Markets have turned optimistic, but it’s late in the cycle and central banks are becoming hawkish. The challenge ahead is to safely navigate between euphoria and danger.
By rights, the current market cycle should be shuffling into retirement, putting its feet up and taking things easy. It is, after all, nearly nine years old, the second-longest bull market on record and positively geriatric by the standard of these things.
But this cycle belongs to the baby boomer generation, and like them, refuses to succumb to dotage. It’s having a vigorous later life while frittering away the next generation’s inheritance.
This raises a critical issue: how to make the most of late-cycle returns while preparing for the inevitable downswing? Late cycle can be the most challenging phase. Valuations are stretched, central banks are taking away the punch bowl and fundamentals look long in the tooth. But markets may surge as investors, buoyed by their recent success, become overconfident and start believing (again) that this time is different.
Our cycle, value, sentiment (CVS) investment decision-making process helps deal with this challenge. We step back from the current market psychology and have the discipline of breaking each decision into the three building blocks: is this asset class cheap or expensive, is the cycle a tailwind or headwind, is sentiment overbought or oversold?
Without a solid process, there is the very real risk of being drawn into euphoria at the market peak and capitulating with despondency at the cycle bottom. Investors can’t afford these mistakes. Particularly given the grim outlook for longer-term returns told by high equity market valuations and low government bond yields.
We spend a lot of time talking about the low-return imperative. For most investors, the market returns available in coming years likely won’t be high enough to achieve their retirement goals.
To have a chance of overcoming this, we believe investors need to respond in three ways: (1) diversify their sources of returns, (2) have effective implementation capabilities and (3) use a robust dynamic asset allocation process to guide tactical positioning.
In other words, they need to squeeze every basis point out of their portfolio using smart strategies, implemented in a cost-effective manner, backed by a dynamic process that leans into opportunities and away from risks.
We’re not especially bullish or bearish about 2018. 2017 delivered better returns than most industry analysts expected, but the cycle is old and the U.S. Federal Reserve (Fed) is about to step up the pace of rate hikes. Our central view is that equity markets can push higher over the first part of the year, before facing headwinds later in 2018 as markets factor in rising risks of a 2019 recession.
Enjoy this energetic old cycle while it lasts, but remember that the Fed Reaper (or Jay Powell1 as he is known to his friends) is getting ever closer...
1 Jerome Powell, a member of the U.S. Federal Reserve Board of Governors since 2012, was nominated in November 2017 to serve as the next Chairman of the Federal Reserve.