Rational exuberance

Ridhima Sharma
clock • 3 min read

Last week, equity markets hit two month lows amid concerns regarding the crumbling support for President Trump, as well as the Spanish terror attacks. Not exactly a major sell off, but a retracement which has historically provided a buying opportunity.

However, we have to put this into perspective. Terror attacks are sadly becoming a regular occurrence, and concern over the Trump Presidency continues to dominate the news. These events present buyers with an opportunity to quickly move in and, as a result, the markets swiftly recover and attain new highs.

We are deep into the summer silly season, with thin markets and skeleton staffed trading desks, which will contribute to some indecision when volatility shows itself.

Permabears are predicting that anticipated September Fed action on reducing its QE book of Treasuries is also partly responsible for an increased sense of trepidation and that we are now seeing the beginning of something more substantive and overdue.

I disagree. If the Fed believed its policy of QE reversal was going to cause a market sell-off, then it would soften it so that markets would welcome it. This has been the case for the last four years, ever since the first taper tantrum. The Fed always blinks when the markets are truly fearful and expected negative action causes weakness. Furthermore, if the Trump reflation trade is at risk of unwinding, then earnings forecasts are too high and the US economy needs stimulus, not the opposite. The Fed is hyper-sensitive to this: preserving economic stability is part of its mandate. Equity and bond market volatility is fundamental to US economic stability, far more so than in any other economy. This is why the markets are able to push the Fed around if they perceive an ill-judged move is being considered.

Valuations are expensive but they will remain so whilst investors continue to find the available alternatives relatively unattractive. Also, markets have been repeatedly reminded that the Fed will continue to blink every time volatility picks up.

This means that the markets will be underpinned by the central banks until interest rates normalise. It will only be at that point that there will be viable risk-off assets, which equity investors will find attractive giving at least a small real return. This won’t happen until interest rates get to 3%, which seems years away.

We have heard of ‘irrational exuberance’ in Fed Chairman Greenspan’s era but the current high valuations are entirely rational, whilst the central bank moral hazard policy remains. President Trump is in desperate need of some good news, as his closest advisers continue to desert him. I wouldn’t under-estimate his ability to deliver some populist tax reforms which revitalise the reflation trade. US investors usually have a mind-set of glass half full, if not being in need of a bigger glass. In the UK, we have a rather more cynical outlook.

We would use this weakness to reduce cash, but carefully, focusing on other cheaper equity markets, as they track lower with the US. However, as key decision makers are on the beach, there may be a delay to buying this dip, which could present lower levels for the patient.

Keep some ammunition cash aside just in case we see more volatility. But cash is likely to remain the asset class for the cynic, waiting for the next black swan to arrive and provide a buying opportunity of a lifetime, having missed the last one in 2008.

Over the long term, returns on reinvested dividends provide 75% of equity total return. All rather strange that timing the 25% capital return occupies so much of investors’ time. Remember, time in the market matters much more than timing the market. The former is easy to do with self-discipline, whilst the latter is virtually impossible and usually down to luck.

Guy Stephens, technical investment director at Rowan Dartington

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