Irrational Exuberance?

With the Dow Jones above 23,500, the S&P 500 above 2,600, the FTSE 100 above 7,410 , the DAX at 13,000 and the Euro Stoxx 50 at 3,580, the question may be justified: Are we in a new bubble?

It is one of the main characteristics of bubbles, that you can only tell with certainty AFTER the bubble burst, that it was one. The tell-tale signs in the run up are mostly ignored or "explained" away, or as Charles Prince famously said: While the music is playing, you have to keep dancing.

While that is true for most institutional investors, as private investors looking after our own portfolios, we can call the shots and take not only a contrarian view, but also contrarian action.

Now, before I go a bit deeper to look at some of the signs that I believe give cause for thought, if not outright concern, I want to emphasis that I do believe everybody should hold some quality investments for the long term, through the inevitable ups and downs. To 'consistently' time the market correctly is a mugs game and you are bound to loose money over time. Hence, a buy high quality investments at a 'reasonable' price and hold them long term is proven to be a successful investment strategy.

However, at some points in the market, the 'reasonable' in the equation seems to fade away and, as your asset prices increased, many portfolios have become overweight certain asset classes. Bringing the weightings back in line could mean a higher than usual cash balance, which, as private investors, I don't think we have to fear (as we don't generally have to beat a set bench mark, but are likely driven to achieve better returns than cash or cash plus inflation).

Are we now at such a point of irrationality?

Lets have a look at some issues of interest here:

The Bank of America Merril Lynch (BofAML) November survey of 209 asset managers revealed that allocations to global equities to net 49% overweight, the highest level since April 2015.

Furthermore, the average cash balances of portfolios fell to 4.4% from 4.7% the previous' month - the lowest level since October 2013 and below the 10-year average of 4.5%. This is coupled with the net share of investors taking out protection (insurance in the form of options/futures etc) against a market correction has fallen this month by 37%.

Looking at it over a slightly longer period, we get to look at the chart from BofAM depicting the cash allocations of their clients.

We see here that the amount of cash Merril Lynch clients' hold in their portfolios is at a 12 year low of 10.4%.

The average over that period was 13% and the previous low (11%) was in April 2007.

Now, people have different reasons for holding cash (or not), but it sure looks like a pattern: In 2007, as stock indices reached their peaks, cash holdings were well below average. They rose quickly as the crisis unfolded, peaking almost exactly with the market low in early 2009.

Putting it another way, at the time when it would have been best to reduce cash and buy equities, ML clients did the opposite - and again, when they should have been raising cash, they kept their holdings low.

I also don't think that this is unique to ML clients, but that we would find similar patterns with other brokers.

Disturbingly, cash levels are even lower now then they were at the 2007 trough.

A major reason for this may well be the extremely low interest rate level, with central banks everywhere trying their utmost to drive savers into more risky assets (with success, as the chart shows). However, the extremely low cash levels seem to suggest that caution is unpopular right now - but that does not have to be the case for you!

A few other points of interest that maybe paint a picture of potential exuberance:

-A painting (which may even be fake) sold for $450m

- Bitcoin (the jury is still out whether or not this is even an asset) soared more than 800% to above $9,600 - a >50% increase over the last 2 weeks

- The BoJ and European Central bank in 2017 bought $2 trillion of assets (For those of you who would like to write that out - it is a 2 with 18 zeros)

- Global debt rose above $225 trillion to more than 324% of GDP

- US corporations sold a record $1.75 trillion in bonds

- European "High-Yield" bonds traded below 2%

- Global stock market capitalisation rose by $15 trillion to more than $85 trillion to a record 113% of GDP

- The S&P 500 volatility dropped to 50-year lows

And there are many more similar issues of extreme valuations. Each one on their own does not seem to register, but looking at them all together, again a pattern may be emerging here.

Finally, courtesy of Michael Lebowitz of 720 Global, we can look at the chart below, which shows the S&P 500 overlaid with the FED's balance sheet incl. the forecast where the FED intends to take its balance sheet.

AS mentioned earlier, central banks did their utmost to push investors into riskier assets by 'creating' all that money (expansion of their balance sheets) - now they are trying to reign it in.

Now, while correlation does not imply causation, I think we can all take a good guess as to what may happen when the ample low-cost liquidity is being taken away.

In summary, while we should all invest in some high quality assets for the long term, there is little harm in holding higher than usual cash positions at times when prices in many assets appear inflated, even if it goes against the majority opinion.

Successful investing,

Jörg

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