The New Year has started well, with plenty of evidence that professional investors are continuing to rediscover their appetite for risk assets, with the price of equities, corporate bonds and high yield debt all heading higher. The charts for leading equity indices, including the S&P 500 and the FTSE All-Share, have been trending higher ever since Mario Draghi, the head of the European Central Bank, announced last summer his intention to “do whatever it takes” to prevent the eurozone from falling apart. He has every reason to be pleased with the response to his intervention, which to date has been effectively cost-free. Would it were always so easy! European stock markets, having been priced for disaster before, have led the way up as fears of the euro’s fragmentation recede. Volatility, as measured by the VIX, has meanwhile fallen to multi-year low levels.
Add in the belated (though only partial) resolution of the US “fiscal cliff” issue at the New Year and some evidence that the Chinese economy looks set to avoid the “hard landing” which many observers feared following last year’s growth slowdown, and it becomes easier to understand why many professionals at least have come to the conclusion that the worst of the downside risks that so paralysed markets last year have passed. The latest Merrill Lynch survey of fund managers’ intentions reveals the most positive attitude towards equities for many a long month, with more than half the constituents now positive on European equities in particular. The majority of New Year broker forecasts I have seen over the past two weeks are bulllish about the prospects for equities in 2013 – always an unsettling sign for the contrarian investor.
Strong running markets like those we have seen over the last few months are certainly there to be appreciated and enjoyed while they last. What started as a relief rally seems to be gathering its own momentum, and that could well take the main market indices back towards their pre-financial crisis highs (1,565 for the S&P 500 index, 6,500 for the FTSE All-Share) at some point this year. My own portfolios are benefiting nicely from this renewed investor enthusiasm. It is useful nonetheless to keep in mind the cautionary words of Howard Marks, CEO of Oaktree Capital Management in the United States, in his latest letter to subscribers. He recalls his advice to investors back in 2004, when markets were also running hot.
“There are times for aggressiveness. I think this is a time for caution.” Here as 2013 begins, I have only one word to add: ditto. The greatest of all investment adages states that “what the wise man does in the beginning, the fool does in the end.” The wise man invested aggressively in late 2008 and early 2009. I believe only the fool is doing so now. Today, in place of aggressiveness, the challenging search for return should incorporate goodly doses of risk control, caution, discipline and selectivity.
Is that right? One specific reason for concern is that the change in sentiment has driven the prices of corporate bonds and high yield debt towards levels that only make sense if you can be sure that that there will be no recovery in government bond yields in the foreseeable future. Yet bond yields already have started to edge up. In absolute terms corporate bonds and high yield debt both look overbought and overvalued on any normal measure. A market where these instruments are being priced for perfection is a time to be careful. Charles Gave, founder of the strategy research firm Gavekal, highlighted the risk in corporate bonds in a recent note. His conclusion:
The most common belief (the consensus again) seems to be that the combination of a budget deficit coupled with negative real rates and massive monetary printing by the Fed could prevent a new recession. In which case one wants to be long risk assets, commodities and gold to protect against currency debasement. But what if that belief is wrong? What if the US economy starts falling below a 1% annual growth rate as seems to be probable if one looks at the ISM, or the negative sentiment among small businesses? Or what if a new recession is coming? Readers know that I am certainly not a perma-bear. But if I have to be afraid of something, it has to be the US economy moving into a new recession with a $1.1 trillion budget deficit, interest rates near zero and an extremely bloated Fed balance sheet. I certainly hope my fears are unfounded. But after years of artificially low interest rates, investors should watch very carefully for signs that the US economy is losing altitude. If so, the low quality credit markets are certainly a dangerous place to be and so are most commodities, including gold. Leveraged companies would suffer a lot. And the euro crisis would start anew.
It is the nature of equity markets that single calendar years tend to produce exceptional moves (up or down more than 20%) more often than not. This could well be one of those years. A lot is riding however on the direction of the US economy, where corporate profit margins look almost as unsustainably high as the Federal deficit. It is easier to justify increasing exposure to Japan, where the market has long been cheap but unloved, than it is to find much to love in say the UK market. No benchmarked professional investor can afford to be left lagging too far behind an upward-trending market. Other investors have no such excuse however. Assuming you already have a significant exposure to the equity market, and are sitting on decent gains as a result, be prepared to think about trimming that exposure in the name of prudence as and when signs of weakening momentum start to appear.