By David F. Lafferty (Natixis) | Over the last few months, we have written, spoken, and tweeted incessantly about the coming headwinds to both the global economy and the capital markets. In July we noted that despite the current macroeconomic momentum, there are many factors that are likely to hamper growth by the time we get to late 2019 or 2020. These include tighter monetary policy that will actually begin to pinch growth, fading tax-cut and fiscal stimulus (especially if the Democrats take the US House of Representatives in the midterm elections), continued trade and export headwinds, a Brexit supply-shock to the UK and EU, and so on.
Moving to the markets, last month we highlighted that the easy money has already been made – simply pointing out that revenue growth is peaking, profit margins are more-than-lofty, and price-to-earnings ratios (P/Es) are elevated. This trifecta doesn’t guarantee equity losses, but the gravitational pull of these metrics does create a significant hurdle to future equity gains. But does this mean it’s time to get out of the market? We don’t think so.
Successful Market Timers Are Hard to Find
Given our outlook, we would love to be bearish. Bearish market calls, conspiracy theories, and doomsday scenarios are so much more interesting and intriguing than Wall Street’s conventional bullishness. One good bearish call on TV, lucky or otherwise, and your reputation as a market guru is cemented for life.
Sadly, that isn’t our style. For starters, jumping in and out of risky assets sounds a lot like market timing – not a skill we have lots of confidence in. Since 1970, global equities (as measured by the MSCI World Index) have generated an 8%+ total return at approximately 14% annualized volatility. This means a common range of returns, say plus or minus one standard deviation, would be anywhere from -6% to +22%. For any asset class with that level of volatility, this seems like a crapshoot. Moreover, if anyone had a crystal ball that accurate and was consistently great at market timing, surely we would have heard of them by now. Successful market timers wouldn’t need to advertise.
Other than a philosophical opposition to market timing, we also don’t like the odds that come with being outright bearish. Equity markets have a long history of going up more often than they go down. This is true both empirically and theoretically. The higher uncertainty implicit in “risky assets” (like stocks, commodities, high yield bonds, etc.) means that their prices are discounted accordingly (on average). For example, sitting at the bottom of the capital structure, equity investors discount prices enough so that, on average, accepting higher risk is commensurate with earning higher future returns.
Many will find the actual numbers more compelling, so here they are for the S&P 500® in the post-war era.
History shows that stocks go up more (and more often) than they go down. That’s hardly a revelation, but it has some strong implications. Just like going to a casino, the odds are not in your favor when you jump out of stocks. Some gamblers leave the casino with more money than they came with. However, if this were true on average, casinos wouldn’t exist.
Does this math mean you can’t ever be bearish? No, but an investor should have fairly compelling evidence to justify trying to beat those long odds.
What would cause us to become more pessimistic? Signs of greater inflation and/or wage pressure that would force the Fed’s hand and cut into profit margins. So far these warnings are flashing a faint yellow, but not red.
If Not Bearish, Then What?
To summarize, we are caught between a rock and a hard place. We believe the global economy is likely to slow in the next 6–12 months and that asset prices don’t fully reflect this. Regardless of the macroeconomy, an upside surprise in stock returns is unlikely with above average (and mean-reverting) revenue growth, profit margins, and P/Es. Conversely, our crystal ball isn’t good enough to time the markets and we don’t like the odds of making a big move to cash.
To cope with this, we believe investors can split the difference by being cautious instead of bearish. That is, stay in the markets, but with a lower risk or lower beta profile.