Market exuberance hasn’t yet reached levels seen in during the previous pre-crisis bubbles, according to Miton Group’s David Jane (pictured), who believes some expensive areas of the market could keep performing well over the medium term. 
Given that economic concerns often drive market behaviour, he said interest rates would have to rise faster than expected and the US Federal Reserve would have to start discussing reductions in its balance sheet to justify any panic.
While he doesn’t believe either of these factors are on the cards, however, he is remaining vigilant and warned that a short-term correction could be on the cards.
“Equity markets are volatile, and while deep bear markets are relatively infrequent, corrections are a regular feature,” Jane said.
Research he obtained from an article entitled ‘The Expectation of Losses’ by Ritholtz Wealth Management’s Ben Carlson shows the biggest annual peak-to-trough falls of the S&P 500 index since 1950, as shown below.
Source: awealthofcommonsense.com
Jane pointed out that, while bear markets have indeed endured substantial losses, it is not uncommon for 5 to 20 per cent market falls to occur on a regular basis. In fact, he argued there’s rarely a year without some form of material fall.
“The market has been on a steady upward rise since a small setback in the summer of 2016 and is arguably overdue a correction. The bigger question is whether we’re on the brink of another 2008-type bear market leading to a fall of 20 per cent or greater,” the manager explained.
“Bear markets generally occur following a period of irrational exuberance leading to high levels of capital misallocation, or as a result of something bad occurring – sometimes both.”
A number of investment professionals are indeed worried that a 2008-style correction could be on the cards.
In an article published last month, Pyrford’s Tony Cousins told FE Trustnet that, over the course of 23 years, his portfolio has never been as defensively positioned as it is now.
He warned that global debt levels are at similar levels to the pre-crisis build-up and, given that interest rates are so low, a vast majority of the population could be unwittingly overleveraged.
Cousins added that years of quantitative easing have made financial assets “exceptionally expensive” amid this turbulent economic backdrop.
“This is the most defensive portfolio we have ever put together. We are very much in ‘hiding in the cave’ mode at the moment, we have our tin hats on,” the manager said.
While Jane believes there is a degree of exuberance in financial markets, however, he is unconvinced this will lead to large-scale capital misallocation.
“Looking at recent examples, the internet bubble was clearly vast in scale in the late 90s, and the US housing bubble was also huge in terms of the amount of money concerned in 2007. The same can’t be said of the current period,” he reasoned.
Performance of index since start of data
Source: FE Analytics
“Clearly, equity valuations are high, and in certain areas, extremely high, particularly for internet companies. In other parts of the economy there’s also evidence of misallocated capital, for example, auto loans in the US.
“However, valuation is not a good indicator of future market returns in the short term, so we need to see something negative on the economic front to cause expectations of future profits to decline.”
In Natixis’s latest capital market notes, chief strategist David Lafferty agrees that there seem to be few scenarios (outside of a cyclical slowdown) which would lead to a significant sell-off in risk assets.
“Central bank policies around the world are at worst ‘less accommodative’, not restrictive. Outside of China, we see few signs of systemic risk in terms of either banks or excessive credit (i.e., too much leverage). The credit expansion in China is a serious risk in the long term, but China’s overall debt burden can be managed in the short run,” he pointed out.
“Finally, geopolitical risk remains high in the middle east (Syria, Iran, Yemen) and Asia (South China Sea, North Korea), but these are poor reasons to be on the sidelines. One, geopolitical risk tends to be episodic and short term – not often the trigger for a true bear market. Two, an investor waiting for all the risks to pass would never get out of cash.”
As such, he sees no reason for outright bearishness, despite the fact he expects markets to become more volatile. However, Lafferty said the biggest tail risk facing markets is elevated valuations.
“While stocks haven’t reached nose-bleed valuations, they are elevated in almost every market – perhaps the natural by-product of super-low interest rates and $18trn of global quantitative easing,” the chief strategist suggested.
“Valuation is of course a poor timing tool, but we eschew market timing anyway. The case for valuation isn’t that it is predictive of market direction in the short term but rather that it properly adjusts the risk/return trade-off in the longer term.”
Jane believes areas of excess in the market should be able to persist for a long time. While he isn’t concerned about the economy, he is keeping a close eye on any capacity for this to change.
“In the meantime, we should be prepared for a near term correction following an extended period of continuous rises,” the manager continued.
“In our view, the small corrections which occur every year are very difficult to anticipate and, while we can take corrective action when they start, we generally have to accept that they are a feature of equity markets at all times. These small bumps are an accepted part of investing for the long term.”
To provide clients with a smooth journey, Jane said it is “essential” to navigate the deep bear markets and what gives rise to them. Chiefly, he said catalysts tend to be huge excess, rapid rate rises and economic contraction.
“We don’t see these features as evident yet so broadly remain confident that equities can continue their rise for a period of time, even if they are overdue a correction,” he concluded.
Since Jane has managed money, he has outperformed his peer group composite by 16.78 percentage points with a total return of 161.51 per cent.
Performance of Jane vs peer group composite
Source: FE Analytics
His largest fund, CF Miton Cautious Multi Asset, has a clean ongoing charges figure of 0.82 per cent and yields 1.7 per cent.