanish and ‘fear of missing out’ prompts wave of optimism and jump in exposure to equities and cyclicals," the investment bank said.

But emotions are a dangerous thing, especially in investing. This implies that, as professional investors get nervous about their performance figures as the cycle becomes long-in-the-tooth, both fear and greed have combined to create this new optimistic backdrop. It could be double trouble.

Of course, the whole point of the stock market is as a discount mechanism that takes into consideration all available information, including present and potential future events. This is the Efficient Market Hypothesis. But, quite obviously, this is not really true. The dot-com bubble was a perfect example where the discounting mechanism turned into hubris. Other examples abound.

Sure, corporate earnings in the third quarter have been slightly better than expected. But market gains have expanded price-earnings multiples so much we need to see a significant rebound in earnings in 2020 to justify this multiple expansion. 

A proportion of these gains is also likely to be down to a short squeeze. Many investors had borrowed stock on the largest US names betting on a market fall. This rapid switch in sentiment has prompted them to close positions and buy the shares back in the market. This is always a temporary phenomenon.

Easing exuberance

I wouldn’t want this piece to read as too bearish, it is meant as a tempering of an over-exuberant bull. The yield on equities remain ahead of those available in bond markets, a recession has been unlikely for some time – and some form of bounce back in earnings in the first quarter of next year is possible if not likely. However, consensus earnings forecasts worldwide appear to be too high right now and are likely to be trimmed over the course of coming months. The earnings multiple expansion we have seen in recent weeks may not be justified by reality.

This combination of fear and greed into a trendy FOMO acronym should raise a red flag for the rational investor. Investing should be emotionless, so the current market euphoria may not last for long. Any upcoming Santa rally may result in a hangover. It may be best not to drink too much. 

A version of this article appeared in Friday’s Daily Telegraph.

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