A few weeks back we talked about how stock markets are born on pessimism, grow on scepticism, mature on optimism, and die on euphoria.
Unfortunately there are no bells chimed at any point in the process.
And so, identifying the signs is fundamental. Many of the signs of euphoria become obvious as irrational exuberance arises.
Irrational exuberance is where people are buying anything, at any price, irrespective of the price, thinking: “it will just go up and everything is ok”.
There are signs of that happening now but I don’t believe we are at the tipping point yet.
After years of central banks pouring money in and stimulating stock markets, investors can only look with glee at their pension and investment valuations. All of this is in the face of serious geo-political headwinds, which markets just seem to shrug off as a breeze.
However, some key pointers need to be looked at:
Bank of America Merrill, surveyed 178 leading fund managers and of those, 48% said equities were overvalued. This is a record level and is higher than at the beginning of 2000, just before the dot com bubble came to a swift end. Moreover, these managers, despite seeing the market as overvalued, are reducing the cash they have in their funds and investing more.
The 10-year average for cash in a fund is 4.5% but the managers’ levels are now below that at 4.4%. However, the bank’s view of the point to begin selling is when cash levels are around 3.5%.
A record number of investors in the survey also admit to taking abnormal levels of risk.
The Nobel economist, Professor Robert Schiller has an outstanding record for calling out bubbles, and his argument that psychology and sentiment drives irrational exuberance is as relevant as ever. His measure for current markets being overpriced (it’s called the CAPE) has only been higher on two occasions in the past: 1929 and 2000 – just before two stock market crashes.
Another expert on valuations of markets, Andrew Smithers also agrees that markets are overvalued.
Markets can however, still become more overvalued and it’s hard in the short term to see where the trigger will come from for the downturn.
One potential reason for the beautiful graph of low volatility in markets and rising returns, may well be corporate buybacks and passive investing.
This creates a scarcity in the market as corporations buy up their shares and hoard them as do passive funds like an exchange traded fund (ETF). Without the seller, there cannot be a buyer so volatility drops away.
Furthermore ETF’s, by definition automatically buy up whatever stock is in an index irrespective of whether or not it’s overvalued driving it higher and more inflated. That’s what they do. Hence we are nine years into this bull run.
You might also look at the behaviour of hedge funds whose allocation into equities is now the highest it’s been in eleven years.
Other factors to consider is the behaviour of the high street investor. There is an expectation now that Midas very much exists.
The extraordinary amount of people asking me about bitcoin and other crypto currencies is worrying indeed.
I was recently asked along to a presentation on one of those currencies and at the end I was more confused than the beginning, as the seller of that multi level marketing pyramid plan told his audience ‘don’t listen to the naysayers’. ‘Just believe’, he said. I nearly choked.
The greatest concern however, was the questions that came to me afterwards from attendees, some of whom knew my position, who asked “should I invest?”
I asked if they understood anything about the presentation, let alone everything they needed to know to make a decision about the ‘currency’. They said no, not at all. Yet, faced with that, they still wanted to invest.
That, is the definition of irrational exuberance.
Have a question on investments or pensions, please call Worldwide Financial Planning on 0800 011 2825, email info@wwfp.net or visit us on www.wwfp.net.
Peter McGahan is the owner of Independent financial adviser Worldwide Financial Planning, which is authorised and regulated by the Financial Conduct Authority.
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