This article will summarize all the existing reasons leading many investors to have a bearish outlook on current equity markets. Here I will highlight many things wrong with valuations, global economies, and investors' decisions, in order to help make my point. Though this article will be filled with negative factors that could bring down equities, and though the tone may seem like it, I do not think the market will collapse and that we are in that much trouble. I would just like to highlight all of the negative points to show why I think the exuberance in current equity prices is a bit ridiculous.
We are currently in the second-longest bull run in US history. All the main indices (SPX, NDX, INDU) have either surpassed or are flirting with their all-time highs. However, price is relative to the time period that you are looking at. That is why I consider CAPE - Cyclically Adjusted P/E ratio, which adjusts for business cycles and inflation - to be a great proxy. CAPE, designed by Nobel Prize winning Robert Shiller, is currently hovering around its third-highest point ever (27.06). 1929, 2000, present day... these are the three highest valuations the stock market has ever seen.
If one were to have no idea about the current market situation, one would probably assume business is doing fantastic and growth is accelerating, which would justify these high expectations. However, as you probably know, this is not the case. We have rebounded well from the financial crises, but economies all across the globe are still feeling the effects and are struggling to grow. Just last week, the US reported a significant miss in GDP growth. Growth is slowing - but growth is the driver of earnings, which is the foundation of valuation. This is what is leading to these heightened valuations in the market. Earnings and growth are slowing, but prices just keep going up. Growth is slowing in the United States, but even more so overseas. Ironically, this is part of the reason why equities are so high. Because growth has been so slow, central banks have been employing easing monetary policies to try to influence growth. Policies like QE have crushed yields, leading investors to look for return elsewhere. This leads into the topic of central banks, interest rates, and their effect on the market.
Central Banks and Interest rates
Since the '08 financial crisis, many central banks have used quantitative easing to influence growth in their respective economies. In its simplest form, quantitative easing is a combination of a central bank lowering interest rates and buying financial assets. This brings more capital into the system by making it cheaper to borrow money, and it artificially tries to get consumers to spend more. Central banks' use of QE all across the globe has been pushing valuations to new heights. Because rates have been pushed to these low levels, there is no yield to be found in the fixed-income space, drawing more investors to equities. Also, investors raise their expectations for economic growth when they hear about this policy. The only problem is that central banks and QE have been losing their effectiveness. Almost no QE policy since 2008 has worked as well as the United States' did, and it appears that prices are not worrying about this fact, since equity valuations continue to rise.
In terms of interest rates, the United States ended their quantitative easing policies a few years ago and have been expected to raise the Federal Funds rate all year since first raising it in December 2015. All year, there have been back and forth arguments about why they should or shouldn't raise them again. Each time this year it looked like those who were hawkish would win the argument, events such as Brexit put anxiety back in the mind of the Fed, leading it to hold on for a bit longer. Even though the timing of the rate increase cannot be predicted, it seems like it is certain.
One thing that is up to debate, however, is the effect it will have on equity prices. Bond prices will go down - this is almost set in stone, as yields and bond prices are inversely correlated. But what effect will this have on stocks? In the short term, it is definitely uncertain, but I would like to believe in the longer term, as rates rise and there is more of a draw to fixed-income instruments, there will be less incentive to be in equities at their current levels. There has actually been a few times in history where central banks have raised interest rates and ended up bursting the very bubble they were trying to prevent from growing further. Examples of this were seen in the US in 1929 and in Japan in 1990.
Growing Bearish Sentiment
In recent months, it seems like more and more influential forces have been warning about the risks that lie within equity markets. Goldman Sachs recently downgraded their outlook on stocks from neutral to underweight (3-month outlook). They highlighted the heightened valuations and their risks. Bill Gross, in his monthly outlook at the start of August, highlighted that he is currently betting on "real" assets, (housing, gold, etc.) because he sees the risk/reward in stocks and bonds as too high. Later in the week, in an interview with Bloomberg, he showed even more bearish, views stating, "The economy, absent consumer spending, is basically in a recession." Bill Gross thinks we are basically in a recession, Larry Summers and other economists still talk about "stagflation", and yet, prices still continue to fly higher. The smartest people in the world are trying to warn investors about the risks at hand, and prices have not reacted to even the most qualified of advice. But why are some of the most qualified of investors and economists still coming out being bearish? Are they short the market and want to profit off their predictions? Maybe - but I think there is a bigger reason here.
A Moral Case For Bearish Behavior
I believe because we have had such bad crashes in the past two decades, those that have influence in the markets feel the need to not let this unjustified pricing get out of hand, and they want to protect investors. This is why in the past, the central banks raised rates specifically in regard to checking speculation. The banks were not trying to cause crashes by raising rates, they were trying to save investors from a bigger crash that could lie down the road. There is an upside bias in the stock market, which there should be - because it allows for business to grow and encourages investors to take risks. However, with this bias occasionally comes an irrational exuberance that can push prices to unreasonable heights and create huge risks for economies.
So, is there any moral reason to be a bear? The more overvalued a market gets, the more vulnerable it is to a crash or collapse. As seen in 2008, a bubble created in the housing and stock market had enormous impact, throwing us into a recession and leaving millions out of a job or home. Crashes are not something we want, and they can have ripple effects outside of the stock market. So why, then, do we allow our emotions and different market media to lead us to push these prices to unsustainable heights that could have dire consequences? That is a question that I cannot answer right now, but it should prove my point. Bears are looked down upon as people betting against your money, but at some points in time, bears are what we need. If we did not have bears, bubbles would be all too common and unstable pricing would create too much risk for investors. I want these prices to drop, not because I am short the market. I want these prices to drop so I get a sense that the market is somewhat rational and not leading us to frequent doomsday-like time periods such as 2008.
What This Means For Investors
After focusing on many negative factors affecting the market and why I think they are justified, let me veer towards what this means for investor portfolios. Now, there is obviously upside potential from where we currently stand. Upwards is the general trend of the stock market - and the reason why people risk their money in these assets. However, I believe as we get closer to what I consider to be a peak in the current bull run, investors need their portfolio hedged effectively, even if there is still upside potential.
Stock and bond prices are currently at or just around their all-time highs. This makes it a little tougher to diversify, as both asset types could start to trend down at any time. Individual investors also find it tough to hedge their portfolios because futures and options, which are great instruments, are not exactly user-friendly. Because of this, I think the best way to currently hedge your equity risk is by spreading your portfolio across multiple asset classes. Assets like gold, oil, and even some currencies are what I consider to be good hedges. The rise in popularity of ETFs in recent years makes this market extremely accessible for individual investors. There are now highly liquid ETFs covering multiple asset classes - metals (GLD, SLV), high yield bonds (HYG), oil (USO), and even the US dollar (UUP) - that are effective ways to take away market risk.
Many people look at equities sector by sector and think that sector diversification is a good way to spread portfolio risk. There are definitely some safer sectors in times of downtrending equity prices, such as consumer staples. However, in general, equity prices follow each other, and it is imperative that you spread the risk in your portfolio across different asset classes.
In conclusion, I believe equity prices to be in a very precarious spot. We are in an extended bull market that is made up of many negative factors that could reverse the sentiment in the market at any time. I personally believe the bias of a bull market, especially when it is unjustified, to be extremely dangerous for individual investors. I hold that there is a moral case that exists to not push equity prices to the overextended points we have in the past, as they have had serious consequences. Because of this, I think investors should hedge their portfolios in as many ways as possible, specifically making sure their risk is spread throughout multiple asset classes. After all these reasons to be a bear, and a moral reason that I consider to be especially thought-provoking, I will end with a quote:
"Logical consequences are the scarecrows of fools and the beacons of wise men."
- Thomas Henry Huxley
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.