March 9th marked the five year anniversary of the current bull market. Memory of the previous bear market is a distant recollection to some. 2013 saw the S&P 500 jump 32 percent and the Nasdaq jump 40 percent while corporate earnings barely increased. U.S. equity indices recently hit record highs. This week we examine reasons investors should be cautious.
Downplaying risk never turns out well. Highly ranked hedge fund manager Seth Klarman writes in his recent letter to investors that “most” investors are downplaying risk and this “never turns out well,” noting most people are not prepared for anything bad to happen. “No one can know what the future holds, but any year in which the S&P jumps 32 percent and the Nasdaq 40 percent while corporate earnings barely increase should be a cause of concern, not further exuberance…someday QE will end and money won’t be free. Someday, corporate failure will be permitted. Someday the economy will turn down again, and someday, somewhere, somehow, investors will lose money and once again come to favor capital preservation over speculation…on almost any metric, the U.S. equity market is historically quite expensive. A skeptic would have to be blind not to see bubbles inflating…there is a growing gap between the financial markets and the real economy…the Fed’s continuing stimulus and suppression of volatility has triggered a resurgence of speculative froth.”
Several valuation measures flash caution warning. James Montier of GMO critiques the CAPE (Cyclically Adjusted Price Earnings) ratio made famous by Robert Shiller of Yale. He analyzes various proposed adjustments to the CAPE, but still reaches the conclusion: the weight of valuation evidence suggests the S&P 500 is significantly overvalued at its current levels.
Heating Up and Thawing Out. U.S. equity indices recently hit record highs. The investment strategists at Charles Schwab encourage investors to be cautious and prepared for the possibility of a pullback in the near term. Investor sentiment, which has reached concerning levels of optimism, is typically a contrarian/bearish indicator. Moreover, the last 13 midterm election years have experienced a substantial pullback, with the average decline for the S&P 500 being 18.7%. Further, they continue to believe risks exist regarding the unwinding of unconventional monetary policy that may not be fully recognized.
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