Markets have made a strong start to the year. The S&P 500 has risen more than 4% YTD with the Hong Kong Hang Seng Index up close to 5%. This strong performance comes on the heels of a 6.1% rise in the S&P 500 last quarter.
While our overall equity market view is constructive, we are doubtful that the current pace of gains can be sustained in the near-term. Markets are becoming over-heated and beginning to exhibit signs of euphoria. The equity markets risk-reward profile is deteriorating.
AAII Investor Sentiment data (as at 03/01/18) 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% of individual investors held a bearish view – the lowest reading since June 2003. On a net basis, the sentiment indicator is at its most bullish level since December 2010.
Extreme levels of investor sentiment are often a pre-cursor to a market turning point. The previous two highest readings of the net AAII sentiment indicator were in December 2010 and November 2014. These proved to be a useful contra-indicator, as the peak in AAII sentiment heralded a decline in markets the following year. The S&P 500 ended 2011 flat and fell 1% in 2015. As Warren Buffet once warned investors, “Be fearful when others are greedy and greedy when others are fearful”.
Investor sentiment towards the Euro is also at extreme levels currently, with traders holding a record long position of 144.7k contracts as at 9th January, according to the Chicago Futures Trading Commission. The same dataset shows oil traders held a record net long position of 657.6k contracts. While we do not question the fundamental reasons behind the market’s positioning, the current extreme level of sentiment and positioning creates an asymmetric risk-reward profile.
The growing clamour for bitcoin and other cryptocurrencies is a further sign of overheating sentiment. While we see value in blockchain technology, the rally in cryptocurrencies is a textbook example of irrational exuberance. Bitcoin neither exhibits the characteristics of 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 current lack of market volatility is another concern, as the VIX index of volatility remains close to records lows. Does this indicate investor complacency? Perhaps, though we think it serves to further highlight the market’s current vulnerability to negative surprises.
Equity valuations are high, with the S&P trading on a 12-month forward price/earnings of 18.4x, a 16% premium to the 5-year average and 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 by 11.8% in 2018.
All 11 sectors of the S&P are expected to grow earnings this year, led by the energy, materials and financial sectors. Net profit margins are expected to reach 10.9% this year – a level not seen before the 2008 financial crisis. The margin improvement is broad-based, with margins expected to rise in nine of the 11 sectors this year.
The forthcoming Q4 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. Conversely, we see scope for profit taking should Q4 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 currently. The growth outlook for the global economy continues to improve, with economic growth currently synchronised across all major geographies. Consensus expect global GDP growth of nearly 4% this year, an acceleration from an estimated 3.8% growth seen in 2017 and 3.1% in 2016.
The US economy should continue to perform well in 2018, with consensus forecasting 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 of this year.
The US PCE Index – the Fed’s preferred measure of inflation – has been slowly ticking up since August and looks set to rise further from here. Core US CPI also rose to 1.8% in December, up from 1.7% during the previous month.
We therefore continue to think the market is under-estimating the scope for a rise in inflation this year – 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 this year, which should in-turn risks leading to greater US Dollar strength than the market is currently anticipating.
On balance, we expect global equity markets to rise this year. However, we expect the rate of increase to moderate, following the stellar performance seen in 2017. Current high levels of investor sentiment, coupled with low volatility are 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 currently anticipating.