When is the top really the top?
Forecasting peaks of cycles is notoriously difficult, and while it may feel like we’re reaching the top, evidence suggests there is still plenty of room to grow.
Equity market tops are often associated with euphoria and overconfidence, when otherwise risk-averse investors finally succumb and buy equities or the trending sector and gradually there are fewer and fewer new marginal buyers. Tops associated with an individual shock event such as a war or natural disaster can of course materially affect major economic outputs but may be more sudden and therefore don’t require euphoria and overconfidence.
Economies can progress from the second type of top relatively efficiently. The aggregate effects of the trade wars and other geopolitical risks and uncertainties are insufficient to have much of a dampening effect on world output, and stability in relation to some of them (or even a resolution) often only takes a short time. In the interim the application of fiscal and monetary stimulus mitigates near-term effects and businesses take action, such as moving supply chains.
We find it hard to argue that the current situation is filled with euphoria and overconfidence. The attempted flight to safety in negative interest rate bonds, the equity market downturn of Q4 2018 and numerous negative sentiment indicators all point to the contrary.
However, conditions are present for a euphoria phase, for example if there is resolution to the trade disputes. In particular, interest rates are artificially low on an absolute basis, coupled with strong employment, strong consumer and other economic conditions. Moreover, investors are aware of huge gains that have been provided by the markets over the past decade. The past decade of private equity funding exemplifies the easy access to investor capital that has underpinned markets. Strong past gains, risk taking, yield seeking and chasing alternatives to zero and negative interest rates provides ample conditions for a sharp upturn when sentiment turns more positive. Valuations are not the binding constraint in euphoria phases of bull markets’ return chasing.
Overall the various indicia of the current markets and economies do not signal a market top.
Interest rates are already undoubtedly low but Central Banks, and especially the United States Fed, having shifted to an easing bias have scope to reduce further. This is notwithstanding the diminished effectiveness of monetary policy upon slowing economies. Monetary policy easing intensifies asset price risks whilst doing little directly for underlying economies:
- A rate cut means the Fed thinks trouble is looming, and doesn’t guarantee to solve it
- Low interest rates reduce borrowing costs, increasing demand for bigger purchases such as cars, homes and appliances, and reduces costs on floating rate mortgages, increasing discretionary spending power
- Businesses’ cost of capital is likewise reduced, which lowers the hurdle rate to justify investments and encourage spending
- Similarly, it reduces the discount rate with which analysts use to value companies’ cash flows. Whilst adjusting your discount rate may not be the most sensible way to value businesses over the long run, consensus valuations are naturally pushed higher in the interim.
Although I cannot forecast the top of the market, it appears that once the current volatility subsides and stimulus action takes effect, we could be left with a clear path to euphoria.