It’s quiet out there. Too damn quiet

London stock exchange © Getty Images
It’s starting to feel that we’re in the early stages of a “melt-up” phase

Listening to your gut is not a viable investment strategy.

This is not because your gut is always wrong. An infallible contrarian indicator is one of the most useful things you could ever have in the markets – you just always do the opposite of what it suggests.

No, the problem with your gut is that it’s inconsistent. Sometimes it’s wrong. Sometimes it’s right.

So you need to try to work out if it’s just your own cognitive biases talking, or if that little voice is actually worth listening to.

At the moment, my gut is telling me that it’s all starting to feel a bit overheated out there.

So where’s the evidence?

Donald Trump has reignited dormant “animal spirits” 

There’s something in the air. Markets – as judged by the S&P 500 – have been overvalued for a while, but the irrational exuberance element has been lacking.

That feels as though it’s changing. It’s starting to feel that we’re in the early stages of a “melt-up” phase in markets. The melt-up may conclude with nothing more than a correction, or it might be the one that ends up delivering us a nasty bear market. I don’t know.

But is this just finger in the air stuff? Or is there any reason to feel that something’s changed? Let’s look at what’s going on.

One thing you need to fuel a good old-fashioned bout of irrational exuberance is a convincing story – a reason for people to believe that a more profitable future lies right ahead of them. This is often based on a technology, but it doesn’t have to be (the property bubble, for example).

In this case, the most obvious catalyst is Donald Trump. The man running the world’s most important economy is shaking things up. Whether you like it or not is beside the point – the world has felt as though it’s been stuck in stasis for a long time.

That stasis is ending. People have been looking for an excuse to shed despair for a while, and – insane as it may seem – Trump is the excuse. That’s the story – Trumpflation is coming. Markets have currently bought the idea that it will end well. If it doesn’t, from current valuations, there will be hell to pay.

The financial fuel pumping this market higher

So we have a story. Another thing you need to fuel a proper old-fashioned bubble is lots of investors pumping money into the market. That’ll often happen via a “new” financial technology that makes it easier or cheaper to do so.

We have a “new” financial technology in the form of passive investing. Passive investing has been around for a long time (I’ve been writing about it for more than a decade now, and it goes back a lot further than that). But it’s only in the last few years that it’s really taken off.

Ordinary investors and their advisors have woken up to the fact that on average, they’re going to be better off just tracking the market rather than paying someone in the hope that they can beat the market. (We’ve written about this a lot, so I won’t go into detail again here – just read this piece if you need more info).

Meanwhile, a specific type of passive investment – the exchange-traded fund (ETFs), a stockmarket-listed passive fund – has made it incredibly easy to nip in and out of the market as and when you want to.

That does rather go against the point of passive investing (it’s not cheap if you trade in and out) and the father of passive investing – Vanguard’s Jack Bogle – has always criticised ETFs on that basis (although it’s important to point out that you don’t have to use ETFs in this way – they just make it easier for us humans to indulge our self-destructive impulses).

In any case, an incredible amount of money has flooded into ETFs in the first two months of this year. As Chris Flood points out in the FT’s FM supplement, in 2016, a record-breaking $390bn went into ETFs. That’s quite an impressive number.

But between the start of 2017 and the end of February alone, another $131bn – equivalent to a third of last year’s record inflows in just two months – had been shoved into ETFs, according to figures from the ETFGI consultancy.

Now I need to make one point very clear, as there are a lot of people in the finance world who would love to see the passive industry fall flat on its face: none of this means that there is anything fundamentally wrong with tracker funds or ETFs. They just happen to be the transmission mechanism for everyone’s enthusiasm these days.

At some point in the future, scholars will perhaps look back and say: “Ah, the crash of the late 2010s/early 2020s – that was partly driven by passive investing, which was then a relatively new financial technology.”

There are other “gut feeling” markers – merger and acquisition activity is starting to hit the headlines more regularly, for example – but even if we’re getting close to a top, what can you do about this?

First, I suspect that the catalyst for any ultimate “top” this year, might well be a relief rally following the European elections. Assuming (and it is an assumption) they go more smoothly than markets fear, we could get a big “buy the rumour, sell the news” reaction.

Secondly, in terms of what you should own just now, I’d stick with the cheaper markets. Japan is the one I always bring up, but there’s good reasons for that. My colleague Merryn Somerset Webb goes into them here.

  • Mark Bishop

    I’m broadly optimistic about the prospects of the UK stockmarket – I think Brexit negotiations may surprise on the upside – and pessimistic about the US, where I think valuations were already too high pre-Trump and where factors such as the FBI probe, geopolitics and any failure fully to deliver the hoped-for expansionist policies could trigger a correction.

    Having said that, I’m nervous about the indices that have attracted most of the passive money, and by extension, about the stocks within them. There’s a risk that the large inflows to ETFs that follow the S&P 500 and FTSE 100 may represent both the result and the cause of those indices’ outperformance of most actively managed funds. In other words, the indices have performed well because they’ve attracted so much money, and continue to lure capital because they can point to excellent recent performance.

    Many studies have attempted to weigh the relative merits of momentum investing versus other strategies, most concluding that the former wins out in the short to medium term, but not in the long. I can’t help wondering whether those who come late to the passive investing ETF party may come to regret it.

  • Tawse

    So, we could be near the top and about to crash… or we could be about to do a final blow-off melt-up and then crash sometime this year?

    Gee, that’s useful.

  • FourTuna

    The problem is that the article doesn’t really offer any advice (other than move some funds into Japan). I am reminded of the RBS call last year to “Sell everything”. If we had followed that advice we would now be over 15% down. Timing the market is a mug’s game.

    • Peter Edwards

      timing the market is only a mugs game if you don’t define an investment duration.

  • FRED

    Japan is cheap but beware Trump’s trade war.

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    • John Stepek

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    • John Stepek

      Hi Dan – you can cancel within the trial period, and get your 12 issues of MoneyWeek for £12. I don’t believe this is misleading – it’s not an uncommon type of subscription deal.

      All the best,

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