If you have teenagers, you are undoubtedly aware of this social media-driven phenomenon, (dare I say curse) that most teenagers have regarding “Fear of Missing Out.” It’s certainly a big reason most are glued to smart-phones nearly 24/7 as they stay connected to the pictures and stories posted by their friends (and it’s Snapchat, NOT Facebook for those keeping score at home).
I believe we’ve entered a phase in the market cycle where this psychological factor is growing in importance to many investors. Q3 earnings results for many of the large-cap Tech bellwethers and the incredible reactions their stocks enjoyed must have weighed on the psychology of the investor who might be “out of the market.”
Imagine the pressure an investor feels (or advisor, fund manager) who has missed this terrific year of equity market returns (and bonds and gold and real estate returns) as they were afraid of high valuations, afraid of Trump, of hurricanes, of North Korea, of rising interest rates and all the other reasons many commentators have offered for why this is a dangerous time to own risk assets. We know that while equity-oriented ETFs continue to enjoy strong inflows ($780B since 2009), there’s has been a net OUTFLOW of equity-market mutual funds ($973B over that same period) making this one of most hated bull markets in history. Corporate buybacks is the missing link for the mismatch of supply/demand.
We have now passed the most dangerous months for equities historically and markets tend to rally into the year-end, especially in years when the 10-month rise has been as strong as 2017’s performance. We must consider the implications of what many describe as the “melt-up” stage of the equity market cycle, where investors throw caution to the wind and “chase” returns into the New Year.
This behavior would not surprise us and it can be a very lucrative time to be fully invested. You don’t want to miss this stage as many professional managers did later in the dot.com cycle when many couldn’t stomach those high valuations.
Recall that markets rallied for THREE YEARS following Greenspan’s famous “irrational exuberance” statement made in December of 19961. Many famous investors and funds so badly lagged the returns of the S&P 500 in 1998 and 1999 that some lost their business, closed their funds and many hedge funds returned cash back to their investors.
Of course, these same managers were vindicated when the bubble burst following the peak in the spring of 2000 but many were also out of business!
Personally, I was co-managing a large-cap, domestic mutual fund and institutional accounts for an asset management firm and while we too lagged the S&P in those melt-up years, I was lucky to be partnered with a more technically-inclined colleague who kept us “in the market” for longer than I would have if acting alone. We lagged, but we “participated” and few (if any) clients fired us for being within 2-3% of market returns.
The point here is that while “melt-ups” feel great and you don’t want to miss them,
you must also be prudent and take some chips off the table on the way up.
“It is nearly impossible to time the top.”
At Fundamentum, while we have taken some chips off the table by dialing back small-cap domestic equities and high-yield bonds early on in 2017, we have largely held the course and in our Tactical portfolios, we have been rewarded by strong absolute returns and out-performance versus our benchmarks for the most part.
Our Investment Committee meets every week, pouring over the economic data, valuation data, technical data, and truth be told, we are looking for reasons to pare back risks more, but have resisted for the most part beyond the measures already mentioned. Surprising to some of us (me), this aging economic cycle appears to be gaining steam globally, and doing so without generating much inflation pressures (so far). Valuations are high but nowhere near the levels of 2000.
It was recently pointed out by Professor Robert Schiller that his “CAPE” ratio2 is now at the same level as it was at the time of Greenspan’s irrational exuberance statement in 1996. Tech stocks, for instance, currently sell at high levels relative to their 200 day moving averages (+15%), but this compares to nearly 50% above their moving averages before the bubble burst in 20003. Equities markets that are overly concentrated and expensive, as they were in the spring of 2000 are clear warning signs. Today, while the largest FIFTY names in the S&P 500 Index sell for 18x forward earnings estimates, they sold for 31x forward earnings in March of 2000. Regarding concentration, the TEN largest holdings in the S&P 500 Index make up 20% of the Index, up only a few points from the 18% lows, compared to the highly concentrated 27% in 2000.
Don’t misunderstand, we know it’s dangerous to attempt to ride relatively expensive markets higher, especially with interest rates and inflation rates likely moving higher.
We get MOST EXCITED about the prospects for equity returns when valuations are low (NOT), when inflation is high and falling (NOT), when interest rates are high and falling (NOT) and when margins, earnings and sentiment are depressed (NOT). Clearly, that is not the environment we are in today.
It’s hard to say whether today, November 1, 2017 most resembles 1996, 1997, 1998, 1999, or 2000, but we feel reasonably good about the economic prospects for the next 6-12 months (with or without tax cuts) and signs of a recession are slim. We are monitoring the yield curve but even here, at today’s level of 75bps (10-year vs. the 2-year), the last four times we are at similar stages, it took 12 months, 8 months, 31 months and 12 months before inverting which is a dangerous time to own equities. It appears we have time.
In conclusion, like many, we are “nervous bulls” for the short term and remain convinced that LONG-TERM equity and fixed income returns are likely to be subpar as the starting point matters most for long-term returns (not so much in explaining SHORT-TERM returns).
Today, at 18x and 2.40% on 10- year Treasuries, we believe these levels represent headwinds for long-term returns, but not so extreme to prevent further appreciation in the short-term.
If a melt-up occurs, enjoy it but be aware that they generally end badly
and be prepared to adjust.
Your Fundamentum Investment Committee endeavors to do the same.
Paul Danes, CFA
Fundamentum Investment Committee November 1, 2017
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