Beware High Returns

  • October 18, 2017

    The U.S. stock market is currently in the second longest bull market in its history. When strong long-term bull markets reverse, it can be painful. The great returns in both equity and fixed income markets since 2009 may be leading some investors down a path with an unhappy ending.

    One of the hallmarks of a prolonged bull market that is headed for a major correction is when a subgroup of stocks reaches extraordinarily high values according to common valuation metrics such as PE ratios. In the 1960s such stocks were known as the “Nifty Fifty”. In the late 1990s they were the high-tech growth stocks of the dot.com bubble such as Cisco and Qualcomm. In both cases the overly-enthusiastic projections failed to materialize and the stock prices collapsed or languished.

    Today, they are undoubtedly the FANG stocks (Facebook, Amazon, Netflix, Google (Alphabet), and the likes: stocks with current prices based on optimistic projections of continued extraordinary growth. Tesla and a slew of internet-based startups also appear to be priced as if best-case scenarios are certain.

    High valuations are not an automatic signal for short-selling or major trades that attempt to time markets. It should be noted that many consumers spend huge amounts of time using the services of the FANG stocks. Amazon and Netflix generate enormous revenues directly from consumers, while Google and Facebook are cashing in on providing marketing services. Much potential remains from offering cloud-based services.

    But the warning signs are there. This is not a time to get caught up in the enthusiasm over high returns to the point of taking on high amounts of leverage, high equity exposures, or disproportionately high exposures to the FANG stocks. Rather, this is a time to consider rebalancing portfolios in which the equity component has risen to very high levels while the investor continues to age. In such cases, investors should consider rebalancing back towards previous equity exposures – or perhaps even lower equity exposures given the natural tendency of investors to prefer less total investment risk as they age, especially as they near retirement.

    The high returns of recent years in both equity and debt markets can fuel further risk-taking. Investors with optimism over these great past returns should keep history in mind and make sure that greed does not overtake common sense.

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