BLOG: A contrarian view on the bull case for equities
Despite market conditions, the views I have read have been remarkably consensual: sell bonds, buy equities, avoid anything with emerging in the title, buy the US dollar, and buy plenty of Japanese equities. As always, it is good practice to have an open mind when reading these documents and to form a view on the merits of the arguments presented. Therefore, let us assess the main reasons why investors are encouraged to stick with equities.
Bull markets climb a wall of worry
Here, the bulls simply brush off any bearish arguments, with no need for further analysis. Of course, this argument probably has some virtues – at the beginning of a bull market most investors will naturally have several concerns deterring them from putting their money to work. While many of these worries will dissipate over time as the market’s worst fears prove unfounded, these negatives have a nasty habit of being replaced by one that is even worse: high valuations – the best indicator of future equity returns.
This is not an equity bubble
This argument apparently rests on the basis that equities were horrendously valued in 1999, and have yet to reach such levels again. Even if this is true, and we would argue on same valuation metrics it is not, why should equities have to reach absurd levels before being considered a tad expensive? After all, there were bear markets before 1999.
Bulls often claim it is a strong contrarian sign if there are too many bears. It is easy to sympathise with this argument. However, if the BoAML Fund Managers’ Survey is anything to go by, ‘everyone’ is apparently bullish.
The Shiller P/E ratio (the market’s value divided by the market’s earnings over the past ten years, adjusted for inflation) is wrongly calculated/misleading/comparing apples with pears/not a great indicator of a market’s future returns (*delete as appropriate)
Like it or not, the Shiller P/E has a very good record in forecasting long-term equity market returns. It is not necessarily a buy or sell trigger – it simply suggests long-term returns will be higher, the lower the ratio.
Moreover, the Shiller P/E is not the only valuation metric that currently suggests equities are expensive. Strangely enough, most Shiller P/E detractors prefer to use other metrics such as forward P/Es – metrics with a far worse historical track record of accuracy in long-term forecasting.
Bear in mind such charts use market-cap weighted indices, and therefore miss the phenomenal run mid-cap stocks have had. An equal-weighted Shiller P/E would undoubtedly offer different, less bullish, conclusions.
It is a stockpicker’s market and there are always cheap stocks
Are there? We have found it increasingly difficult in this bull market to identify cheap stocks. Typically, there is a good spread between cheap and expensive stocks, but in this cycle, the spread has proved frustratingly small and consequently reduced the number of so-called ‘bargain basement’ offers.
There are finally signs of sustained economic improvement, the US economy is recovering strongly
Europe is past the worst, Japan is showing more life than has been seen for years, and the Chinese authorities are pulling off a soft landing’. Obviously, this is a touch simplistic. For example, the US economic recovery is actually pretty long in the tooth compared to previous recoveries, and many European countries appear as dangerously indebted as ever. However, these arguments are irrelevant, as many studies have shown the lack of correlation between economic growth and stock market returns.
Equities are cheaper than bonds
Possibly true, although, not necessarily within the time horizon of most investors. Lauding the prospects for one asset class after comparing it to an unattractive asset class is not the toughest test of cheapness. Could both asset classes be expensive?
Profits growth is likely to surge if economic growth is strong, thus validating valuations
Even assuming economic growth is strong, there is no guarantee this would feed through into earnings growth. An earnings recession is possible outside economic recessions. Yes, earnings growth is possible, but would result in a further reduction in the government and employee take of the economic pie.
Given both these latter measures are at multi-year lows, this seems an unsustainable situation.
There is no obvious reason why equities should suddenly fall sharply
There rarely is until it happens.Investors love to highlight potential catalysts for price movements, however, in reality, only correctly identify them when writing their end of year reports. We are quite prepared to accept we are wrong and markets are much cheaper than we believe. However, the current bull arguments seem to rest more on aphorisms and clichés than anything concrete.
Alastair Mundy is portfolio manager of the Investec Cautious Managed Fund