Research Note - April 2017

April 21, 2017 | Market Commentary

In the early 1700s, one of the most popular stocks in England was that of the South Sea Company, which traded goods in the Americas and other parts of the world. With European overseas expansion in full swing, these types of companies appealed to many investors, including one-Sir Isaac Newton. After participating in the initial run-up of the company’s stock price, Newton sold his shares for a substantial profit. However, after having seen his neighbors get rich as the company’s stock price kept rising, Newton bought back in only to lose the vast bulk of his savings when the stock price subsequently crashed. While the above anecdote is not meant to scare investors nor to classify today’s financial conditions as a market bubble, it should serve to remind investors about the dangers of capital risk (i.e., permanent losses of capital).

In the current environment, the most prevalent debate has been that of soft data (e.g., consumer sentiment & business outlook surveys) vs. hard data (e.g., actual economic activity). As we have discussed in earlier research notes, sentiment measures have increased rapidly over the past several months while hard data, although generally positive, has not kept pace. While we can debate at length which type of data is more in line with actual economic conditions, we believe that most investors should primarily focus on longer-term objectives, and their ability to take on various risks (e.g., capital risk) instead of near-term data.

With the latest economic releases being generally positive and stronger near-term market returns, investors can be forgiven for being more optimistic about the markets and perhaps tempted to increase their risk tolerance. However, even though we have no explicit knowledge regarding exactly how long the current economic cycle will last, we do know that it has persisted for many years and generated strong market returns, particularly in the US. Since capital risk tends to increase during the later stages of a market/economic cycle, as these are generally followed by a market correction/recession, we believe that investors should, at least, evaluate the appropriateness of their current asset allocation and their ability to take capital risk.

If an investor determines that their current equity allocation is appropriate, we would not necessarily urge them to reduce their exposure to equities. However, for those who are considering increasing their equity exposure without a change in their long-term objectives, we would suggest caution. Again, we would like to stress that caution does not imply that stocks are at the precipice of a bear market, but rather, that the balance of risk/reward in the current market environment suggests that unmitigated gains are unlikely.

As the markets are a discounting mechanism, it is important to have a sense of what exactly markets appear to be discounting. Put simply, are markets priced for calm waters, or is the margin of safety attractive enough to account for unpleasant surprises? While today’s valuations may be satisfactory should the status quo persist, the margin of safety seems slim for any exogenous shocks (e.g., as compared with 2011 when valuations were a substantial backstop).

For example, many equity markets remain at or above fair value and high yield bond spreads remain below average. Likewise, both sentiment and expectations are no longer depressed indicating that investors are more confident regarding the direction of markets and the economy going forward. While the above is not enough to predict an imminent bear market, it does help answer the question regarding what is currently priced into the markets. Most notably, while earnings growth has shown some signs of improvement, it not only has to be positive going forward but sufficient for companies to grow into current valuations. Similarly, while the economic data also has been positive, it too must improve enough to satisfy investor expectations. Thus, at current valuations and sentiment levels, the data doesn’t just have to be good, but better than the market expects.

Lastly, we should point out that political uncertainty around the globe has yet to recede. The recent failure to pass the healthcare bill in Congress and military action in Syria illustrate the unpredictability of political events. Furthermore, the outcomes of the upcoming elections in France and Italy remain contested. In this context, investors should consider whether the markets are priced attractively enough to discount unfavorable political outcomes.

At the end of the day, the risk tolerance and asset allocation range of most investors was likely set with their long-term objectives in mind. Unless those objectives or the ability to meet them have changed dramatically, we believe that now is not the time to structurally increase risk.


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