Value for money
Overpaying for an asset is one of the surest ways to limit your return potential and lose money. After several years of rising prices and weak fundamentals, such as earnings, most developed equity markets, particularly the US, look expensive.
The most benign resolution would be for prices to tread water and earnings to catch up, thereby reducing the price/earnings ratio. The less positive route would be for prices to fall to more realistic valuation levels. Higher interest rates, in turn leading to higher discount rates, could be a trigger for such a de-rating.
Either way, with market expectations already high, it is difficult to see them rise significantly from here and the risk of disappointment is high.
This can be compared to sovereign bond markets, which capitulated from their own extreme valuations in the middle of last year in response to the prospect of debt-fuelled fiscal spending in the US.
Even with no real details, this was enough to shake bond investors from their complacency and shows just how vulnerable overvalued markets can be.
Equity and bond markets have been driven higher by excess liquidity rather than fundamentals for several years. Against this backdrop, market complacency seems high. Corporations and households are re-leveraging balance sheets from already extended levels, even as central banks have allowed unconventional monetary policy to continue distorting markets.
Quantitative easing and debt are effectively drawing consumption and real returns from tomorrow to fuel meagre growth and asset price rises today.
With this in mind, it is difficult to build a compelling outlook of sustained fundamental economic growth that would justify the current valuations on many equity and bond markets. Even if economic growth does materialise, it is not clear that expensive markets will necessarily retain current levels as key price supports are withdrawn.
While it is entirely possible that markets will muddle through and shake off the troubles posed in the near future, after several years of exceptional investment returns I would advocate now is the time to take some profit and add downside protection.
In our portfolios, we have taken profit in equity and bond markets over the past year, and increased our exposure to alternative asset classes and cash. Markets can remain irrational but the further they go, the less upside and more downside I see.
Anything that triggers a wave of rationality at this stage would inevitably spell bad news for asset prices.
