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A risk with this upbeat backdrop is that it may force central banks to raise rates and that overall monetary conditions tighten.
The financial conditions index incorporates Fed tightening, along with a range of other inputs. Levels of the stock market, credit spreads, yield curve and the US dollar are among such factors.
1. High Levels Of Debt
Corporate balance sheets don’t appear overly stretched, and appetite for M&A doesn’t stand out as exuberant as one may typically expect at market tops.
Perhaps the dangers may come from the East?
Whilst growth in China still easily outpaces most of the world, concerns are mounting over the increased debt levels needed.
I see the trajectory in debt a worry but not yet the overall levels. These don’t cause too much alarm when considering debt levels compared with many developed countries in the world. I would also add that the assets side of the equation often gets overlooked in the debate over China’s debt levels.
2. Geopolitical Risks
Geopolitical risks also must be taken into consideration.
The US market would not react too kindly to further tensions with North Korea and Iran. A risk for international trade also lies with tensions in the South China Sea. These things are of course very difficult to forecast. The answer may be to exercise some caution though given these risks are lurking in the background.
Investors should also be sitting on good gains given the extent of this current bull market.
3. Inflation Risk
The easier monetary conditions I touched on earlier may be a double-edged sword for investors. Economic momentum in the short term may be greeted with inflation risks further out.
I see this is the main risk for equity markets and it has been a long time coming. It is likely that many of today’s market participants have never worked in an environment with serious inflation risks. If you believe inflation about comes, you may consider some gold mining stocks or even direct investment in gold.
4. Expensive Valuations
The other major risk lies with expensive valuations, even though they may not be as troublesome as the late 90s and. In spite of we can still find great dividend stocks for investment and companies with strong growth such as Google and Amazon – there are not many other times where we can point to valuations being as worrying as they are right now. Some say we need a catalyst for a bear market, yet simply overvaluation could be it. Arguably this was the case that brought about the bear market in 2000 after the tech boom.
Measures such as the CAPE ratio or comparing the index market cap to GDP show some dizzying heights. We only find a few other periods over the last century for similar comparisons. Namely just before the last recession, the tech boom in the 90s, and the roaring 20s saw similar expensive valuations. Things didn’t end well after these periods.
We do hear some well-reasoned arguments that support such high valuations. The CAPE ratio still includes some depressing earnings after the last recession. CAPE has also been criticized with regards to accounting earnings used and it not being that useful for timing purposes. Also, markets have tended to look expensive for decades, so it is tricky to analyze what is considered normal these days.
Is the Buffett indicator above as relevant these days?
Companies earn more overseas, and some of the tech heavy weights are expected to experience rapid earnings growth. Interest rates are far lower today, should we, therefore, place less reliance on these types of measures?
I get very worried when I hear investors relying on such arguments. I do accept though that they have some truth behind them. Therefore, I conclude it merely means valuations are still very expensive rather than perhaps outrageously so. The low rate argument concerns me for two reasons.
Firstly, that extremely high rates in the early 1980s marked a fantastic entry point into stocks. It gave a huge tailwind for P/Es to expand once rates fell again. It seems like we have a mirror image here of this now. Secondly, if rates are so low does that tell us something about future economic growth not being that strong?
5. Extreme Levels Of Optimism
Other factors I find worrying surround investor sentiment and evidence of speculation. Many sentiment surveys, especially prior to the February correction, suggested extreme levels of optimism. Stats on margin debt and the excitement over Bitcoin before Christmas suggested animal spirits were running. It would be the typical stuff that you may look back on as signs of the market topping. Another example would be the lack of corporate executives buying their own stock in recent years.
6. 200-day Moving Average As a Signal
I have read some compelling arguments why the 200-day moving average is a good signal for identifying the trend. I believe it tends to often produce good results for a few reasons. The short-term nature of performance chasing from fund allocators and retail investors is conducive to momentum strategies to work. Likewise, are industry participants being wary of “career risk” and tending to stick with popular themes.
I wouldn’t place that much faith on such a signal for moving around huge amounts of my portfolio. It’s just that if this 200-day moving average breaks to the downside on the major indices, I see it as extra worrying given the backdrop of expensive valuations.