John Templeton, the legendary global investor and founder of Templeton Funds, was fond of saying, “Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.” After a uniquely strong 2017, during which the S&P 500 posted a positive gain in each of the 12 months, for the first time ever, where are we now on Templeton’s bull market cycle? Our observations seem to indicate that we ended the year coming out of the skepticism phase, and are just now moving into the optimism phase. Accordingly, 2018 should deliver another positive year. However, the environment will be significantly more volatile, and investors will need to be globally diversified and less devoted to the well-loved technology names in order to achieve solid results.
The prevailing bearish view focuses on a number of legitimate, but not necessarily imminent, concerns. Based on our client conversations, the most common worry is high stock valuations – “nothing is cheap.” Stock valuations are modestly high, but they are so in response to positive trends in corporate earnings and employment, lower corporate tax rates and cash repatriation incentives, and recent strength in previously lagging value sectors such as financials and energy. So, above trend-line valuations alone is not a sell signal, particularly if these positive trends fill in and sustain. The second most common concern is political unrest, both in Washington and around the world. While it is a reasonable concern, we remind our clients that a diversified portfolio of well-managed and profit-driven companies will outmaneuver bad politics.
In our view, a more tangible risk to the bull market cycle is higher interest rates and rising inflation, and most investors are unprepared for the rising rate possibility. Higher interest rates put downward pressure on stock valuations for many reasons. Wage growth (ultimately a positive event) and rising input prices cut into corporate profits. Furthermore, fixed income investments react negatively to higher rates. The most plausible scenario is that interest rates and inflation rise gradually. If so, the harm can be mitigated well enough by reducing exposure to debt, leverage, and fixed-yield investments, while favoring assets in sectors that are cash rich and have the ability to raise prices. If gradual becomes forceful, alternative investments would become useful.
The surprise in 2017 was not above average gains in global stocks, but rather the unprecedented absence of volatility. We expect volatility to return, ushered in perhaps by peaked stock valuations, political events, rising interest rates – or a combination of all. But a return to traditional levels is not a signal to sell, nor a reason to sit on the sidelines. Our view is that we are in the early stages of optimism, euphoria is a bit down the road. While we are confident that solid returns can be achieved in 2018, there is never a bad time to check the risk profile of your portfolio – and we offer the tools to do so.