Tactical Asset Allocator: Markets are overheating, but pockets of value remain

The City spent the summer fretting about an important indicator of stock market sustainability: the cyclically adjusted price-earnings ratio (Cape), which compares companies’ average annual earnings over 10 years (adjusted for inflation) with their share price. By any historical standard, this measure screams that global equities are hugely overvalued.

The last time wealth and asset managers were as concerned about the market overheating was back in 1999. The current Cape of US stocks, with a score of 28 times, has only ever been exceeded in 1929 and 2000 – in both cases heralding major market crashes. This compares for example with scores of 15.6 times for the UK market, 20 times for India and 14 times for Italy.

Yet markets have continued to climb inexorably, particularly the US market, which has risen over 170 per cent in the last seven years. That compares dramatically with a rise of around 70 per cent for the MSCI EAFE index, which tracks non-US developed markets in Europe, Australasia and the Far East, and just 30 per cent for emerging markets.

Robert Schiller is perhaps the best-known Cape advocate, but he is far from alone. What most commentators are not expecting, however, is a crash of 30-40 per cent plus, as occurred in 2008 when the Dow Jones index fell 34 per cent, the FTSE 100 fell 32 per cent, its worst year on record, and the Shanghai Compsite index ended the year some 65 per cent lower.

Some wealth and asset managers are talking about a 10 per cent correction, while the consensus is that markets will simply ebb sideways, producing much lower returns of perhaps just 1-2 per cent for the next five to ten years.

The credibility challenge is that some big-name investors have been warning about these high valuations and calling the top of the market since 2011. They include hedge fund manager Bill Ackman, a follower of Benjamin Graham, who warned in a newsletter that the absence of cheap stocks was a strong indicator of a bubble and argued that not one US stock could be termed ‘deep value’. Since then there have been six years of robust market gains.

-UK slips in global competitiveness ranking

A recent paper co-authored by GMO investment strategist James Montier and founder Jeremy Grantham, who are famous for having predicted past market crises, has added grist to the mill. They point out that US gains have so far been driven by an expansion in profit margins and valuation multiples to historically high levels, and probably cannot expand any farther, so for growth to continue, dividends and earnings must start to grow at a much faster pace – yet over time they tend to be stable.

Overpriced over there

Montier says buying US stocks ‘now requires a belief that “it’s different this time” with respect to the valuations that people will put on stocks, and the margins that companies can command’. In fact, he argues that the Cape valuation metric flatters the situation and that today all sectors are overpriced, not just technology, as was the case in 2000. Yet investors are still hungrily buying the dips, and looking for a silver lining in every piece of news. Even the threat of nuclear annihilation has not stopped the US market from rising.

Remarkably for example, Trump’s recent deal to extend the debt ceiling to December has been viewed positively, even though members of his own party are enraged that he did not fight harder against the Democrats to push the next round of debt talks beyond the November 2018 mid-term elections.

.tg {border-collapse:collapse;border-spacing:0;}.tg td{font-family:Arial, sans-serif;font-size:14px;padding:3px 0px;border-style:solid;border-width:1px;overflow:hidden;word-break:normal;}.tg th{font-family:Arial, sans-serif;font-size:14px;font-weight:normal;padding:3px 0px;border-style:solid;border-width:1px;overflow:hidden;word-break:normal;}.tg .tg-g4n2{font-weight:bold;font-size:12px;font-family:"Times New Roman", Times, serif !important;;background-color:#f3eddf}.tg .tg-o3my{font-size:10px;font-family:"Times New Roman", Times, serif !important;;text-align:center}.tg .tg-ol4m{font-size:10px;font-family:"Times New Roman", Times, serif !important;;background-color:#f3eddf;vertical-align:top}.tg .tg-u8r7{font-size:10px;font-family:"Times New Roman", Times, serif !important;;background-color:#f3eddf;text-align:center}.tg .tg-ljnk{font-weight:bold;font-size:10px;font-family:"Times New Roman", Times, serif !important;;background-color:#f3eddf}.tg .tg-5n53{font-weight:bold;font-size:10px;font-family:"Times New Roman", Times, serif !important;;background-color:#f3eddf;vertical-align:top}.tg .tg-ae2m{font-weight:bold;font-size:10px;font-family:"Times New Roman", Times, serif !important;;background-color:#f3eddf;text-align:center}.tg .tg-cdn0{font-size:10px;font-family:"Times New Roman", Times, serif !important;;background-color:#f3eddf;text-align:center;vertical-align:top}.tg .tg-m0eb{font-size:10px;font-family:"Times New Roman", Times, serif !important;;text-align:center;vertical-align:top}
Stock EPIC Cate-gory Risk Level* Quan-tity Price paid £ Current price
Current value
Weigh-ting (%)
Lyxor ETF FTSE 250 L250 UK equity 81 1000 12.32 23.78 23,775.00 13.04
iShares Core S&P 500 UCITS
CSP1 US equity 110 100 103.70 180.05 18,005.00 9.87
Euro Stoxx Total Market Growth
IDJG Euro equity 104 525 18.14 31.77 16,676.63 9.14
iShares FTSE EPRA/NA Glbl Prop
Yld (2)
IWDP Property 84 402 13.38 19.79 7,953.57 4.36
Neptune European
NEOA Euro equity 104 1097 3.62 6.26 6,863.93 3.76
dbx MSCI Russia 25% Capd XMRC Em mkts equity 214 400 17.64 18.76 7,502.00 4.11
Schroder Frontier Markets
Equity fund
M9S0 Em mkts equity n/a 80 100.00 123.87 9,909.60 5.43
iShares Japan Sterling
hedged ETF
IJPH Japanese equity 139 200 47.41 53.49 10,698.00 5.87
Standard Life Investments
Emerging Market Debt
GU4Z Bonds 58 1300 5.15 6.29 8,180.90 4.49
XCX5 Em mkts equity 143 900 6.59 9.09 8,182.80 4.49
DB X-Trackers MSCI EM Asia
XMAS Em mkts equity 129 420 24.12 38.16 16,027.20 8.79
iShares Global Clean Energy
INRG Global equity n/a 300 3.59 4.06 1,219.20 0.67
iShares China large cap FXC Em mkts equity n/a 100 81.66 96.72 9,672.00 5.30
iShares Physical Gold SGLN Commodities n/a 300 18.26 20.24 6,070.50 3.33
Polar Capital Global Insurance
NAU4 Equities 99 400 5.35 5.72 2,287.20 1.25
Ground Rents Income IT GRIO Property n/a 1000 1.41 1.23 1,225.00 0.67
iShares Automation &
Robotics ETF
RBTX Equities n/a 1000 4.66 5.15 5,150.00 2.82
iShares J.P.Morgan EM Local
Currency Bond
LEMB Bonds n/a 100 36.59 37.57 3,757.00 2.06
JPMorgan Emerging Markets IT JMG Equities 135 1000 8.46 8.46 8,460.00 4.64
Cash (see below) 10,777.01 5.91
Total 182,392.53 100.00
Notes: Portfolio start date is 10 August 2012. * Risk level is produced by FE Analytics and references the FTSE 100 as benchmark of 100.,** Name change - formerly iShares DJ EuroStoxx Growth. £10 standard Interactive Investor dealing charge and 0.5 per cent stamp duty deducted from cash holdings on new purchases and sales. Cash at beginning of period =,£19,247.01. Dividends in this period: nil. Purchase of 1000 XJPMorgan Emerging Markets IT = £8,460 plus dealing charge £10.,Cash at end of period = £10,777.01. Standard Life Investments Emerging Market Debt,interim dividend due soon.Source: Interactive Investor as at 7 September 2017

Perversely, the market liked this move, and portrayed it as a way to alleviate the fallout from Storm Irma. But such optimism could make investors take risks at just the wrong time, as geopolitical and economic events are set to come thick and fast over the next few months.

It is very hard to try to time the market or to rotate market sectors, as the erraticism of value-oriented stocks over the last few years demonstrates all too well. About this time last year, high-dividend stocks sold off in the UK and growth-oriented sectors have led the way since, with biotech and technology doing particularly well, while commercial property, telecommunications and energy sectors have lagged behind.

Yet housebuilders such as Taylor Wimpey, Persimmon, Barratt Developments and Berkeley – which one might have expected to be similarly struggling in the post-Brexit doldrums – have enjoyed good gains since the start of the year. That’s despite the fact that house prices have only very recently started to recover, rising by 1.1 per cent in August according to the Halifax house price index. Despite the prospect of rising interest rates, the building industry has been taking advantage of low costs for building materials and ample land availability to maintain margins and profitability. Bovis shares have soared this week on startlingly good numbers.

-The ‘trapped’ capital cycle spreads to energy

So where can the bargain hunter now look? Valuations across the emerging market space do not look quite so stretched. The MSCI Emerging Market index is on a price earnings ratio of 15.7, and some of the most attractive markets on a Cape basis are in the region, such as China at 10 per cent. As the tech sector becomes more important, the region is no longer just a commodity play.

We are therefore boosting exposure to the region, which should benefit as the weight of money moves out of developed markets, particularly as investors switch out of the US. We’ve chosen JPM Emerging Markets trust (JMG), although the Templeton emerging market trust TEMIT would be a good alternative as both still languish at double-digit discounts.

 Another debate is around market volatility. A common misconception is that market volatility has been high in recent years, but in fact the opposite is true. The CBOE Volatility Index – or Vix – measures investors’ expectations of market volatility, and has crawled along near record lows for months. It currently stands at 12, around half its average level over the past 25 years.

The danger is that a prolonged period of low volatility heralds a greater risk of a market drop. During the financial crisis in 2008, it was as high as 60 – but in the lead-up it was low as it is today. The calm it reveals can therefore be viewed as a dangerous complacency. In part this may be because of the so-called ‘tranquilising effect’ of index funds. Meanwhile, all the flipflopping from one sector to another and the increasing apertures between the best-performing industry and the worst suggest cross-currents we would be foolish to ignore. 

Keep up to date with all the latest personal finance news and investment tips by signing up to our newsletter. Email subscribers will also receive a free print copy of Money Observer magazine.

Subscribe to Money Observer Magazine

Be the first to receive expert investment news and analysis of shares, funds, regions and strategies we expect to deliver top returns, plus free access to the digital issues on your desktop or via the Money Observer App.

Subscribe now

Add new comment