Emotion is the single most disruptive force when investing. We are all prone to bias’s which include overreacting to a news event (recency bias), seeking out information that supports our pre-existing ideas while ignoring other relevant information (confirmation bias), or anchoring, which can involve an attachment to the highest value your investments have reached without considering that you could not have reached that level without the value decreasing from the high-water mark at some point. The cycle of emotions illustrates a counterintuitive fact. That the point of maximum risk is usually when we feel the best about investing. We are not yet seeing Euphoria take over the markets and we are optimistic that optimism is currently where we sit.
The wall of worry has been a constant this cycle, with the current bull market amongst the most doubted. Many reasons have been given for doubt, be it the slow and fragile nature of this recovery, or the fact that Central Bank support has been present throughout. Doubters say what they may, the fact of the matter is underlying global economic fundamentals are positive and strengthening all on their own. It has been a long time since a self-sustaining expansion has been experienced, yet this seems to be occurring now.
In fact, the current economic conditions have been described by many as “Goldilocks”. This is an environment where volatility is low, employment is high, where neither deflationary or hyper-inflationary conditions exist, confidence is high, earnings are growing, monetary policy remains accommodative (albeit tightening in the U.S.), and both developed and emerging market economies around the world are expanding on a synchronized basis. Accordingly, there are very few recessionary signals flashing caution at the moment. With many equity markets closing off the third quarter at all-time highs, and bond yields remaining low, a melt-up scenario has been unfolding.
While there may be little reason for doubt regarding fundamentals, lower returns going forward are a reasonable expectation for stocks and bonds given current valuations and sentiment. In terms of valuations, equities trade at higher than average valuation levels. The historical low interest rate environment and improvement in earnings growth offer some support. Yet one could argue that investors have now more fully discounted the improvement in economic fundamentals. Sentiment looks to have moved to optimistic on the Cycle of Emotions chart, and in some cases excitement (e.g., Bitcoin, marijuana stocks). This validates some caution, yet the low likelihood of a breakdown in fundamentals over the near-term provides downside support in our view. This establishes our base case outlook for stocks, being a more modest yet positive near-term total return outlook.
Into the future
We live in an age of continuous technological advancement which often also brings some disruption. This trend is still in the early stages, yet the implications are far reaching. The largest taxi company doesn’t own any cars. The largest hotel company doesn’t own any rooms. Autonomous and electric vehicle research and development has ballooned disrupting the automotive and insurance industry. Retail shopping verticals continue to feel the pressure from better online price discovery. Companies in general have lost their pricing power resulting in downward pressure on inflation, while lower skilled labour has also lost bargaining power. These are just a few examples to illustrate the broad and significant changes occurring in many industries all at once. There are clear winners and losers in this process, and we do not want to be exposed to those industries that are being disrupted. We prefer to either own the disruptors or industries that are resilient to this trend.
As always, we welcome your comments, calls and suggestions.