March 28, 2018
This excerpt, taken from Balentine’s 2018 Capital Markets Forecast, reflects upon the strength that the current bull market has exhibited over the last eight years and considers the evidence of whether or not we may be nearing another market peak. Want to learn more? Don’t miss Balentine’s full 2018 Capital Markets Forecast, our signature research piece that serves as the foundation of our investment process.
Although the Capital Markets Forecast is a strategic document (i.e., the focus is longer term), we would be remiss not to offer a short-term tactical outlook to address market conditions entering 2018. Because our near-term perspective is far enough out of sync with our longer-term slant, we do not want the longer-term outlook to erroneously skew in investors’ minds our short-term, tactical perspective. While the divergence in outlooks is not new this year, the magnitude of the divergence has increased to the point that we feel now is the time to juxtapose the two. However, our longer-term viewpoint continues to be the focus our investment process, and it is where investors are best served focusing in order to achieve their financial goals. Equities should experience further gains in 2018, on top of 2017’s stellar market performance, as investors have become more confident—but expect increased volatility like that we saw in February.
Last year was yet another impressive year for equity prices. With a 24.6% total return, the MSCI All Country World Index (ACWI) experienced the best annual performance of this bull market aside from the rebound from the bottom in 2009. Since the commencement of this bull market through the end of 2017, ACWI has experienced a total return of 275%, or 16.2% annualized. For comparison purposes, ACWI returned a total of 346%, or 13.0% annually, from January 1988 through the bull market peak of March 2000, making the current bull market even more powerful per annum than that of the 1980s and 1990s. Yet, despite its strength, this bull market has exemplified the familiar adage that “bull markets climb a wall of worry,” as skepticism of equities over the past nine years has been consistent and pervasive. However, we are finally seeing signs of abatement in the apprehension upon which this bull market has been built. To be clear, this wall of worry has not fully been ascended; rather, concerns are expressed less often and with less trepidation. Beyond a decline of anxiety, there has been a resurgence of general “animal spirits” over the last year, as evidenced by the price action in cryptocurrencies and the increases in margin debt. Additionally, surveys now show that a majority of investors finally deem this a good time to invest.
A paradigm shift from skepticism to optimism typically marks a transition from the end of the beginning of the bull market to the beginning of the end. Having said that, it historically has not been an indication of market peaks; mere optimism is not enough for the market to crescendo. Rather, market sentiment must move from optimistic confidence into euphoric exhilaration, and we are not seeing anything near that right now. Yes, we see some examples of potential excesses fueled by cryptocurrencies and record prices in art and ultra-luxury real estate. However, the last two market peaks experienced extreme exhilaration. Notably, in 1998-2000, “clicks and eyeballs” were the golden ticket to riches, while in 2005-2007, “housing prices will never go down” was the latest version of “this time is different.”
However, that is not what we are seeing today for numerous reasons:
- While the market is by no means inexpensive right now, valuation levels need to be normalized for interest rate levels. At today’s lower interest rates, current valuations are still high, but they are not as excessive as they would be under a higher interest rate regime.
- The most often-quoted valuation measure, the 10-year cyclical adjusted price-to-earnings ratio (i.e., the CAPE/Shiller PE) is poised to decline as the earnings collapse of 2008 rolls out of the 10-year lookback period.
- Although some companies today are trading at high valuations, they are real companies with real products and cash flow; this is in sharp contrast to the Internet bubble in which many companies were highly valued without any particular product or service of note.
- The leverage in the system today is nothing like the peak of the housing bubble, when leverage was fueled by cashing out home equity which led to excessive spending on credit.
- Breadth is still strong across different sectors and across the globe. Cracks began to assert themselves well in advance of the prior market tops.
While things appear pricey on the surface, there is more underlying strength than at first glance. Overvaluation, the bears’ number one argument, is a condition that is necessary but not sufficient, as anyone who invested in the late 1990s can attest. In other words, expensive assets can become far more expensive before the market wakes up to any concerns.
It is an exercise in futility to attempt to predict specifically when the peak will come. Indeed, our process intentionally waits until the market’s momentum confirms a turn for the bearish (or, conversely, a turn for the bullish during a bear market) is at hand. Evidence shows that the amount we gain by listening to our model and not selling out of bull markets or buying into bear markets too early more-than offsets what we forfeit by the inability to perfectly time peaks and troughs. Our current model readings indicate an equity market top is not imminent; subsequently, we continue to participate in the market’s ascent as fully as possible across all strategies, all the while keeping a close eye on our models. Investors are becoming more optimistic, but there are still many out there who will be surprised by how much more life this aging bull market has left in it; this is a contrarian indicator that will propel stocks.
In his book The End of Alchemy, Mervyn King, former governor of the Bank of England, references a cricket fielder who sees the ball come off the bat and, in an instant, takes off to catch it. This player can make the best possible calculations that a human is able to compute, all the while knowing that his route to the ball will likely be imperfect. Our investment philosophy is similar: we make the best possible calculations and use our understanding of the context of the market situation to maximize our odds of investment success. The current context, gleaned via our model readings and understanding of the world economy, is that there is more to laud than fear. Our calculations may be as imperfect as the fielder’s route to the fly ball, but, as our model has repeatedly demonstrated, adhering to its discipline will maximize our chances of investment success. This, of course, does not mean that our outlook cannot change, but that the outlook for equities remains favorable at this time. As a result, we must not fail to take advantage of these near-term opportunities provided by the markets.
The transition to fiscal policy in the U.S. should allow for stronger earnings growth, meaning that domestic equity prices can continue their ascent in 2018 without the need for multiple expansions.
To that end, we expect that domestic wage growth can reassert itself on continued tailwinds in both deregulation and fiscal policy. One of the Trump administration’s goals is to drive sustained economic growth, and the new tax law is one avenue through which it aims to accomplish that. Some cite increased hourly rates and bonuses from large corporations (rather than solely funneling earnings to dividends and stock repurchases), as early examples of reinvestment in business and productivity growth. While it’s too early to know whether the tax package will be successful, these actions exemplify the shift from monetary policy to fiscal policy, which we believe will lead to yet another transition, this time from fears of deflation to fears of inflation.
Our preference for international equities over domestic equities remains unchanged.
Given that our preference for international equities is more strategic in nature, domestic equities could continue their recent streak of annual outperformance in 2018. While we have no way of knowing what will occur over the next 12 months, we are confident that this outperformance will not continue for the next nine years. Our preference stems from looser international monetary policy, more compelling valuations, and expected mean reversion in performance. Our models began to pick up on a change in this trend late in 2016, leading us to initiate a position in Emerging Markets. Then equities of international developed markets became in favor and, as a result, were added to portfolios in mid- 2017. Both trends continue in spite of the modest drift back toward domestic markets during the second half of 2016. We remain optimistic that international equities are the superior way to achieve outsized returns moving forward.
In contrast to our near-term outlook, the long-term outlook for equity returns remains weak, but diligently sticking to our process will allow clients to achieve their financial targets.
Although our outlook for 2018 maintains our bullish posture, our strategic outlook over the next seven years continues to remain meager. This is not a new theme for us; in fact, our seven-year outlook is even weaker than that of a year ago. The most effective determinant of an asset’s long-term returns is the starting valuation; expensive assets generally lead to poor returns, whereas inexpensive assets produce strong returns. Therefore, strong performance in the equity markets often leads to a reduced forecast in long-term returns. Adding to our projection is what we perceive to be an increase in global uncertainty, owing not just to geopolitical issues (e.g., North Korea, Mideast tensions, terrorism, populism, etc.), but also due to the effects of central bank’s actions, such as those first implemented in the throes of the 2008 Global Financial Crisis. Owing to their actions over the last nine years, central bankers and central planners have created a world in which uncertainty looking forward has substantially increased because they effectively borrowed certainty from the future in smoothing equity price returns during that time period. This was not by chance, as the central banks have been rather explicit about targeting asset prices in their quest for reflation. Unfortunately, these policies tend to be asymmetric in that central banks are often proactive in preventing further downside, but reactive in slowing asset price inflation. Economist Hyman Minsky famously noted that stability begets instability; unless wage growth can be sustained, a rise in asset prices will not last, which could lead to exacerbated volatility in equity markets. Put differently, this bull market’s ability to persist is less about reflation and more about income gains from stronger capital investment than we have seen to date.
What do we do in the face of uncertainty? Quite simply, we hold the course on creative solutions previously introduced while depending on our models to deliver excess returns to benchmarks both within Market Risk, as well as across Market Risk and Fixed Income. The models’ track records have demonstrated an ability to do this consistently over seven-year periods, and we expect no differently going forward. While market turmoil may cause short-term weakness during some point in the forthcoming seven-year cycle, we are confident in our ability to drive the returns necessary for clients to achieve their goals.
 Since global equity markets bottomed in March 2009, the S&P 500 has experienced annual total returns of 19.4%, handily trouncing the 13.3% posted by the ACWI ex. U.S. index.