Fragile foundation underpins future market growth
If your equity investments are diversified across industries and geographies, you did well in 2017. The question, of course, is whether the bull run that started in March 2009 will carry on for a 10th year.
There are plenty of reasons to suggest it will: the market’s underpinnings are still positive; the world economy is going through a broad-based growth phase; profits are increasing and will be further boosted by U.S. tax cuts; and inflation remains low, providing little impetus for interest rates to rise.
Besides, when it comes to competing for investors’ capital, fixed-income securities aren’t putting up much of a fight.
Nonetheless, there are plenty of signs the foundation of this growth is fragile. Almost every chart I look at shows an imbalanced or extreme situation.
Debt is high and continues to expand faster than incomes. Real bond yields (after adjusting for inflation) are near zero in North America and decidedly negative in Europe and Japan. And corporate bond spreads, which represent the additional yield an investor gets for taking more risk, are at historically low levels — in other words, investors are blasé about potential defaults.
The imbalance in fixed-income markets is illustrated by the simple fact European high-yield bonds (that is, less credit-worthy issuers) yield less than the U.S. Treasury bonds. That is remarkable, but the extremes don’t end there.
Profit margins are at cyclical highs due to a combination of economic growth, low commodity and energy prices, automation and modest wage growth, while price-to-earnings multiples are 20 to 30 per cent above historical levels.
In Canada, explosive real estate prices in the major centres have resulted in poor levels of affordability and created an economy that is more dependent on housing-related activity than at any time since the late 1980s.
Some of these measures may have found new, permanent levels, yet most will return to their trend line over time.
But the fragile foundation isn’t the result of any one indicator, but rather the wall of extremes. The path of least resistance is for things to get worse, not better.
Something else that has little room to improve is investor sentiment.
The shift in market mood to greed from outright fear nine years ago would appear to be substantially complete. One prime indicator is bitcoin mania, but there’s plenty of other evidence.
More often now I’m hearing investors say, “I know I’m doing fine, but shouldn’t I get a little more juice in my portfolio. Stocks are really doing well.” Or, as I heard last week, “I took out an investment loan to buy dividend stocks. It’s a slam dunk.”
Phrases such as “more juice” and “slam dunk” certainly indicate a bullishness that might be overlooking at least some of the things that could come into play.
I’ve never forecasted shortterm returns and I’m not about to start now. It’s not because I’m chicken, but rather because it’s impossible to do consistently well. There are just too many variables, of which only a few have been mentioned above.
Looking further out, however, I’m more comfortable setting expectations for clients. I can say with certainly that fixed-income returns will be in the low single digits during the next five to 10 years. That confidence is because current yields are a reliable predictor of future bond returns. Near-zero yields? Near-zero returns.
As for stocks, the combination of high valuations on cyclically high profits usually leads to modest returns in the subsequent three to five years. If the strong market continues for the next year or two, which it could, it will likely be borrowing heavily from future years.
In a time of euphoria, this subdued outlook will make it difficult to do the right thing in 2018, which is to stick to your long-term asset mix and make sure you’re not taking more risk than your plan calls for.
For example, managers of our Founders Fund have eased back on corporate bonds and are highgrading the stocks they hold. Overall, I’m running with slightly less stocks than usual and keeping some cash at the ready.
I may have wimped out on a specific forecast, but I can say with perfect foresight that 2018 will once again reinforce why I’ve been in the investment industry for 35 years — it will be interesting.