Whether the market is overvalued or not is becoming trending topic among investors and managers. There are some of them who are radical about their ideas, while other have some intuitions, but are sceptical about them. One example of this last group is Howard Marks, who has recently published a memo called Latest Thinking, in which he shows how he see the markets and give reasons to support his ideas.
As he mentions in the memo, people who say that he is “ultra-bearish” or that he suggests that “it’s time to get out” are wrong. The reason, he argues, is that that extreme views cannot be hold in such an uncertain environment. In addition, he gives some reasons to be bullish in the stock market, though he gives bearish arguments to.
- Almost every country in the world is growing, specially the U.S. economy.
- It seems that the growth is not a booming one, that is, it is sustainable.
- Trump administration is pro-business and contrary to excessive regulation, which generates optimism and confidence, as well as “animal spirit” behaviour among executives.
- Recent tax reform will improve profits and cash flows. Furthermore, companies are going to repatriate cash generated and retained abroad.
- Unemployment rate is in its 60 year’s lowest level, at 4.1%.
- Interest rates are too low as well as inflation, so central banks do not “need” to increase them abruptly. The near-term rise in rates is expected to be gradual and limited in scope.
- Investors’ behaviour can’t be described as euphoric or imprudent. The market has been “climbing a wall of worry” in the last years.
- The usual catalyst for market downturns (recession, inflation, interest rate hikes, wars, etc.) are unlikely.
- There are some uncertainties regarding some issues that should concern investors (slow long-term economic growth, potential for rising interest rates and inflation, impact of reversing stimulative monetary policy, implications of automation to employment, the world’s dependence on China’s growth and political risks).
- Interest rates are rising. But we don’t know by how much.
- The current recovery is the longest ever, GDP growth is at the top of the range for the last decade and profit margins are well above the average.
- Valuation parameters are really high (bond yields, CAPE, etc.). Is this time different?
- Prospective returns are very low.
- The low-return environment is causing investors to engage in pro-risk behaviours.
- Volatility is at its lowest level in history, and drawdowns seems to have disappear in the last months.
- Investment decisions are being made on the basis of relative return with respect to cash, which has led to high valuations.
- Potential catalysts for decline might be the unknown ones, that is, potential black swans.
His conclusion, therefore, “is that some people are excited about the fundamentals, and others are wary of asset prices. Both positions have merit, but as is often the case, the hard part is figuring out which one to weight more heavily”. So that, neither being 100% long in high-beta assets, nor being net short are the best solution currently, which would be somewhere in between.
So that, based on Howard Marks’ analysis of the situation, there are two important factors we should consider: i) we need to improve our stock picking process to avoid the potential losers and invest in the defensive long-term profitable ones; ii) we need to hedge against tail events such as market crashes.
The first idea, improving the stock picking process, is based on paying even more attention to the fundamental analysis of companies and the trends among industries in order to avoid overindebted and pro-cyclical business, which are the ones who are going to suffer most in case of downturn.
Regarding tail hedging, it is based on the idea of protecting the portfolio against non-normal events such as crashes. By this strategy, the investor can have an insurance which will protect his investments when the market become bearish, as Spitznagel explains here.
In addition, managing liquidity is crucial in this market context. An extreme downturn may give good opportunities to buy cheap securities who will increase the intrinsic value of the portfolio. Thus, it is worth considering having some liquidity available to maximize long-term returns, besides its negative correlation with equities.