Stock markets have been on a roll and investors who’ve been leery about owning stocks are now wading back into the risk pool. With good returns comes confidence.
In the face of this better vibe, it’s important that investors don’t stray from their investment disciplines and decision-making process. My routine, no matter what the markets are doing, involves assessing the fundamentals (the outlook for long-term profits), valuation (what we’re paying for those profits) and investor sentiment (are people feeling greedy or fearful?).
As always, the fundamentals at the macro level are mixed. On the positive side, the outlook for economic growth has improved. The United States is on a better track and there are signs that parts of Europe are improving. And although there is a real risk that China will slow down, investors are well aware it.
Tempering this outlook is the fact that Western economies are still balancing, or perhaps teetering, on a mountain of debt. Governments and central banks are addressing the problem with easy money and more debt, intent on getting employment back to normal levels. Unfortunately, we’re not in normal times, and such an admirable goal means delaying a much-needed repair to government balance sheets. Without that, the economic situation remains fragile.
As for valuation, the situation is also mixed. Murray Leith, head of investment research at Odlum Brown, takes the positive view. In a note to clients last week, he said, “We think the current valuation looks very attractive and intriguing relative to history, especially given that interest rates are considerably lower today than they were over most of the 20-year period.”
On the other end of the spectrum, portfolio managers who live by Robert Shiller’s CAPE multiple (cyclically adjusted price-to-earnings ratio) are downright bearish. CAPE is currently six to seven multiple points above its long-term average and shows the U.S. stock market to be 40 per cent overvalued.
I’m closer to Mr. Leith than Mr. Shiller. The data series I rely on is from Value Line, a U.S. research service. Since the beginning of the year, the Value Line P/E has risen from 16 times (its long-term average) to 18. It’s now at the top end of a normal range, but to Mr. Leith’s point, P/E’s should be above average given where interest rates are.
I use market sentiment as a reality check. It’s a contrarian indicator that says, if everyone is bullish, I should be careful, and vice versa. At this stage, my reading on sentiment is – you guessed it – mixed. The various surveys I watch (individual investors, traders, portfolio managers) are indicating general bullishness, but none shows stocks to be seriously overbought. The VIX, however, is more concerning. This volatility measure for the S&P 500 is bouncing along the bottom of its range, meaning a general peacefulness in the markets. To a chronic contrarian, this is a warning sign that investors are too complacent. Volatility has nowhere to go but up.
Adding it all up, it’s time for investors to be patient. To use Warren Buffett’s baseball analogy, there’s not a lot of “fat pitches” out there right now. You can afford to let a few go by.
That’s not a short-term call on the market – another 20 per cent up wouldn’t surprise me, nor would a significant retrenchment – but rather an acknowledgment that some of the recent returns have been borrowed from the future. My target for the next five years has come down to a more modest 5 to 7 per cent a year.
But while your bat is on your shoulder, there are things to do. You should compare your overall portfolio to the asset mix targets you set out for yourself. Stocks are up a lot and bonds have retreated, so it’s likely some rebalancing needs to be done. In addition to topping up fixed income, you should look hard at the other laggards in your portfolio, and consider nibbling away at resources and emerging markets.
If you’ve been underinvested in stocks, one thing you shouldn’t do is take comfort from rising prices. It’s not necessarily a sign that it’s safe to jump back in the water. That’s best left to fundamentals and valuation, which are indicating one toe at a time.
Tom Bradley is president of Steadyhand Investment Funds Inc.