A common question I get from clients right now is that markets have gone up a lot and therefore should we wait to buy at better levels later? The problem with this is that markets are typically higher than they were before, as the nature of equity markets is that returns arise from capital gain and dividends, so we would expect the index to rise over time.
In the absence of any other information, the right time to invest is today, and today the market is most likely to be higher than it was in the recent past.
The problem with this is that markets do, in fact, very often fall. In almost every year, the market will experience a fall from its highest point to a lower point at a later date. Of course there are the occasional, and much more profound, bear markets where the market falls significantly. In fact, in more than 50 per cent of past periods, the market falls 10 per cent or more from its peak during a year, yet most years it ends higher than in starts. Equities, while in the long term a successful strategy, do give a bumpy ride.
It is the prospect of smoothing these bumps that makes mixed asset funds in general, and outcome-driven ones in particular, attractive. Clearly, a diversified asset allocation, across a range of equity markets and other asset classes, is likely to smooth returns to a greater or lesser degree, depending on the mix of assets chosen. But to what degree can we predict when the bumps will occur and adjust our portfolios to reflect this?
Looking through this lens, what can we tell about today? Equity markets have had a strong run from the lows of early 2016, but at the same time the outlook has improved over that time. Company-reported earnings and forecasts have greatly improved and analyst forecast profits have been rising, which is an unusual occurrence. In general, analysts are overly optimistic and have to revise down their forecast over the course of a year. This year, they have, on average, been upgrading. At the same time, valuations on many measures are high compared to the past, so are arguably discounting this reality.
The factors that might drive future profitability, such as the economic prospects, inflation and interest rates, have also been relatively supportive. Although recent evidence might suggest that the acceleration in growth is slowing, there is little, if any, evidence to suggest a contraction is on the horizon.
Economic forecasts have little accuracy, so we should not apply any great weight here. However, we can reasonably assess that in the absence of any signs of stress, we are unlikely to move from this benign environment to an extremely negative one in the near term. Generally, large market setbacks coincide with bad real world events that impact profitability of companies materially. These often follow periods of excess that need to be reversed. Examples would be the financial crisis that followed a period of reckless mortgage lending in the US, or the Asian crisis that resulted from an excessive reliance on US dollar-denominated debt in Asia.