Valuations are stretched and economic data is cooling, yet markets are complacent. Why? The following are rationalizations of current market values.
1.) Massive movement from active management into passive strategies. Why pay someone to under-perform the S&P 500? Passive investing implies no trading, which means less volatility.
2.) Increased regulation has permanently caused a decline in the riskiness of markets. Insurance companies and financial institutions no longer have autonomy over what they can invest in. With more oversight comes less risk…
3.) Lower interest rates globally have caused investors to flood into riskier assets. With more investors seeking risk, demand is high, creating inflated but stable asset prices. Argentina, who has defaulted on Government debt SEVEN TIMES, just issued a 100-year bond at a 7.9% yield. Demand for the high yielding asset was strong.
4.) JPMorgan estimates that stock pickers account for just 10% of trading volumes, with 60% done by quantitative trading strategies and passive investing. With more trading done by ’emotionless’ quantitative algorithms rather than hot-blooded traders, market risk has declined permanently. We’re in a “new normal” of low volatility and interest rates. Sounds firmiliar… *cough* Tech bubble in 2000 *cough*
5.) “Stocks always go up.” 😉
6.) Quantitative Easing in Europe and Japan cause inflows to higher yielding assets. The Bank of Japan (BOJ) or the European Central Bank (ECB) pumps liquidity into markets through open market operations (bond buying initiatives). Sellers of the bonds use the Yen or Euros to buy US Dollars. They use the Dollars to buy equities and debt. QE by foreign governments is inflating assets prices. As they continue to ease, i.e. flood markets with liquidity, we should see the trend continue. However, we have seen the USD decline since December ’16. Keep an eye on foreign monetary policy moves. A sudden move by the ECB or BOJ might cause fluctuation in US asset prices.
Thanks for reading.