There are, it has been said, two types of people in the world. There are those who, when presented with a glass that is exactly half full, say: this glass is half full. And then there are those who say: this glass is half empty. The world belongs, however, to those who can look at the glass and say: What’s up with this glass? Excuse me? Excuse me? This is my glass??? I don’t think so. My glass was full! And it was a bigger glass! Who’s been pinching my beer? Terry Pratchett in “The Truth.”
Ever since equity market indices surpassed previous peaks, there has been a constant voice of doom, claiming that the markets are overvalued and headed for a spectacular crash. That voice has been on a steady crescendo and now has become loud enough to have become a significant topic of debate for the fund and asset management industry. In simple terms, the human brain has evolved and is wired to look for patterns that suggest danger is imminent so as to avoid being eaten by wolves or lions, and so, when presented with a chart that looks like this:-
[Fig 1: FTSE 100 index 1/10/94 – 31/7/17]
the natural human assumption is that the line should have already turned down and surely will be a steep downturn when it comes. The problem with this is that there is no logical reason to say that the pattern that we discern should be the true course of events. The market is not driven by the need to adhere to a pattern.
Given our pre-disposition to expect the pattern to be followed, however, we are compelled into assessing the impact of every twist and turn in economic data, geopolitical tensions and world events as though they might be the catalyst for that downturn and so each of these events assumes a greater significance than perhaps it should.
There are many faithfully stated and well-reasoned cases as to why markets are overvalued, particularly when looking at straight P/E or Shiller P/E ratios, but there are also counter arguments to be heard.
If we look at long term trends in prosperity around the globe, it is an absolute truism to state that for the average person life is as good as it has ever been – we are wealthier and healthier than any generation that has gone before, and have a future ahead where health and wealth will only improve. It is also true to state that, over the long term, equity markets are always higher than they were. In the short term, there is also cause for optimism. As pointed out in his blog last week, Brian Westbury at First Trust, notes that, based on a current Shiller P/E ratio of 30.5, for stocks to be as bad a deal relative to bonds as they were in 1999 (the first peak of the above chart) the yield on 10-Yr US Treasuries would have to be 7.3%. Similarly for them to be as bad a deal in May 2007 (the second peak on the chart, the yield would have to be 4.4%. Clearly, bond yields are nowhere near these levels, and therefore equities remain an attractive asset class.
Further optimism can be found in the generally upbeat corporate earnings reported over the first half of 2017 with a record number of companies beating earnings expectations. Simple arithmetic tells you that if the ‘E’ side of the P/E ratio is increasing, the ratio has to decrease, thus making equities relatively more attractive.
If we also consider market values on an inflation-adjusted basis, we can see that they have really not progressed all that far. In fact, adjusted for inflation, the S&P 500 Index shows barely any growth at all since 2000. By this measure, therefore, it is hard to say that equity markets are overvalued.
Of course, the only way that we will know whether it is the ‘half empty’ or the ‘half full’ brigade who are correct will be with the benefit of hindsight.
Accordingly, our approach as Discretionary Fund Managers is to try to restrict the impact of over optimism and excessive pessimism on our views, and ensure that our portfolios are properly diversified, thereby allowing them to participate in any positive returns that are available, whilst limiting the potential impact of negative ones.
For the record though, I am very much a believer that someone has been pinching my beer!Is the glass half full?