With global stock markets running at or near all-time highs and valuations looking stretched, questions of when the eight-year-long bull market will come to an end are inevitable.
Indeed, the oft-cited cyclically adjusted price/earnings (CAPE) ratio chart for the S&P 500 shows the index is trading at just over 30 times, almost double its long-term average.
Bears will argue it’s only been higher twice in history – in the build-up to 1929’s Black Tuesday crash and shortly before the tech bust in 2000.
Bulls will argue the measure, also known as the Shiller PE after the economist who popularised it, was much higher – 44 times – at the start of this millennium, meaning we’ve got a long way to go.
Those in the latter camp will also roll out the line that bull markets do not die of old age.
Still, there will be a pullback in asset prices at some point in the future. Investors will need to make sure they are aware of the risk as we move into a new year. Arguably, they already are.
The Investment Association Sterling Strategic Bond sector has been the most popular with investors in the year to October 31, according to Morningstar Direct data.
Jason Hollands, managing director at Tilney Group, says this is perhaps because bonds are traditionally perceived as a safe-haven asset class. However, he counters, “mispricing in the bond market is arguably more extreme than the stock market”.
Clearly, a correction will come at some point and a few commentators are gearing up for one in the coming 12 months. Next year could be the year of euphoria, according to market strategists at Bank of America Merrill Lynch (BAML).
They note that the S&P 500’s bull market will be the longest ever on August 22 and the index is likely to reach 2,863 in early 2018. The Nasdaq Composite could reach 8,000. But that will be followed by an anticipated 10% or greater correction and slower growth for the remainder of the year.
“History suggests that some of the best returns can come at the end of bull markets,” says Candace Browning, head of global research at BAML. “With valuations and sentiment as high as they are, amid relative economic calm despite political turmoil, we view a pullback in the market next year as an expected norm.”
Plenty of Risks to Rallying Market
We’re currently in a positive environment, with synchronised global growth, a pick-up in global earnings and subdued inflation. But Anton Eser, chief investment officer at Legal & General Investment Management, says there are plenty of risks that could upset that prevailing narrative.
The switch from quantitative easing to quantitative tightening next year is one. QE policies have been used by central banks to take bonds out of the system and force institutions to buy investment grade credit, high yield and equities instead.
In 2018, we will move from having around $300 billion taken out of the system to pumping in well over $500 billion of bonds. “That net supply of bonds will crowd out the private sector,” Eser explains. That means a big driver of liquidity and asset prices will shift in 2018.
Alongside that, the volume of credit creation in China has also been a “massive factor” in driving markets over the last few years. That’s now beginning to reverse as well. Therefore, “a number of things that have been very supportive for liquidity over the last two years go from tailwinds to headwinds”.
“As we look into 2018, this very low-volatility, high asset price environment there is a potential trigger that could lead to some degree of volatility,” he says. “The timing of that is really difficult, but at sometime next year we do expect a pick-up in volatility and a re-pricing of the risk premium.”
However, predicting the scale of the correction is a really hard question to answer, Eser admits. The logical answer would be around 20-30%, as that’s how expensive US equities are on the CAPE measure relative to previous cycles, he explains.
The problem, he adds, is that when you go through that type of re-pricing you always overshoot on the downside. Therefore, “it could be well in excess of that”.
