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inside the market

Ian McGugan

Here at Complacency Central, we like to keep tabs on exactly how blissed out this market has become.

Not that there's anything wrong with a bit of summer rapture, you understand, but our crack team of researchers (translation: me and my dog, Booker) find ourselves more and more perplexed by the degree to which normally cautious investors have overcome their fears and become the financial equivalent of Flying Wallendas.

The bond market offers some useful ways to gauge the recklessness. In one striking example, buyers queued up this past week to participate in Iraq's first bond sale in more than a decade. They happily loaned $1-billion (U.S.) to a nation that is just about the exact opposite of whatever credit-worthy is typically deemed to be.

For bond investors desperately searching for yield, doling out cash to the world's dicier jurisdictions has become something of a habit. Over the past couple of months, speculators have also loaned billions of euros to Greece – yes, Greece, that paragon of economic stability – and snapped up a 100-year bond from Argentina despite that country's long history of confusing sovereign finance with musical theatre.

Mind you, bond buyers look positively staid compared to the wave of investors flooding into the cryptocurrency area. Those optimistic folks have boosted the value of bitcoin, the best known virtual money, by more than 300 per cent during the past year, to more than $4,000 (Canadian) a coin. Nagging problems, such as a major split among users that has resulted in two competing versions of bitcoin, don't seem to faze people who are in love with the idea of mining their own money.

And that brings us to the stock market, which may be the most complacent arena of them all. Its best-known fear gauge, the VIX index, has been bumping along historic lows despite Wall Street's soaring valuations. Measured by some yardsticks, such as stock prices compared with earnings over the past decade, or median stock prices relative to sales, the S&P 500 looks as richly valued as it has at any time outside the dot-com bubble or 1929.

What to make of all this? Howard Marks, the widely followed co-founder of Oaktree Capital Management in Los Angeles, wrote a note to clients in late July that listed numerous examples of market exuberance. Today's giddiness isn't likely to end well, he warned.

"The only reason to be aggressive today is because defensive investing implies low prospective returns. But the question is whether pursuing high expected returns through aggressiveness can be counted on to be rewarded. If the answer is no, as I believe, then this is a time for caution," he wrote.

Mr. Marks doesn't recommend that investors go to cash, but he does urge them to avoid reaching for return. In a market where "there's too much money and too little fear," people who venture too far in pursuit of high profits could find themselves walloped by a downturn they didn't see coming.

Mr. Marks's advice seems eminently sound. But you have to wonder whether people will act on his wisdom. When stocks are going up, as they are now, and the global economy is expanding, as it is now, it's easy to argue that this time is different.

Perhaps it is. The most remarkable aspects of today's market are some of the lowest interest rates in financial history. Stock prices don't seem so out of whack if you compare them with safe government bonds, which produce absolutely no return after inflation.

"We don't think that the valuations of many risky assets have become unsustainably high," analysts at Capital Economics wrote in a note this past week. "This is because their rise has been supported by a structural decline in real interest rates, which is likely to endure."

Given continued low rates, "we believe that investors' exuberance for such assets is rational," the Capital Economics team asserts. But there's a catch: While investors may not have lost their heads, the upside for risky assets is limited. "Indeed, our forecast is for the U.S. S&P 500 to end next year a little lower than it is now."

The real fun is likely to emerge around 2019, according to Capital Economics, when the rising risk of a downturn in the U.S. economy could bring stocks crashing down.

But that raises an interesting question: Why stick around a risky market for what look like very scant rewards ahead? It's one of the questions we keep pondering here at Complacency Central. Right, Booker?

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