We were recently asked by a financial journalist to name the biggest investment risk of 2017.
Given we are towards the end of a near decade long bull market in virtually all asset classes (bonds, equities, residential property and commercial property) fuelled by ultra-low interest rates and quantitative easing, most assets look either expensive or very expensive based on historical measures.
Therefore, we believe the greatest risk to investors in 2017 is simply the potential for a return to more balanced valuations, which would lead to a substantial fall in asset values. This is especially true for the United States equity market.
Current Price/Earnings (PE) ratios for US stocks are high on both historical and future earnings. The Shiller PE is well above normal levels at around 28 times. In addition, US markets have priced in approximately 9% EPS growth in the coming year. Finally, earnings themselves are probably close to cyclical highs, inflated by low wages growth and corporate buy-backs, both of which are unlikely to be sustainable.
To put those numbers into context, the combination of a fall in PE multiples from 28 times to 22 times, and a fall in earnings growth from 9% to 5%, would lead to around a 25% market correction. And that really only brings PE and earnings growth numbers more in line with historical averages. When you consider that corrections of that magnitude usually coincide with such multiples being lower than average, it’s not that hard to imagine how a 30% plus fall could occur off the back of even a minor slowdown in the US economy.
It’s impossible to know what would cause such a slowdown, however that’s the nature of risk. Very few market corrections are caused by widely known events.
Given most other global markets follow the US lead to at least some degree, a US market decline would spread around the world. At a time when most governments and central banks have limited levers left to soften the blow, this global contagion could be reasonably severe.
But before you rush off and sell everything, there’s something you should know. It’s not unusual for exuberance to take over and fuel market booms in these late cycle stages. So, markets could just as easily increase by 20% from here as decrease by 20% in the short to medium term.
While we are constantly thinking about risks, we are cautious of making large portfolio bets based on forecasts alone. While assets are expensive on most metrics, our investment approach is to make portfolios as resilient as possible to both produce reasonable long-term results and withstand a wide range of risks. This isn’t as safe as having your cash in the bank if a big correction happens. But it does mean that if markets continue to move substantially higher, you’ll still have an opportunity to capture most of the upside.