Even with little debate over this “fundamental” support for markets, opinions differ greatly whether this is a reason to be constructive on the market outlook. Fear that much of the good news is priced by markets already, that QE or regulation is distorting asset prices or that valuations are stretched keep many investors worried despite the good news show from the underlying economy.
It has to be acknowledged indeed that current market prices or, more importantly, the level of observed risk premiums in markets depress part of the returns that can realistically be expected in the near to medium term. However, this mainly hold for the strategic exposures in investor portfolios or for buy-and-hold or index strategies that basically passively collect the premiums that the market provides for risk takers. The level of prices or risk premium has no influence, however, on the ability to generate returns in market by dynamically playing factors that cause markets to move. The skill to do this well is not easy to find, but the opportunity to grow returns in this alternative way is certainly there.
The fear for excessive market valuation or distortion is understandable, but that does not make this emotion a good driver of future returns. Actually, basing one’s investment approach too much on fear has a higher probability of leading to opportunity losses that eventually undermine your return potential. Some of the more active players in the markets clearly seem to understand this, because dynamic Multi Asset and CTA (sophisticated momentum traders) funds have recently not shied away from significantly upgrading their sensitivity to equity market risk (see graph below). Many other investors, both professional and private, have remained much more cautious.
Source: NN Investment Partners
The exact motivations of all these different investor groups will always remain a mystery, but our own investment belief also suggests it continues to make sense to look for risky asset exposure despite some fear factors out there. Two observations are key in this respect. First, that markets are not a rational and stationary system, but an adaptive complex system that has a life of its own. It behaves in a non-linear and non-mechanical way. Rather than assuming that an objective equilibrium (valuation anchor) can be determined, its behaviour has to be studied with an open mind and flexible toolkit.
Our research on drivers of market emotion and behaviour suggests that we have certainly not entered a negative territory for risky assets. Many metrics on sentiment, investor emotion, herding behaviour, liquidity conditions and positioning insights help us to reach this conclusion. The simplest way however to explain this is that there are still no clear signs of an exuberant narrative floating around in markets. Few voices of excessive optimism about new business models, accelerating economic growth or new “Goldilocks” regimes are heard. Maybe Bitcoin is the only real exception to this rule, but that is not an “asset” that we consider part of our investment universe.
Second, the direction of change in both fundamental and behavioural drivers of markets has clearly proved itself as a much better market timer than valuation metrics. The latter cannot be ignored completely and might offer some medium-term return optionality, but our research suggest that the growth of future returns is much more robust by giving more weight to directionality of the business cycle, corporate earnings or sentiment and flow factors. With basically all these measures pointing up now and also political and policy newsflow being either marginally better or stable, it seems hard to justify giving into valuation fears at this point in time.
Next to these beliefs on how to exploit market opportunities dynamically, it can even be argued that this source of return is more needed than ever. With “passive” investment styles more likely to generate relatively modest returns going forward, it makes sense to look for alternatives to still being able to grow returns that can help to achieve future savings objectives. Growth is good, markets look rich and fear feeds caution, but returns are grown by looking right through it all.
<blockquote class="twitter-tweet" data-lang="en"><p lang="en" dir="ltr">How to generate returns when everything looks expensive? <a href="https://t.co/1cOCNRct91">https://t.co/1cOCNRct91</a></p>— V van Nieuwenhuijzen (@ValentijnvN) <a href="https://twitter.com/ValentijnvN/status/928644976719917056?ref_src=twsrc%5Etfw">November 9, 2017</a></blockquote>
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