In my ‘lovelife’ I have only ever been dumped, rather than initiating the ‘it’s not you, it’s me’ conversation myself. But in my working life, I feel the 'cautious' badge is undeserved. Rather, I see myself as a realist.
As a realist there are always times when one wants to remove the shackles and join the countless hordes of investment optimists. Pessimism and realism are often considered handicaps in an industry where optimism sells.
Everyone benefits from joyous projections; clients buy in, fund managers' assets grow, markets rise, profits are made and confidence soars. What's not to like with this positive feedback loop?
There's also less chance of you looking a chump, as bull markets typically last many years longer than bear markets, whose swingeing effects are usually fast and furious.
For all the scarring effect that the brutal '08 market crisis had, the worst of the selling took place in under a year and was sandwiched either side by at least five years of gaining markets.
Performance of developed markets over 11yrs
Source: FE Analytics
So, after the US S&P 500 smashed another record yesterday, I'm going to discard my protective cloak of pragmatism and outline the case for why the next few years could be a golden age for equity investing.
Let’s assume for now that the global economy can continue to hum at around the current growth rate of 3.5-4 per cent, which is the long term trend. (This means for now that you must ignore geopolitics and European nonsense).
Best value out there
The opening argument in the bulls' case is the wide gap between bond yields and equity risk premia (earnings yield over the risk free rate/ treasury yield).
Nowhere is this more obvious than in Europe, where German bund yields have now collapsed to below 1 per cent on the 10 year.
This ‘yield gap’ in favour of equities is a worldwide phenomenon. Corporate free cash flow yields and dividend income is extremely attractive in a world where the risk free rate is practically zero.
A common objection as to why equities are so attractive is because nothing else is. There’s a lot of truth in this.
We live in a ‘Goldilocks’ world
Clearly the fly in the proverbial ointment is that at some point the risk free rate will shift higher.
However, many commentators still see this risk as negligible and it is clear from the central banker get-together at Jackson Hole last week that Janet Yellen will do anything she can not to raise rates, allowing the bulls to run riot.
The general view is that we live in a ‘Goldilocks’ world, where inflation and growth are neither too hot to raise rates quickly (if at all) or too cold to worry about asset prices.
Let's party like its 2003-2006! Are we once again in the 'Age of Moderation'? That ended well, didn’t it?
If rates do go up in the US and the UK (they may never again in Japan and Europe, where yet more stimulus is probable) they will do so at a timid trajectory, so the central bankers do not find themselves blamed for choking off the nascent recoveries, much as the Federal Reserve did in the post-depression years in the 1930s.
Cheap money aids profitability
If rates are kept low then the ‘corporate profit miracle’ we have enjoyed over the last five years can continue, claim the bulls. A better economic environment (that we expect and have assumed here) should lead to increased sales, particularly as pent-up demand flatters revenues.
But just as important is that the cost of borrowing inspired by low rates should allow companies to issue debt at low levels and they will continue to use the money to buy back their own shares and pay dividends to investors (Apple being a classic case in point, where aggressive buybacks allied with growth in their business has helped the stock achieve new record heights).
‘De-equitisation’ can continue to be a potent influence on stock markets and profitability.
Valuations are fair
In terms of valuation, the bullish thesis for equity markets is less obvious, but is still valid. If you take a simple forward P/E measure (next year’s profits) then you can claim that (based upon reasonably optimistic forecasts) the US market is trading on 16x earnings, European and UK markets on around 13.5x (the UK is somewhat skewed by the cheap resources companies) and the emerging markets are on 11x.
Generally, stocks are not cheap but nor are they expensive. There are some pockets of real value, where we are overweight, such as Chinese cyclicals, Japanese growth companies and peripheral European banks.
So, even as equity markets seem likely to test new highs, it is clearly possible to make an overtly bullish outlook for equities in the next few years and there are elements within the case championed by the bulls that we agree with.
We also wouldn’t disagree that equities should be your ‘asset class of choice’, but as realists we would have to admit that there are a number of ‘ifs’ to question within the argument I have set out. We don’t want to ruin the ‘pleasant’ reading we hope this has made and will return to those points on a different day.
Tom Becket is chief investment officer at Psigma. The views expressed here are his own.
