US equities have hit 53 record highs in 2017, the equal highest streak in the 10 years since the financial crisis with more than six weeks remaining (2014 also had 53 record highs). This boom in asset prices has resulted in a range of sentiments, with some respected pundits, including Jeremy Siegel, claiming that equities are still a bargain relative to bonds, while others such as Alan Greenspan declaring: “We are moving into a different phase of the economy – to a stagflation not seen since the 1970s. That is not good for asset prices.”
Add to the mix US president Donald Trump and it is little surprise the topic of “market prediction” is getting so many headlines. Yet, if Mr Trump’s one-year election anniversary has taught us any lesson, it must be the perils of forecasting. To demonstrate, we only need to reflect on his journey from an unlikely Republican candidate to an unlikely presidential nominee who eventually defeated Hillary Clinton to get the post.
With hindsight, the outcome was a declaration of both hope and frustration by the American public and, thus far, has seemingly resulted in improved prosperity with strong consumer confidence, falling unemployment and growing asset prices. Yet his election has similarly reinforced the danger of inference between politics and market returns. Initial fears of a substantial market decline, expressed by respected economists, were misjudged and, in some cases, blatantly wrong.
Where many predicted the market would crash by as much as 10 per cent, it has instead increased by approximately 25 per cent.
The relevance of this observation should not be understated. A prime example is the impact of the ongoing hostility between Mr Trump and North Korean leader Kim Jong-Un. South Korean and Japanese equities are often considered to be vulnerable to the threat of war and this naturally encourages investors to attempt to discount the cost of such an event into asset prices. Yet I question whether this is a rational response by investors as their efforts to discount such an extreme event will necessarily dominate their view of the attractiveness of the affected markets.
Moreover, a tendency to confidently infer market movements from such political events mean behavioural biases get in the way of rational investing. Politics spark an emotional response in society, but emotions mean we do not act rationally all the time.
When it comes to investing, this irrationality is further exacerbated by biases known as loss aversion (fearing loss more than appreciating gain) and temporal myopia (too great a focus on the short term), both of which are incredibly important as we think about Mr Trump and the prospects for the US equity market.
As tempting as it might be, predicting political outcomes and the commensurate market move has no place in the rational investor’s toolkit. Instead, we need to overcome our behavioural biases by sidestepping the political noise and focusing on investment fundamentals. This does not mean ignoring topics as far-reaching as tax reform and sanctions, but it does mean focusing intently on corporate fundamentals and how much is priced into markets.
Key points
- US equities have hit 53 record highs in 2017.
- Behavioural biases often get in the way of rational investing.
- US price growth has far exceeded any reasonable estimate of fundamental growth.
By using this framework, we need to determine two key variables. First, what the fundamental backdrop is for US equities; and second, how much of this is priced into markets. Regarding the fundamental backdrop, we can see in the chart that both earnings and dividends have excelled in real terms since the financial crisis. This is generally supportive of long-term growth, although one must also be careful to extrapolate this into some sort of prospective trend.
