Overheating, euphoria and low volatility a precursor to change
• Consensus is for strong global GDP growth, but there are risks to short-term performance
Markets have made a strong start to the year. The S&P 500 has risen more than 4% in the year to date, with the Hong Kong Hang Seng index up close to 5%. This strong performance comes on the heels of a 6.1% increase in the S&P 500 last quarter.
While our overall equity market view is constructive, we doubt that the pace of gains can be sustained in the near term. Markets are becoming overheated and are beginning to exhibit signs of euphoria. The equity markets risk-reward profile is deteriorating.
Data on sentiment from the American Association of Individual Investors (as at January 3) showed 59.8% of individual US investors were bullish on markets on a six-month view — the highest reading since December 2004. Only 15.6% held a bearish view — the lowest reading since June 2003. On a net basis, the sentiment indicator is at its most bullish since December 2010.
Extreme levels of investor sentiment are often a precursor to a market turning point. The previous two highest readings of the net sentiment indicator were in December 2010 and November 2014. These proved to be a useful contra indicator, as the peak in sentiment heralded a decline in markets the next year. The S&P 500 ended 2011 flat and declined 1% in 2015.
As Warren Buffett warned investors, “Be fearful when others are greedy and greedy when others are fearful.”
Investor sentiment towards the euro is now at extreme levels, with traders holding a record long position of 144,700 contracts as at January 9, according to the Chicago Futures Trading Commission.
The same data set shows oil traders held a record net long position of 657,600 contracts. While we do not question the fundamental reasons behind the market’s positioning, the extreme level of sentiment and positioning creates an asymmetric risk-reward profile.
The growing clamour for bitcoin and other cryptocurrencies has been a further sign of overheating sentiment. While we see value in blockchain technology, the rise in cryptocurrencies has been a textbook example of irrational exuberance. Bitcoin exhibits the characteristics of neither a currency nor an investment. Bitcoin is a bubble, plain and simple. Looking forward, we expect the cryptocurrency market to come under increasing regulatory scrutiny.
The lack of market volatility is another concern, as the VIX index of volatility remains close to record lows. Does this indicate investor complacency? Perhaps, though we think it serves to further highlight the market’s vulnerability to negative surprises.
Equity valuations are high, with the S&P trading on a 12month forward price-earnings of 18.4, a 16% premium to the five-year average and a 30% premium to the 10-year average. While valuations appear rich, the outlook for corporate earnings remains robust, with S&P 500 companies forecast to grow profits 11.8% in 2018.
All 11 sectors of the S&P are expected to grow earnings in 2018, led by the energy, materials and financial sectors.
Net profit margins are expected to reach 10.9% in 2018, which is a level not seen since before the 2008 financial crisis. The margin improvement is broad-based, with margins expected to rise in nine of the 11 sectors tin 2018.
The forthcoming fourthquarter results are likely to be a near-term catalyst for the market. A strong earnings season, leading to material upgrades in corporate profit forecasts, has the potential to drive equity markets higher. But we see scope for profit taking should quarter four corporate earnings fail to beat expectations.
While we expect markets to exhibit more volatility in 2018, the outright risk of a bear market remains low. Bear markets are normally triggered by recessions and there appears a limited risk of that at present. The growth outlook for the global economy continues to improve, with growth synchronised across all major geographies.
The consensus expectation is for global GDP growth of nearly 4% in 2018, an acceleration from an estimated 3.8% growth in 2017 and 3.1% in 2016.
The US economy should continue to perform well in 2018, with a consensus forecast for GDP growth of 2.5%. The US labour market remains tight, with employment at, or close to, a cyclical peak. While the inflation outlook appeared benign for much of 2017, we expect the rise in energy prices and recent dollar weakness to result in higher inflation into the second half.
The US PCE index — the Federal Reserve’s preferred measure of inflation — has been slowly ticking up since August and looks set to rise further. Core US consumer inflation rose to 1.8% in December, up from 1.7% during the previous month.
We therefore continue to think the market is underestimating the scope for a rise in inflation in 2018, both in the US and globally. We also believe the market has potentially misjudged the Fed’s desire to normalise interest rate policy as we approach a peak in the economic cycle. Consensus expects the Fed to raise rates between two and four times in 2018, which should in turn lead to greater dollar strength than the market is expecting.
On balance, we expect global equity markets to rise in 2018. However, we expect the rate of increase to moderate following the stellar performance in 2017. High investor sentiment, coupled with low volatility, is a risk to short-term performance.
As such, we expect markets to exhibit greater volatility through 2018. The easy money has been made in equity markets and we expect 2018 to be a more challenging year than many are anticipating.
THE EXTREME LEVEL OF SENTIMENT AND POSITIONING CREATES AN ASYMMETRIC RISKREWARD PROFILE