If you are someone who is skeptical of where equity valuations are right now, and see this latest bull run as a sign of a runaway market, the first half of 2019 may have been a rough ride. If you decided to sit out, you have missed some impressive gains. You may even have been criticized for your excessive bearishness, and encouraged to jump in while you still can. And this strikes at the core as to why most people find it difficult to resist buying runaway bull markets -- they are afraid of missing out.
Beware rising prices
A recent note from Morgan Stanley (MS, Financial) argues this exact point. A mix of unexpectedly dovish Fed policy and Chinese fiscal stimulus sparked the rally from last December’s lows. But the most recent breakdown in U.S.-China trade talks has dented investor exuberance:
“That’s how markets work: just when you think there’s no risk, it shows up. That’s why we use a framework to tell us when the risk/reward is good, and when it’s not. Recently we have been taking some heat for not being more bullish as US equity markets were making new highs. However, by definition, higher prices in the absence of improving fundamentals means equity markets must be less attractive, not more.
My experience tells me getting more bullish or bearish simply because prices have gone up or down is a bad strategy. Using a rigorous framework that incorporates fundamental inputs, rather than emotion and price momentum has served us well over time, and importantly helps us provide sound investment advice to clients. Investment is a discipline, and abandonment of one’s framework at wrong time is usually costly.”
There’s always risk
The note goes on to argue that the specific source of risk that undercuts investors chasing the bull market does not matter so much. If it wasn’t for the trade war, something else would have surfaced:
“If trade issues hadn’t escalated last week, some other risk would have, and it would have caught the imagination of the investing public to the same effect ... I continue to think that there are other concerns that have been dismissed by investors and traders this year. Most notably, US earnings growth expectations still look too high to us, based on our fundamental models.
I suspect there is risk of further downgrades this summer when companies begin to report second-quarter results. This is the time of year when companies like to reset their full year expectations if things aren’t tracking to plan, something they generally don’t tend to do in the first quarter, and why investors may have gotten too excited over what were weak results.”
In other words, even if the trade conflict goes back to being a non-issue, those who buy at high valuations will always face an inherently higher level of risk, because they need everything to stay perfect just to maintain the valuation that they bought at. The note concludes by recommending that investors stay defensively positioned, and focus on stocks like utilities, consumer staples and telecommunication services.
Disclosure: The author owns no stocks mentioned.
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