Although the current bull market (starting from around March 2009) has now entered its 8th year, current sentiment indicators and fund flows show that many investors remain unconvinced and have not been participating in its run. One likely reason is that they had just experienced the worst drawdown in history (the 2008 Great Financial Crisis), which was also only the second time in history that a 10-year period in holding equities had yielded negative results. However, we see many signs that this secular bull market will continue.
The weight of the evidence compels us to favour equities as the asset class possessing the most stamina and potential – with bond risks being the proverbial elephant in the room. For as long as our Risk Matrix© does not signal heightened financial stress or the start of a bear market, we need to treat this uptrend as our friend.
The stock market continues to recover nicely from the sell-off at the beginning of the year and, more recently, the BREXIT event. With the exception of Europe and China, most stock markets are at levels last seen in Dec 2015. The positive signals from our Risk Matrix helped us to stay invested during this volatile period when everyone else was selling. Investors who sold at the height of the panic would have despaired to see how quickly the market did a sudden U-turn and recovered.
We urge investors not to get distracted by the noise all around us. No one can forecast what will happen next year, but right now, the market remains investible and we should thus stay allocated to take advantage of all the returns it can provide. We will walk through some of our thought process on why we think this current rally can continue.
Distrust of equities...
Ironical as it sounds, the fact that many investors do not believe that there is a secular bull market is the reason why it would continue. Many have been scarred by the horrific experience of the Great Financial Crisis of 2008 (which incidentally holds the record as the largest annual decline in the S&P500 index since 1941). Understandably, investors remain jittery and are ready to sell stocks at the slightest hint of trouble. This has resulted in a huge inflow of monies into bonds and perceived “high quality” stocks like utilities and consumer staples, thus pushing the valuations of these assets to extreme levels. Data on money flows (see below) shows that retail investors are continuing to pull money out of equities and place it into bonds even as stock markets continue to climb (Fig 1). We are thus far from any euphoric or bubble-like levels in stocks as investors are in fact shunning stocks at this time.
Fig 1: Retail (Dumb) Money Has Allocated a Huge Amount To Bonds Whilst Continuously Pulling Money Out of Equity Markets
...but feeding a bubble in bonds
A chart we frequently utilise to gauge long term secular trends is shown below (Fig 2). Note that this covers an expansive time period, stretching from 1900. Whilst there are counter/cyclical rallies and dips in the shorter time periods, long-term trends are obvious.
Bonds have seen an excellent 30-year rally with yields now touching record lows (remember that yields go down when bond prices rise). A shrewd investor would thus be very wary and see that this trend is nearing an end. The charts do not lie, but in true human fashion, people will choose to ignore this, thinking that the party can continue (going into negative yield) and that they are in safe assets when the reverse is actually true. When you think how much money is continuing to flow into bonds, this makes us extremely worried that many people are unknowingly sitting on a pile of debt that is waiting to implode. Although we still have bonds in our asset allocation models, we are sticking to very short maturity fixed income instruments to lessen interest rate risk and volatility.
Fig 2: Don’t Miss the Forest for the Trees; Long Term Bond Market Trends Are Peaking
Why we disagree with GIC
Another reason why the chart on long-term asset class trends is so useful is that it allows us a look at more than 100 years of history. Our sovereign wealth fund, GIC, recently reported that the next 20 years of returns would never match the golden days of the 80’s and 90’s.
We find this comparison incomplete. Whilst the 80’s marked the start of a long secular bull market in equities, it also coincided with the start of the bond bull market. You would need to go back to 1940 to find a situation that is similar to today’s (start of an equity bull market and a reversal of bond market yields). Although investors cannot get the same returns from bonds, there is no reason why they cannot achieve decent returns from the equity markets.
GIC also highlighted that Shiller P/E levels indicated that the equity market was at the top of its historical valuation currently. We respectfully disagree. We prefer to use Tobin’s Q or Enterprise Value (Fig 3), which gives a more accurate measure of market valuation. Many have written about the flaws of using the Shiller P/E, notably when corporate earnings collapse or when interest rates are at extremely low levels, both of which are recent occurrences due to central bank policies and weakness in the commodity sector. Furthermore, the spread between choosing to invest in stocks or bonds is currently at very high levels due to depressed interest rates (Fig 4), making the risk/return trade-off for equities very attractive.
Fig 3: Tobin’s Q Valuation of the Stock Market (S&P500) Does Not Show Extreme Overvaluation.
Fig 4: Valuation Spread Between Stocks and Bonds Favours Stocks.
Room for volatility and equity risk premium to tighten
Equity risk premium is the excess return an investor gets by investing in the stock market versus a risk-free instrument e.g. government treasury bonds. The chart below shows how equity volatility and equity risk premium gradually taper to extreme low levels during the progress of secular bull markets (Fig 5), i.e. as more people pile into stocks, which drives stock prices higher, the potential for higher returns diminishes. Following the recent flash sell-offs in Aug 2015 and Jan 2016, the measurement of volatility and equity risk has been reset (back to a higher equity premium). This provides a compelling case for a long-term secular bull market, as we are currently not near previous sentiment extremes.
Fig 5: Volatility and Equity Risk Premium Has Room to Tighten Further, Implying That More Risk Taking Can Drive the Market to Higher Highs.
Follow the leader
In a global equity allocation, 53% of the allocation is to the US stock market. We have shown in past articles that a US-led economic recession or US-led equity bear market typically drags the whole world down with it. As the US is very important in both equity markets and in the world economy, the majority of our market indicators invariably would comprise US-related data. Thus, it is important to know the relative strength of the US equity market versus the rest of the world. The chart below shows that a secular global equity bull market is typically characterised by a strong performance from the US equity market, which is currently the situation today (Fig 6).
Fig 6: A Strong US Equity Market Leads To A Strong Performance In Global Equity Indices
So this means that stocks always win?... Not quite
Most investors know that stocks outperform in the long run (provided one can stay the course!). However, that has not always been the case. Twice in the past 80 years has holding stocks for a 10-year period generated negative returns (Fig 7). Unfortunately for most investors, we have just experienced such an event. When you couple this poor return with the worst equity market losses recorded in 2008 (ref our second paragraph), this perfect storm has resulted in an aversion to taking equity market risk. It has also triggered very short-term thinking amongst investors. Whilst in the past, investors believed in buying stocks and holding for more than 20 years, they now view a 3-5 year timeframe to be a long period. This is unfortunately very detrimental to their investments. Empirical evidence has shown that the consecutive 10-year periods after a 10-year loss-making period is almost always very much more rewarding.
Fig 7: Only Three Times in History Have Stocks Underperformed Bonds – 1929 Stock Market Crash, 1973 Oil Shock and 2008 GFC. Twice only if you Measure Negative Performance from Holding Equities for 10 Years and We Have Just Gone Through Such an Event!
When does it end?
The truth of the matter is that no one knows! It is a matter of fact that no one has been able predict market tops (or bottoms) consistently, and we would thus be lying if we were to make such a claim. However, after many years of investing, we have learnt to ignore the advice of the talking heads on TV or proclaimed investment gurus. The odds are they will get it wrong. We believe that the real signals are in the market data. The problem is that there are just too many market indicators, and they often provide conflicting signals beyond what the human brain can mentally analyse. As such, many investors give up.
But we didn't give up, and instead spent many months diligently working on this as well as back-testing our models and algorithms to see if they worked. We finally launched our proprietary Risk Matrix© system (click here to read our interview with The Edge) in Dec 2014, and we now rely on this to answer a simple question each day – whether to stay invested or not. In addition, we track numerous other market indicators, which measure the longer term market health and signs of an impending bear market. When our indicators breach their key thresholds, we will act to advise our investors to seek safe haven assets. However, at this time, there is no such signal.
The market still holds a lot of upside potential. The current market is not unprecedented, as previous market cycles have had a similar shape and form. So, until we are triggered by our Risk Matrix©, the best investment approach now is to follow the secular bull trend – using any dips or short term corrections as buying opportunities. As they say: The Trend is Your Friend!