January 31, 2018
Excerpted from a letter sent to clients on January 30, 2018:
The world economy has continued to strengthen. Growth in both emerging and advanced countries has been on the rise, with the latter showing a particularly rapid comeback:
Source: Markit Economics, Capital Economics
This is actually the first time since the global financial crisis that all the world’s major economies are growing at the same time:
Source: New York Times (original here )
Global stock markets have surged on the positive economic news, and investors are feeling optimistic. Veryoptimistic. Just for fun, here are some examples…
Individual investors are more bullish on stocks than they ever have been:
Source: Bloomberg (original here )
And they have a higher allocation to stocks than at any time outside the tech stock bubble:
Retail “mom and pop” investors seem particularly enthused, based on this rapid recent increase in their trading activity:
But it’s not just mom and pop — there are fewer bearish financial advisors than at any time in the past 30 years:
Market moods follow (but do not predict) returns
Looking at those charts, you probably noticed that investors on the whole always get optimistic aftermarkets have done well, and they become pessimistic after markets have done poorly. This gets it backwards, in our view: the best long-term results usually follow the downturns (after valuations have declined), and vice-versa.
A US stock forecast that’s based on valuation, rather than recent performance, looks a lot less optimistic. In fact, a typical moderate risk, buy-and-hold mix of US stocks and bonds has never been priced for worse returns .1
Fortunately, there are other investment options with significantly better prospects. We’ve often discussed the fact that international stocks are quite a bit more reasonably valued than US stocks. Both have soared over the last year, with international stocks doing even a little better than US stocks. Still, our overweighting to international continues because the valuation gap between US and international stocks remains, and has rarely been larger than it is now.2 Elsewhere, bond prices have been declining lately as yields have risen, and we’ve been finding some opportunities in short-term, high quality bonds.
We can’t talk about optimism with at least mentioning Bitcoin and other cryptocurrencies. This market that shows all signs of a raging speculative bubble: exponential returns, people quitting their “day jobs” to speculate on cryptocurrencies, red hot hedge funds run by twenty-somethings, and people buying Bitcoin with their credit cards. Reminiscent of the dot-com bubble, companies can see their stocks rise hundreds of percent just by adding the word “Blockchain” to their name. And as in all bubbles, the true believers heap scorn upon the skeptics who just don’t get it.
We’ve seen all these signs before, though rarely to this degree.
Cryptocurrencies and blockchain technology may well turn out to be important and transformative. But they can still be the focus of an investment bubble! The internet, for example, has utterly changed the world — but that didn’t stop internet stocks from experiencing a tremendous bubble and crash. No matter how good a technology or innovation is, the assets involved can still become overpriced. And as much as tech stocks soared during their bubble… here’s Bitcoin in comparison:
The recent nearly-50% selloff could mark the beginning of the crash, or just be a break before cryptocurrency prices shoot even higher. There’s no telling how far bubbles will go before they end, but they do always end. And cryptocurrencies look to us like a serious bubble.
How to approach optimistic markets
Regarding the more mundane markets like stocks and bonds, we think the best way to approach a situation of pervasive optimism is simple: don’t get sucked in. (Actually, we’d say exactly the same about market pessimism, too).
The prevailing mood, the media stories of the day (which simply reflect and amplify the prevailing mood), and how markets have done in the recent past — none of this matters to the long-term investor. What matters is buying fundamentally sound investments at a reasonable price.
It’s human nature to get complacent after things have gone well, as is clear from the charts above. But at times of widespread optimism, and the high valuations that often tag along with optimism, it becomes more important than ever to stay disciplined and focused on what really matters. Through all the market’s mood swings, whether positive or negative, this will always be our goal.