There’s a line in the old Grateful Dead song Truckin’ – “Lately it occurs to me what a long, strange trip it’s been” – that I think is an appropriate synopsis of the market environment in which U.S. investors find themselves today.
In many ways, the bull market of the last eight years has no precedent in recent market history. The confluence of (1) a secular shift to index funds and ETFs with the Labor Department’s fiduciary rule as an accelerant, (2) record low implied and realized volatility, (3) almost a decade of central-bank mandated ultra-low interest rates, (4) anemic economic growth and inflation, and (5) equity valuation multiples in line with past market peaks, has created a world in which the market doesn’t behave as it has in past cycles.
From our vantage point, it seems many professional investors are suffering from low-grade anxiety about the sustainability of the second-longest bull market in the last hundred-plus years, but no one seems to be changing their behavior accordingly. For fund managers, not being fully invested means not keeping up with the FANG-driven S&P 500, which every Wall Street professional knows could mean standing on the street with your office contents in a box. On the retail investor side, Jack and Jill Boomer have no incentive to act more cautiously either, because eight years after the recession ended the equity market is still the only place they can seemingly earn a decent return, especially if they depend on a retirement portfolio to meet living expenses.
Fellow Deadheads will recall another verse from Truckin’:
Arrows of neon and flashing marquees out on Main Street
Chicago, New York, Detroit and it’s all on the same street
Your typical city involved in a typical daydream
Hang it up and see what tomorrow brings
My concern is that retail investors on Main Street are being blinded by the “neon arrows and flashing marquees” of the market’s recent performance and the message that low-cost passive ETFs and index funds are the only way to invest. Likewise, professional investors in the nation’s financial hubs of Chicago and New York have become so comfortable operating in an environment of steadily rising markets and low volatility and interest rates that they may be caught daydreaming when risk does rear its head again.
Valuation matters, and the “greater fool” strategy of buying high and selling higher only works until it doesn’t. Metrics like CAPE, or Shiller P/E, may be poor market timing indicators, as the market has often stayed elevated relative to historical averages for extended periods, but they are strongly negatively correlated with long-run forward returns, especially at the extremes. According to research compiled by Pension Partners, S&P 500 valuations in the top CAPE decile have historically generated 0% returns over the subsequent four to five years and only 3% annualized over the next decade. For context, the S&P 500’s valuation today is in the 96th percentile going back to 1928.
We believe it’s imperative to construct clients’ portfolios using strategies that have earned superior risk-adjusted returns over full market cycles rather than chasing recent performance with no consideration of risk. There is no magical market “fair value” above which you should sell and below which you should buy. Markets can stay rich for long periods of time and cheap for long periods of time. However, markets can also get turbulent very quickly — too quickly for investors to alter their portfolios — and it would be foolish to assume the current winning streak and low volatility will last forever. As the song says, we’ll “see what tomorrow brings.”