As equity markets around the world continue to rise, it is timely to remind ourselves of one of Warren Buffett’s most famous quotes – “Be fearful when others are greedy and greedy only when others are fearful”. As a natural contrarian, my level of fear regarding markets is flashing amber, although rational analysis suggests that markets may continue to rise for some time yet.
Looking back, I was fortunate to incur my first significant investing loss very early on in my investing career, as a university student in the mid-80s. A few of my fellow economic students and I established an investment company that we thought could take on the world and for a little while it seemed that we were onto something. The euphoria of riding a raging bull market, however, was soon followed by the despair of watching our portfolio get wiped out as the market fell over 40%, including 25% in a single day, in October 1987.
My experience of the '87 crash profoundly influenced my attitude towards markets and I have managed to avoid substantial losses in all of the major market corrections that have occurred over the subsequent 30 years. I have learned that the key to investing through market cycles is to manage our emotions, whether those be fear or greed, or many of the range of other emotions that influence investment decision making. It is only through strict emotional discipline that we can avoid being enticed by the excesses of a bull market and capture the opportunities presented to investors in a bear market.
The Cycle of Market Emotions
Equity markets have always gone through boom and bust cycles, driven primarily by investor emotions. These emotions have been depicted in a chart known as the Cycle of Market Emotions, as depicted below by Russell Investments.
What this chart tells us, based on historical evidence, is that human emotions amplify the effect of the underlying economic and business fundaments throughout the economic cycle. Asset prices, therefore, become overpriced in bull markets and under-valued in bear markets.
The key to successful investing, therefore, is to not allow our emotions to influence our investment decision making and to always stay one step ahead of the curve. Obviously that is easier said than done and the reality is that most investors, including many professionals, are at least one step behind on the curve.
Where are we on the market valuation cycle?
In terms of underlying valuations, the US and Australian equity markets appear to be at different stages of maturity.
US equities are now trading at one of the highest valuations in history, second only to the dotcom bubble. This has led the fund manager GMO to predict a negative return (-4.4%) for the US market over the next seven years.
In contrast, the Australian market has underperformed and appears to have significantly more scope to move higher based on the historical precedents, as we wrote about in our last article "ASX breaks 6,000 - Time for pessimism?". The underperformance of the Australian market may be due to its heavier weighting to cyclical companies such as energy and resources rather than growth stocks. This could, however, work to the advantage of Australian equities over the coming years if, as now expected by most economists, synchronised global economic growth continues to accelerate. Such a scenario would provide a boost to cyclical companies and could see the Australian equity market play catch up, as was the case in the last economic boom period to 2007.
Where are we on the emotional cycle?
Investor emotions can drive irrational market pricing for extended periods, so the fundamental analysis of equity valuations does not indicate the short-term direction of markets. Market sentiment can also change unpredictably, which is why we do not attempt to forecast market movements.
We do, however, look for indicators that the market may be approaching the ‘euphoric’ phase of a bull cycle. Key amongst these is the emergence of dominant and seductive market narratives that attempt to rationalise ever increasing asset prices and justify why ‘this time is different’. Such narratives are potentially prevalent in relation to the future disruptive power of tech stocks and the expectation that interest rates will stay low for an extended period. ‘Irrational exuberance’ is another telling indicator and we can see potential examples of this behaviour in the markets for crypto-currencies and small technology stocks.
We believe, however, that many investors are still scarred by the GFC and the end of the resources boom, resulting in a degree of scepticism continuing to influence investor sentiment. Take for example the investment analyst community that have significantly under-forecast commodity prices over the last two years. Also, many investors are still sitting on large cash balances, another indicator that investors remain cautious.
The ‘euphoric’ phase of the market is likely to be characterised by signs of capitulation by investors and the professional investing community. The fear of missing out and the pressure for short term returns will lead many to increase their equity exposure, potentially in the most over-heated sectors, just as the market is reaching the point of maximum financial risk.
Investors need to be cautious and selective
As advisors, one of our key roles is to help clients deal with the range of emotions associated with investing. At times like this we think it is critical to stress the importance of disciplined decision making with a focus on capital preservation and long-term returns. Investors should be prepared to sacrifice some short-term returns in order to avoid getting burnt in the next market correction and to be in a position to capitalise on such an event.
Disclaimer
This publication is issued by JJT Advisory Pty Ltd and is intended to be general information only without taking into account the investment needs, objectives and financial circumstances of any particular investor.
Past performance is not a reliable indicator of future performance.