It Could Be A Long, Hot Summer For Investors
Normally, I can't wait for summer to arrive. Long days, warm nights, family vacations, summer movies and escapist / beach literature, etc. This year, however, I admit to feeling a little anxiety about the months ahead, as I suspect many other investors are.
Consider the following:
- Six years into the bull market, major US equity indexes are setting new highs. This comes amid sluggish earnings growth and a round of generally disappointing economic reports. The resulting valuation for US stocks implies a very narrow margin of safety and only modest expected returns for the years ahead. Overseas stock markets are a little more attractive, but not by much.
- Global bond markets are also richly priced. While there is usually some comfort from lower volatility in bonds, compared to stocks at least, the past few weeks have been a truly wild ride for European bond investors. With interest rates near zero (or even negative in some parts of Europe) it doesn't take much of a shift in yields for bond prices to whip around in dramatic fashion.
- The Federal Reserve is preparing the markets for an eventual shift in monetary policy, the so-called liftoff, hoping to minimize "unintended consequences" that might result from taking anyone by surprise. Good luck with that. A recent Bloomberg Business headline read "Debt Traders to Fed: We Dare You to Try Raising Rates This Year," suggesting the futures markets are no longer pricing-in a rate hike in 2015. So, the party continues for those who can access cheap credit – borrow money for free, invest in risky assets and hope to get out before it all comes crashing down – and margin debt in the US stock market has risen to new record.
- Meanwhile, as the Fed hopes to raise interest rates in the US, the European Central Bank is actively buying assets in their own version of Quantitative Easing, trying to stimulate growth in the Eurozone. If that isn't enough for Europe to contend with the sideshow in Greece is a huge distraction, both tragic and comic at the same time. The danger of a "Grexit" from the EU or Eurozone isn't so much from the economic impact – Greece is too small to have much effect on the larger economy – but rather from a Lehman-type disruption to global financial markets and the daisy-chain linkages between governments, banks and investors.
Given all of the above, the financial markets could well spend much of the summer "climbing the wall of worry, struggling to move higher against a backdrop of concern and disappointing news. It wouldn't be the first time. Financial markets in general, and equity markets in particular, often become overextended at turning points in the cycle – that's part of what makes them cycles – so why should this time be any different? Our concern is with how to manage through this period.
The following two articles provide a brief glimpse into our current thinking along these lines. In the first article, Jim Mahoney discusses opportunities outside of the mainstream asset classes, where there may be more opportunity for return and a greater margin of safety. In the second article, Brendan O'Sullivan-Hale discusses risk-taking in the bond market, both for taxable and tax-exempt investors.
Get a couple of good books and scan the movie listings each week. It could be a long, hot summer.