Once again we are witnessing a time when investor expectations are on the rise. High growth in certain tech stocks in particular and the upward momentum of the market since the U.S. election are creating a situation in which some investors are throwing caution to the wind in the hopes of capturing some quick wins.
This is not just an anecdotal observation. Wall Street's VIX index, which gauges investor fear, is at some of the lowest levels in more than 20 years. That is indeed worrisome, because it tells us there is a level of complacency and potential cockiness on the part of investors that we have not seen since the pre-1999 days. As a result, investors are no longer hedging their bets or buying the protection they need to sustain a strong investment portfolio.
This upswing in investor attitudes is a growing concern for a number of reasons. We only need to look back to the fallout of the dot-com bubble, when high-flying tech players were trading at 40 to 60 times earnings or greater. A majority of those did not survive the carnage. Some that did are shells of their former selves. Others regrouped, returning with much more respectable multiples trading at 14 times earnings.
Granted, earnings multiples are not reaching the giddy heights we saw in 1999. The S&P 500 for example is posting 17 to 19 times earnings, which historically is close to average. While these numbers are respectable, it also means bargains are hard to come by, driving some investors to be more reckless in their search for the quick win.
Investors that were once delighted to see a 7-per-cent to 10-per-cent return are now being regaled with stories about 30-per-cent or greater returns in a very short period of time – in the large-cap tech name category especially. This has led to the FOMO (fear of missing out) phenomenon when investors hear how others have scored big win on a new IPO within days and start chasing the latest and greatest hot investment with remarkably little to go on. This is especially worrying in a world of geopolitical instability, fluctuating valuations and uncharted investment cycles. Then there is Donald Trump who represents the X factor in all this.
The market optimism to date has been justified to some degree given the Republicans' business-friendly tax reform agenda. However, movement has yet to happen on that front, and as time passes, and crises build, the markets will be hard pressed to keep the momentum going.
Investors should bear this in mind. Right now, they are feeling the kind of excitement and thrill of investing that is often identified on the "Cycle of Market Emotions" as approaching the time of maximum financial risk. History has shown that these feelings are common just before a market pullback.
Consider the fact that any day we see the White House in crisis – of which there have been several – the VIX number jumps within a matter of hours. Then the question remains: When a correction happens, which is inevitable, would those same investors be the first to run for the hills and pull out their money, making that correction even bigger? I suspect they would, although more savvy investors see pullbacks as prime opportunities to buy more.
This is not to say investors should bow out of the markets. Given the economic conditions today, being out of the market pays you nothing, and most fixed income vehicles can't even keep up with the rate of inflation. The only way to grow your wealth is to assume some risk.
Diversification has always been, and will always be, the cheapest form of protection. Investors should not be chasing high valuation tech stocks to the detriment of maintaining a fully diversified portfolio. They should continue to be vigilant and rotate their assets around, instead of going full force into tech stocks. They may not experience the occasional windfalls their colleagues did with their tech gambles; but history shows those same risk takers will likely experience a major hit the second or third time around.
It is often said be fearful of those that are greedy. I would contend that we should also be fearful of those that are complacent.
Allan Small is the senior investment adviser of the Allan Small Financial Group with HollisWealth, a Division of Scotia Capital Inc. (allansmall.com), as well as the author of How To Profit When Investors Are Scared.
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