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How should investors be responding to rapidly rising equity markets?

This article, written by Patrick Cairns, was originally published on Moneyweb.

Last year was a very good one for equity markets around the world. The MSCI All Country World Index gained 24.0% in dollar terms, and the S&P 500 was up 21.8%.

Locally, investors saw a 21.0% rise in the FTSE/JSE All Share Index.

At the start of 2018, the consensus was that there was still reason to be positive equities. Although 2017’s returns were unlikely to repeated, there were still opportunities for growth.

Few, however, expected markets to start the year with so much of a bang. The general view was that the S&P 500 in the US would be up around 10% for the year. It’s already seen more than half of that gain in just over a month.

This is the result of investors moving into equities with an optimism that has not been felt for many years. Global markets have been seeing record inflows.

An ageing bull market?

The question for investors is where this is leading. For some time already a number of market watchers have been expressing concerns about how long this bull market has now been running, and for much much longer it can continue.

“Last year cemented the ninth year in the current bull market,” says Investec Asset Management portfolio manager Iain Cunningham. “Historically, that is the second longest bull market in the last 100 years. So statistically it’s getting old. But the good news is that bull markets don’t die of old age.”

He points out that valuations have become more expensive, but that doesn’t mean that they can’t still move higher. Investors have to look at other things as well.

“The fundamentals remain supportive,” Cunningham says. “The global economic environment has improved and corporate earnings are phenomenally strong.”

This means that, for now at least, there is still reason to be bullish. However, he has at the same time began to position his funds more defensively, because there are some ‘red flags’ that shouldn’t be ignored.

Signs of euphoria

“Investors have become more fully positioned in equity markets, and there are some signs of euphoria,” Cunningham points out. “Typically when you look at bull markets through history, you have a period of time when they are unloved and climbing a wall of worry, but as you get towards the latter stages people become more enthusiastic and areas of the market make exponential-type gains.”

He points out that this was the case with technology and IT stocks in the 90s before the dotcom bubble. In the following decade, leading up to the global financial crisis, it began in housing and banking before broadening into emerging markets and commodities.

“When we look at things now we see similar signs,” Cunningham argues. “Money is flowing into anything related to artificial intelligence or automation, and we all know what cryptocurrencies are doing. When a company like Kodak says its bringing out the KodakCoin and its share price goes up 600% in a few days, we see reason for concern.”

Quantitative tightening

Cunningham adds that another reason for investors to be cautious is that the quantitative easing engaged in by central banks around the world is reaching its end.

“We can’t underestimate the impact this liquidity has had on the bull market,” he says. “Close to $20 trillion has been printed by the world’s major central banks. To put that in context, the US economy is $18 trillion, so that’s a lot of money.”

A natural consequence of having more money in a system where there are a finite number of assets is that prices will go up. And this is exactly what has happened in equity markets.

Investors must therefore consider what will happen when this liquidity starts being withdrawn. Although central banks have signalled that they will be very careful about tightening, reducing the money supply must impact on equity prices.

“Almost all bear markets are caused by a material increase of the cost of capital – in other words interest rates rising,” says Cunningham. “These are clouds on the horizon that we need to monitor closely.”

These factors do not mean that a market downturn is imminent, but there is reason for investors to be cautious. The way that markets have started 2018 has created a lot of positive sentiment, but Cunningham believes investors shouldn’t get overexcited.

“There are times to allocate capital to risk, and times to diversify and be more defensive,” he says. “The current point is not the time to be highly concentrated and have all your eggs in one basket. We believe it’s time to take some chips off the table.”

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