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Today I have done something I will very rarely do – perhaps only once in a decade – I’ve bet against an entire market. I must quickly add that I’m not pessimistic about shares everywhere; I continue to hold a portfolio of deep-value UK companies. I just want to hedge my overall position, protecting the downside should things go terribly wrong in the US.
Any trouble there will ricochet around the world. Even if my estimate of the probability of anything dramatic happening is under 30% I still think it worthwhile buying some protection.
What are the odds of your house burning down in the next 12 months? Significantly less than 1%? And yet you pay for insurance year after year. This is the mind-set I’m in with regard to the equity markets.
There is a reasonable chance (more than 1%, but less than 50%) that there will be a major decline in US shares. Those of you who have read my recent Newsletters concerning cyclically adjusted price earnings ratios (CAPE), record debt levels in the US and record levels of dependence on the kindness of strangers will be aware of the reasons I have for some degree of pessimism.
I don’t know what the trigger will be
If I think back to 2007 I was not aware of the danger wrapped up in the sub-prime mortgage market – and yet that house of cards was the trigger for a financial crisis and the Great Recession. Likewise, I do not know what the trigger might be this time.
All I know is that US shares have not been at this level in terms of CAPE before, except in two years, 1929 and 1999. US share valuations are very stretched, they are priced for perfection (see earlier Newsletters for the evidence on CAPE being useful for estimating future returns).
The Perfection elements baked into share prices
- US economic growth will accelerate from around 2% to around 4% year after year.
- The corporate profit share of GDP will be maintained at record levels (in other words labour will not grab a bigger share, even at low unemployment) and corporations will maintain the extraordinary level of share buy backs and mergers to help hold up shares
- US interest rates will remain low
- Foreigners will continue to buy US assets
- No war
- A large reflationary spend on infrastructure in the US
- Taxes will be cut, particular for corporations, and this will stimulate faster growth and therefore reduced government deficits
- Donald Trump’s antics will not damage (a) international trade, (b) investment in America (c) America’s power, soft or hard.
Other potential triggers
- China’s financial system collapses even after government assistance, followed by property slump, stock market slump, slow/no growth and withdrawal of cash from the world economy
- Central banks around the world raise short and long term interest rates too fast, moved by unexpectedly high wage inflation. Bond markets collapse, especially junk bonds.
- The US car loan market implodes (currently there is a large quantity of sub-prime securitised bonds floating around)
- A well-loved company with an exceptional influence on investor mood disappoints the market greatly, stimulating thoughts that disappointments will hit investors……………………………………….
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