What follows is a section from the “Thoughts & Analysis” portion of my monthly letter to investors at T11 Capital.
A sense of absolute clarity has suddenly developed within the minds of investors in U.S. equities. A clarity as to the future of the economy. A clarity as to the future of the markets. A clarity as to the future of their own personal fortunes. This clarity has been thrust upon the hearts and minds of investors from one source: Government.
The changing of government that will take place in earnest later this month ushers in an incubator-esque, pro-business environment that the country has never experienced. It is only appropriate that in the face of pro-business policies, designed by individuals who have a lot of money, for people who want to make a lot of money, that the markets would applaud loudly by driving up equity prices to record levels over the past couple months.
That very same comfort and clarity, however, creates some of the most perilous conditions we have had in all the time the markets have been advancing since 2009. There is a premium that has now been baked into the market based on governmental policy and action. In the past years, we have only seen premiums baked into the market for earnings and monetary policy reasons. The current affinity for fiscal policy, whether in the form of stimulus or deregulation, reflected in the premiums individuals are suddenly willing to pay for stocks, changes the game completely going forward.
Investors have now tied themselves to a group that has influences from an infinite number of outside groups that have contradictory interests tied to numerous other groups. This is no longer a game if earnings are good then markets will rally; if monetary policy remains accommodating then the markets have a base from which to rally; if geopolitical and macro uncertainty stays out of the picture then the markets will appreciate in value.
Things just got a lot more complicated while investors have become extremely comfortable with their investments. How comfortable? Take this comment from the CEO of Trimtabs as one example:
“The stampede into U.S. equity ETFs since the election has been nothing short of breathtaking. The inflow since Election Day is equal to one and a half times the inflow of $61.5 billion in all of last year.”
Investors, in other words, have digested all of the positive soundbites coming from various media sources and have concluded unanimously that they are underexposed to equities.
And this note from Bank of America courtesy of ValueWalk:
ETF buying by Bank of America’s retail clients was the fourth largest in the bank’s data history for the five trading days to 17 December. In the prior week, the bank recorded its greatest ever level of ETF buying among retail clients.
This bullish behavior is being caused by “bell ringing,” which creates a problem for investors who are choosing to listen. The bell ringing comes in the form of the comfort created by new government suddenly making it safe to invest in equities. The proverbial dinner bell is being sounded for investors who only seem too eager to listen.
What's on the horizon, however, are events that are extremely difficult to gauge appropriately while being inherently volatile in nature. By no means does this mean that the bull market is finished. Rather, the bull market will be putting together some ferocious tests of the hearts and minds of investors who have only been too eager to embrace its song.
In the face of this eventuality, those who are underexposed to equities would be ill-advised to increase their exposure during Q1 2017, despite the fact that markets may continue to rally for the first half of the year. Those who are adequately exposed to equities have incentive to reduce exposure in the months ahead, knowing that buying opportunities await as volatility increases after Q1.
While I am taking a cautious tone in my outlook given the new landscape of volatility that awaits investors, the long-term prospects of this bull market remain largely intact. The mad rush of capital away from fixed income into equities may be on its first legs here, depending on a lack of surprise events taking place on the geo-political front. What we have experienced in recent years has been a long-term distrust of equities. It would be wrong to take the simpleton contrarian approach, thinking that since bullishness has suddenly returned, the markets will simply top out around current levels. Yes, the short to intermediate term could be fairly dicey.
And 2017 will indeed bring its fair share of surprises that cause more downside than most are comfortable with. However, the long-term reasons to remain substantially exposed to equities remain intact. In fact, they not only remain intact, but have strengthened given potential policy measures that will be in place over the next few years. Those investors who can withstand the volatility while taking a long-term approach to the markets will continue to fare the best in 2017 and beyond.
