Got a view on equity markets? Three things you should know

Stephen Arnold

Aoris Investment Management

The three indicators that investors most often use to inform their view on equity markets provide signals that are fuzzy at best. In this wire we explain why valuation, duration of the upcycle, and expectation of a recession can misinform equity allocation decisions.

1. Valuation

Are market aggregates expensive? Do pricey markets suggest you should reduce your allocation to equities. Market multiples are a lot less helpful than you might think as a market timing signal.

In the following chart we show, for each month since 1950, the Shiller PE relative to its full history from 1871 up until that particular month. So, for example, in 1985 the US equity market, measured by the Shiller PE, traded on about 0.7x its average for the period 1871–1985, while in 2005 it was valued at about 1.6x its average of the period 1871–2005. The red dots indicate the 17 market peaks prior to declines of 10% or more.

It is interesting to see that the three US equity corrections between 1976 and 1981 occurred when the market was trading at abnormally low valuations relative to a long-term history. The GFC market crash happened after valuations had become significantly cheaper than the prior 10-year period. In 1992 an investor may have observed that since 1950 the Shiller PE had been below 1.3x its long-term history 85% of the time. They may have decided to use a relative Shiller PE of 1.3x as a sell signal. Had they done so they would have been out of the equity market for 23 of the next 26 years.

2. Duration of the upcycle

A second pointer that investors often use when seeking to time an exit from the market is time itself, i.e., how long the market has been appreciating. Is the market cycle ‘long in the tooth’, or is there ‘plenty of runway left’?

You can see from the above graph that time itself provides no reliable exit signal. The number of months between US equity market troughs and the next market peak has ranged from 12 to 93. After 1990, 30 months might have seemed like the point at which the equity hourglass had run out and was a good time to sell. Had an investor followed this rule, they would have sold more than five years before the market peak in 1998 and three-and-a-half years prior to the October 2007 peak. The investor would have sold in September 2011 after the market had already fallen 12%, and would have exited four-and-a-half years prior to the September 2018 sell-off, over which time the US equity index doubled.

3. Recessions

There are lots of sensible reasons to expect trouble ahead for the world economy, not least of which are trade and geopolitical tensions. In fact, on October 15th the IMF downgraded its outlook for world GDP growth to the slowest rate in over a decade.

This would seem to have significant implications for investors. The US has been in recession on ten occasions since 1950 and in every case an equity market correction followed. So, if you can anticipate a recession you can dodge an equity market bullet. When it comes to forecasting recessions, though, history is not encouraging. Taking the IMF’s work, of the 469 recessions across the globe in the last 30 years, the IMF anticipated just 3% in the year prior to the economic decline. The inherent complexity in economic behaviour means anticipating recessions is just plain hard, undermining its usefulness as a market timing tool.

Investing conservatively without timing markets

Having a market timing indicator that works every now and then is not enough. Repeatability is key. If valuation, duration of the equity upcycle and forecasting a recession can't provide reliable market timing signals, what’s one to do? At Aoris, we don’t attempt to time markets. We don't even have a view on market aggregates. We own businesses. We do seek to protect capital through avoiding businesses – at all times - where periods of economic or market stress may result in the permanent loss of capital, not just a temporary dip in the share price. These include banks, commodity business and highly indebted companies. 

Stephen Arnold
Managing Director & Chief Investment Officer
Aoris Investment Management

Stephen founded Aoris Investment Management in 2017 and has been investing internationally for around 25 years. Prior to Aoris, Stephen was Head of International Equities at Evans & Partners where he directly managed $1bn of client assets.

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