Remain vigilant – no time to lower the guard

After many years of strong performance and low volatility, the biggest risk for many investors might be to fall into complacency. While human nature is often backward-looking, this is no time to lower the guard but rather to heighten vigilance and to remember that major changes in market trends and crises often happen when they are least expected.

We should emphasize that we do not have any crystal ball to predict the future and that we do not know what will happen in 2018. A continuation of the current trend is certainly possible and even likely, considering the fact that a dramatic worsening of economic and financial conditions does not appear imminent. However, the key issue is to manage the risk responsibly in order to be ready also for the less likely but potentially devastating consequences of adverse market developments.

While markets are impacted by several economic factors, one of the key parameters is valuation. At some point in time assets reach excessive valuations. When this point is reached becomes clear only in retrospect, as overvaluation and undervaluation are often in the beholder’s eye and there is no infallible indicator to objectively define them. The best one can do is to try to get a sense of whether assets are closer to being undervalued or overvalued. After ten years of increases in asset prices, the answer to that is clear: currently, almost every asset class is trading at all-time highs by any metric (s. graph below).

The question is not whether markets have reached their top or not, which nobody knows. The right question is about the risks and the opportunities markets currently offer. The elevated current valuations mean that equity markets will likely deliver considerably less than the long-term total return averages of 8-10% in the coming years – in our view a 4-6% return for the next five years looks like a realistic possibility. On the risk side, it is in our view illusory to try to put a number on the probability of major correction, but historically equity markets have regularly experienced bear markers with drops of 30-60% (s. table below). A traditional portfolio with a 70% equity allocation can in such circumstances easily experience a 30% drop, which is unacceptable to many investors.

The current combination of limited upside and increasing downside risk calls for prudence and for overweighing lower risk-assets and those with limited correlation to equity markets. This is a challenging task, considering that bonds offer little yield and considerable duration risk. The only solution in our view is to look for less conventional investments that still offer an attractive value proposition. Those willing to take the risk of paper losses should focus on those rare niche opportunities that currently entail high single digits or low double digits return potential –more than what we expect for equities, and sometimes with less risk.

Finally, an important point to keep in mind is that while history is an important teacher, it does not necessarily repeat itself. A widely held view is that “in the long-term stocks always go up”. While this has generally proven true, there were exceptions. For the fourteen years period between 1968 and 1982 the real return for the S&P 500 (including dividends) was slightly negative (the real return for bonds was even worse due to inflation). The Nikkei index of Japanese stocks is today still almost 50% down from its peak level three decades ago.

In summary, this is a time to remain vigilant and to look for investment opportunities also outside the traditional tracks.

The article was written together with Ilan Weil,CIO of Rosetta Investments.

About the Author
Orit Raviv Swery is the founder and CEO of Rosetta Investments LTD., a Boutique Multi-Family Office.
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