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Question of the Week, April 13, 2015

Question of the Week, April 13, 2015

Guest Post - Monday, April 13, 2015

When is the crash coming?

This question is more hypothetical than one we've actually been responding to yet, but it's important to lay the groundwork for these things while conditions are good so clients avoid becoming complacent—not an easy task. Historically, we know that each year brings a pretty good chance of a -10% correction, with less severe pullbacks happening more frequently. Often, these pullbacks aren't predictable or obvious events that can be avoided in advance, but valuation conditions can also play a role in expected return outcomes before and after such corrections.

As we know, conditions have been good recently. Valuations for risk assets are nowhere near the deep discounts they were in 2008-2009, and the recovery years since then have been quite productive for equity investors. Now, conditions are a bit more difficult, with 'near fair value' being an appropriate description across several asset classes. However, bull markets often don't end at fair value; in the absence of other cross-currents (2008 was such an exception), they grow beyond a reasonable level to much more expensive levels—2000-2001 was naturally an example of that tendency. This current rally has been described as one of the most skeptical/least believed rallies in several decades, which is not surprising considering the severity of the Great Recession—memories tend to persist and can often affect an entire generation of investors. We saw this tendency in those raised through the Great Depression, watching parents struggle, resulting in a long-lasting distrust of financial markets and banks in a pre-regulatory world and no FDIC to protect depositors from bank runs. Considering those factors, the distrust wasn't entirely unjustified. The maligned asset or villain changes every time. This go-around, coupled with a distrust of financial markets (that seems to be a constant), it's a skepticism of real estate being a great no-lose savings vehicle. But this skepticism does seep into other assets, and stocks have not yet experienced the exuberance from Main Street that has characterized prior bubbles.

Manias and bubbles generally coincide with a disregard for anything contrary to the trend—often to the extreme or delusional. We always remember the tale of well-known early Wall Street 'operator' and father to a future U.S. president, Joe Kennedy Sr., who sold his long positions and even began to short markets when he began getting stock tips from none other than his shoe-shine boy in the booming pre-crash late-1920's. We also tend to hear descriptions such as a 'new paradigm' or the usual 'it's different this time,' in order to justify newly elevated valuations. By contrast, there still appear to be a lot of concerns in the world today that keep exuberance in check—European deflation, Japanese economic stagnancy and poor demographics, Chinese maturity (and slower growth rates), the Middle East (as usual), and low oil/commodity prices (for mixed reasons, but in the past would have been welcomed, at least compared to the opposite). A plodding-along U.S. growth story continues to be question, as it's not as strong as it could be—although it's the envy of many other developed nations.

In short, P/E ratios are higher, but they tend to be and should be higher when interest rates are low, as the discounting forward elevates the value of cash flows, and hence, dividends and stock values. If rates were to rise dramatically, it could put a crimp in these values, but, at the same time, rapidly rising rates would imply and be generally coupled with much stronger economic growth, which helps offset these impacts over multiple-quarter periods. In fact, under rising rate scenarios, equity volatility rises in the near-term, but often prices end up higher in the ensuring 12 months (aided by the implied higher growth).

Bonds are a different story, more for perhaps another day, but rate dependencies are reliant on the same factors as equities—economic growth and inflation (these are often intertwined). 'Real' rates are where everything starts, and debate continues about the appropriate place for these real rates to be. As with any asset, if more uncertainty looms, investors demand a higher rate, and will accept a lower rate if stability is the norm. In previous decades, the Fed would act more or less in secret, by raising and lowering target rates behind the scenes and in open market Treasury operations to achieve its aims. Now, we're in the midst of an extremely public central bank environment, where the timing of quarter-percent changes are scrutinized months in advance—this takes away some of the central bank's power and adds to fragility somewhat. That said, we may not see sharp policy moves for this reason, but volatility may come from market participants themselves. Despite the need for some 'safe' assets in a portfolio, low coupons do not give fixed income investors a lot of room for error.

Additional Reading

Read our Weekly Review for April 13, 2015.

Read the previous Question of the Week for March 9, 2015.

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