Capitulation of US equity bears is danger sign for Wall St

Sensible investors should hold more cash as rewards for owning stocks diminishes

Miles Johnson

Three years ago it sometimes felt that one of the most wildly contrarian opinions one could hold about the stock market was that it wasn’t staggeringly overvalued and primed for a crash.

Voices as varied as Donald Trump and the Yale University market scholar Robert Shiller warned of bubbles inflating in financial markets, with the latter observing how “It looks to me a bit like a bubble again”, and how “many people are re-evaluating their exposure to the stock market”.

Since then, with hindsight, they both were wrong, or — if one wishes to view their prognostications more charitably — simply too early. The US S&P 500 index has risen 34 per cent from the start of 2015 and after entering the White House Mr Trump instead took to tweetingabout rising stock prices as if they were a barometer of his political success, rather than a warning of growing over-exuberance.

And in the past three years there has been a notable shift in the tone of financial commentary.

With US equities up by more than a third the once plentiful number of financial commentators convinced markets are going to tumble appears to have shrunk. While such measures of sentiment are fuzzy, anecdotal and imprecise, it is this gradual disappearance of outspoken bears that should be noted by anyone thinking of deploying capital into financial assets today.

Media commentary, which invariably reflects the opinions of influential market participants, appears to be becoming steadily less bearish the further we move away from the last crisis. My colleagues on FT Alphaville have pointed out that the number of articles mentioning the term “market bubble” have fallen sharply, with mentions in 2017 sightly higher than the year before, but lower than every year since 2013. Media mentions of this term, according to a Factiva search, were also lower than the years between 2002 and 2008.

Professional investors meanwhile appear to be engaging in buying behaviour apparently contradictory to their views on the market. The closely followed Bank of America Merrill Lynch monthly fund manager survey, which polls investors managing $541bn of assets, showed in June that equity investors had returned to being overweight US equities for the first time in 15 months. This is in spite of US stocks being the most richly valued of all developed markets.

At the same time the respondents said they were most overweight global technology shares, while simultaneously believing that being long large US and Asian technology shares was the “most crowded”, and therefore dangerous, trade at the moment.

On top of all this a growing number of commentators have moved from warning of overvaluation to simply acknowledging markets are expensive, and encouraging their followers to remain invested and run away just before things get ugly. This is at precisely the time when higher interest rates in the United States will probably diminish the appeal of stocks to investors previously desperate for yield.

An example of this thought process is Jeremy Grantham of the US fund house GMO, who at the start of this year argued that “we can be as certain as we ever get in stock market analysis that the current price is exceptionally high”.

Mr Grantham concludes that “a melt-up or end-phase of a bubble within the next six months to two years is likely, ie, over 50 per cent,” and how one should be “ready to reduce equity exposure” when “either the psychological signs become extreme, or when, after further considerable gain, the market convincingly stumbles”. None of this amounts to a dire “get the hell out while you still can warning” in spite of his observation about extreme overvaluation, and instead boils down to a strategy of trying to rush for the exits just before everyone else does.

Common sense dictates that if you believe something is expensive then you don’t go out and buy it, and if you already own it, but believe it is so expensive that it has risen to a price far more than it is really worth, then you sell.

Instead of twisting themselves into logical knots over “melt-ups” and trying to time when the markets will finally turn, sensible investors should simply refuse to play if they feel they are not being offered the right rewards to compensate them for buying or holding financial assets today.

A prolonged market rally has left many “bears” fatigued, with those who acted on their fears having suffered years of poor performance. Now it appears many are throwing in the towel just at a time when real warning signs of over-exuberance in parts of the market are becoming ever more apparent. Instead of embracing the folly of being the “fully invested bear”, holding assets they believe are overvalued, it would be more prudent to reduce market exposure and simply hold more cash than normal.

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