Is investor sentiment getting too positive?

The world has recently seen a dramatic turnaround in investor sentiment and market performance, but should investors be worried about the cheery consensus? Dominic McCormick writes.

Late last month, one of the regular daily financial industry emails contained the following four stories.  

• Aussie equities to rise another 20 per cent in 2013’ 
• There’s no bubble in bond markets’ 
• Cash rate falls good for property’ 
• 2013 a turning point for world economy’.  

Apparently all is good with the world. It has been a dramatic turnaround in sentiment (and markets) since the despair at the end of 2011, and even as recently as mid-2012 as fears over the Euro dominated.

Markets have since rallied 20-30 per cent and sentiment has moved from deep pessimism to widespread complacency, and arguably some elements of euphoria. 

I have difficulty recalling such a rapid turnaround from negative to positive sentiment in my 30 years of following financial markets.    

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In fact, it was precisely around these times that I was highlighting the extreme pessimism and the attractive value in equities (see ‘Nowhere to go but Up’ January 19, 2012 and ‘Why Shares are an investment in the Future’ June 27, 2012).

Indeed, given the low level of cash and bond rates one can still make the case that attractive ‘relative’ if not ‘absolute’ value remains in equities. 

Given this, it would be easy to come to the conclusion that investors across equities, bonds and property assets have little to worry about looking forward.

In terms of this line of thinking, the only investors that should be currently concerned are those sitting on too much cash who are about to miss the bonanza on offer. 

However, I have an uneasy feeling that the path forward from here will be anything but plain sailing for mainstream asset classes and the global economy.

Of course, this does not rule out continued good returns from equities, particularly in the short term. 

Will the rally last? 

In my first article mentioned above from early 2012, I was discussing the capitulation of the bulls as previous bullish commentators recanted and moved across to the bearish camp, something we can see in hindsight was precisely the wrong timing.  

Recent months have clearly seen a capitulation, or at least a widespread retreat, of the bears. This is never a good thing, as it takes away a solid chorus of scepticism and doubt that is part of a healthy equity rally (the so called “wall of worry”). 

Even if 2013 turns out to be another good one for equities, investors should not be complacent. If equities are expected to perform well, there is a key question to ask. Is it primarily because: 

1. Global economic growth is going to be strong, surprise on the upside, taking earnings with it and providing a sound basis for a multi-year fundamental bull market; or  
2. Very low interest rates, liquidity and increased appetite for risk and momentum-chasing from investors? 

These two scenarios have very different implications for the path of equity returns and indeed for those of other asset classes. 

If the former, then equities should deliver strong returns, but the view that there is no bubble in bond markets could be tested as last year’s record low bond rates rapidly re-set to more normal levels.

If this is the case, investors need to be very careful about their fixed interest allocation. 

Other assets that have been supported by very low interest rates such as gold could also perform poorly if this is the case.  

If instead, equities perform because of liquidity, the change of risk preference and simply momentum, one would have to be worried about the sustainability of such a move and the risk that it is a developing bubble which eventually ends badly.

I lean towards this view. If this is the case, then bonds would hardly be exciting investments but could do better once the equity bubble busts. 

Many commentators are talking about “the great rotation” from bonds to equities, but as several have pointed out, there can be no “rotation” at the overall level because ultimately someone has to hold every secondary asset.

If someone sells bonds, someone else has to buy them.

Certain categories of investors might “rotate” into equities or risk assets, but there must be others that are rotating out at the same time. 

For example self-managed superannuation fund (SMSF) investors with high cash might add to equities but others - perhaps institutional investors - have to be selling these for cash at the same time.  

It is true that some central banks buying assets with “new” money have complicated this picture somewhat, but more likely we are seeing not so much a rotation as an increased “appetite” for risk.

Buyers of equities become more aggressive than sellers, so prices paid rise. The chase for yield has been an important feature of this move.   

In the context of these scenarios and particularly my leaning towards the second view, this is not a year to give up on sensible diversification and a contrarian approach. 

Investors have had plenty of time to add sharemarket exposure in the weakness of late-2011 and mid-2012. Why some have been waiting for equity markets to go up 20-30 per cent before jumping in is anyone’s guess?

Ideally, now should be a time of reducing equity exposure into strength, not increasing it.

Of course for those who abandoned equities totally in years past, the decision is much more difficult.    

Of course, for those who have more conviction than I that this is the beginning of a true multi-year bull market (scenario 1) where there could be plenty more upside, one could afford to be more aggressive. 

The problem with this view is that market valuations at current levels don’t provide significant support.

Trailing price-to-earning (PE) ratios are above long-term averages, especially for Australia, and it is difficult to see the strong future earnings growth that will be necessary for this scenario to play out.          

There are even challenges for those that see continued gains under scenario 2. It is rare that the Australian sharemarket runs its own race, and the problem is that some key markets (especially the US) already have benefited from a more extended period of extremely low interest rates and liquidity. 

A sharemarket rally built almost totally on improved sentiment and liquidity can start to resemble a bubble that can be pricked relatively easily and at any time.

And while both of these scenarios can see higher equity returns in the short term, there are a range of scenarios that are much more hostile to equity investments.

A refocus on the sovereign debt issues in Europe and other developed countries is one, as is a possible stalling in the US economic recovery.

While China has continued to avoid a hard landing, a range of long-term imbalances need to be addressed. The risk of geopolitical issues weighing on markets is also growing.         

So what should investors do? 

Investors who took advantage of the weakness in recent years to build equity and listed property positions should be considering taking profits or at least rebalancing. 

One should not give up on diversification into other asset classes and alternative investments.

Some, such as managed futures, selected hedge funds and gold could do reasonably well in a liquidity-driven rising market, but also provide some diversification in the rougher scenarios for equities mentioned above. 

Other means of protecting portfolios: use of options or long volatility funds could also be considered, particularly if markets move significantly higher.

While some areas of fixed interest make sense, we certainly have not yet seen the level move upwards in yields that would make broad fixed interest valuations attractive.   

Clearly, those with very little or no growth asset exposure here have some difficult decisions to make.

The temptation will be just to join the crowd, with that temptation growing further if markets rally strongly.

One can see investors getting burnt by investing heavily following strong rises. Gradually adding a modest exposure - ideally on pullbacks - is probably the best approach, albeit from a very sub-optimal starting point. 

Of course, the strongly bullish views could prove right in 2013.

After all it’s been a pretty tough environment the last few years and the Australian market is still well below its 2007 levels.

But the major macro risks have not disappeared and new risks could emerge. Valuations are not cheap.

If it is a strong year for equity markets I believe it will be driven primarily by liquidity and momentum, a basis that results in bubbles and makes markets vulnerable to severe weakness at some point. And other more adverse scenarios for equities are possible even before bubbles develop.      

“You pay a very expensive price in the stockmarket for a cheery consensus”, Warren Buffett once said. It is no surprise that there are rumours going around that Buffett has been selling some stocks recently.

Those advisers and investors thinking that now is a great time to load up on growth assets should tread carefully.

The easy gains have already been had.      

Dominic McCormick is the chief investment officer and chief financial officer of Select Asset Management.