End-of-cycle and riding an ageing bull
My first boss and mentor always knew when it was going to rain. He would stand up from his desk, stretch an aching leg, and declare that a thunderstorm was coming. He could “feel it in his bones.” Today the received wisdom in the market, especially from investors with a little grey hair and barometric bones, is that we are in the final stages of the bull market, one that has now become the second longest in history. At some point in the not-too-distance future, the “correction is coming”.
What a bull market it has been
From its lows in 2009, through to the end of March 2018, the MSCI All Country World Equity Index (MSCI ACWI) has risen by 227% in US dollar terms, equivalent to an annual rate of return of 13.9%. The biggest driver of gains for global share markets has been the returns delivered from the US, with the S&P 500 index increasing by 311%, or 16.8% annualised. In turn, the biggest driver of US market returns has been the gains in the technology sector. The NASDAQ, an index dominated by US technology stocks, has increased by 552%, equivalent to an annualised rate of return of 22.9% over the last nine years. These gains have happened against a backdrop of near-zero interest rates in almost all the world’s developed market economies (Australia and Canada two notable exceptions). The opportunity cost for an investor who has stayed in cash over this period has been extreme.
Such equity market returns are not sustainable over the long run. It is a brave investor who assumes equity market investments will deliver double-digit returns over a full investment cycle. Over the past 30 years, the annualised returns of the S&P500 and the MSCI ACWI have been just 5.4% and 5.2% respectively. It’s understandable why investors who have lived through a few market cycles have a gnawing sense of unease about how easy it has been to make money in recent years.
The challenge investors face today is how to approach markets when history suggests we are closer to the end than the beginning of the current cycle. On most conventional measures, equity markets look expensive, the current P/E of the S&P 500 at 21.4 is comfortably above its long-term average. Corporate debt levels have increased considerably. High price to earnings valuations are justified when interest rates and inflation expectations are low as discount rates are lower. High debt levels are sustainable when borrowing costs are near all-time lows. Both positions however, rely on interest rates remaining low to support the status quo. However, financial imbalances have built-up in the decade since the financial crisis, and most economists and central bankers do not believe such low interest rates are sustainable in the long term.
Forecasting: the art of saying what will happen, and then explaining why it didn’t
Consensus, even if it’s true, doesn’t give us much to work with. Forecasts are easy. Being in the ‘final stages’ of the current bull market could mean markets are three months or three years from their pending highs. In December 1996, amid a market rally similarly driven by technology stocks, Alan Greenspan, then Chairman of the US Fed, famously opined that markets had become irrationally exuberant. Few people would have disputed Mr Greenspan’s assertion that markets were expensive at the time, however markets continued to rally for a further four years, rising 116% in the process. Secondly, history suggests that the final stages of a bull market often generate the greatest period of returns as caution gives way to euphoria. Exiting now may lead to missing the great returns that are still to come.
Finally, as was the case in 1996, we are currently living through a period of immense technological change, one that most traditional investors (myself included) do not fully understand. Companies like Google, Amazon, Uber, and Tesla have radically changed well-established businesses landscapes in just a few short years. Here’s a remarkable and recent example: Researchers working at the artificial intelligence (AI) unit, DeepMind, created a game-playing AI program called AlphaZero. In the space of just four hours, AlphaZero taught itself to play chess and then went on to decisively beat Stockfish, widely regarded as one of the world’s strongest chess engines. These sorts of advancements tell us that serious changes are underway to both the jobs market and the business landscape, changes that will both create and destroy considerable value from an investment point of view.
Checklist for the end of the cycle
The two most important things investors control are their investment horizon and their risk tolerance, and both these parameters should be set by individual circumstances, not the market cycle. Putting that aside, below is my checklist for investors trying to navigate the final stages of a bull market.
Be disciplined and rebalance. We all have winners and losers, and after a 9-year market run it would be unsurprising to find individual investments within a portfolio that have done remarkably well. The path of least resistance is often to let these positions continue to run. Be sure to ask yourself if you would put them on again at their current size today.
Adjust for volatility. The final years of a bull market are often the most volatile, but as risks increase so do the potential returns. An increase in volatility acts like a form of leverage, and your actual investment exposure to the market in dollar terms can increase without a reduction in the amount of money you have invested.
Forget timing. One of the great fallacies of investing is the idea that it is possible to time markets with any real precision. Far more important is to match what you want from your investment portfolio to your investment horizon. If you were 25 when 2008 struck, what happened to the shares in your super fund will be distant noise when you come to retire. If you were 65, it was a different story.
Technology. Tech stocks are the defining characteristic of this cycle. Disruptive technology clearly creates problems for many established business models, but in aggregate, it should be positive for equities over the long run. New technologies are dramatically increasing the productivity of existing capital and putting more money back into the hands of consumers to save or spend. The pace of this technological change is unlikely to correspond neatly to any historical expectations we have about how long a bull market should last.
Miles Staude of Staude Capital Limited in London is the Portfolio Manager at the Global Value Fund (ASX:GVF). This article is the opinion of the writer and does not consider the circumstances of any individual. Mirabella Financial Services LLP is the investment manager of the Global Value Fund and has seconded the investment team at Staude Capital to manage the Global Value Fund.
