Investors beware: the warning light has begun to flash amber

Warren Buffett recently observed that markets can quickly turn from green to red, without pausing at yellow.  It was a veiled warning that when valuations are at extremes – as they are today – it doesn’t take much to trigger something serious.

We’d argue that the rewards for being fully invested today do not outweigh the risks.  Another way of thinking about it is that when you pay a high price for an asset you are locking in low returns. Those low returns might be volatile, or they may be smooth but it is an inescapable truth of investing that the higher the price you pay, the lower your returns.

It’s also worth remembering that a period of very strong returns that exceed long term historical averages, is borrowing returns from the future. For example, if the long run average return of the stock market is, say 9 per cent, and you have just enjoyed few years of 30 per cent returns, you can be almost certain that the long run average will stay at 9 per cent and therefore future returns won’t be anything like 30 per cent.

I have written previously about the boom, and associated world record prices, in assets that produce no income. Things like art, wine, collectible cars, licence plates, coins and stamps have sky rocketed amid punitive returns on cash and a strong fear of missing out. This boom in collectibles is an amber light.

Another amber light is the ominous warning from the massive shift in credit market interest rates over the last few months, much of which has received little attention.

Corporate bonds have been selling off at a faster rate than government bonds, widening the spreads between them to the largest difference in six months and at the same time these investment grade US corporate bonds are trading at their highest yields in six years. So while equity investors flirt with all-time highs, their bond counterparts are evacuating, demanding higher returns.

These interest rate changes have occurred under the noses of share market investors who have recently plunged more money into exchange traded funds that at any time ever before. In the United States the lover affair with technology stocks such as Facebook, Twitter, Netflix and Google parent Alphabet was reflected in a single week injection of $3.3 billion being pumped into the PowerShares QQQ Trust Series 1, the biggest exchange-traded fund tracking the tech-laden Nasdaq 100 index. Equity investors also poured a weekly record $34 billion into equity ETFs in the week ending March 16.

We could say that irrational exuberance by less sophisticated investors – those who are unaware of bond market sentiment, is itself another amber light.

Further alarm bells should be triggered by recent moves in several markets you may not have heard of.  One of those is the TIPS market (Treasury Inflation-Protected Securities), another is the recent spike in LIBOR and the LIBOR-OIS spread (Overnight Index Swap), which has more than doubled since January to levels last witnessed during the GFC. The three-month London interbank funding rate, which some of the world’s leading banks charge each other for short-term loans, rose to 2.27 per cent recently, the highest since 2008.

Putting aside the impact on investor sentiment, the rise in LIBOR will make funding more expensive including for Australian banks where funding costs are on track to experience their biggest monthly funding increase in nearly eight years.

These are signs that monetary policy has tightened considerably and that rising rates for private borrowers are already occurring and may be a bigger concern than whether central banks raise rates or not. Moreover, growing nervousness in credit markets will add to the stress associated with trade tensions and growing talk of inflation and tightening monetary policy.

With stock market earnings multiples at historical extremes in the US – a market whose sneezes cause colds here in Australia – and with volatility at all-time lows, it is very likely we will see a return to normal levels of volatility and historic returns. This is because when volatility increases, investors demand higher returns to compensate. In order to receive those higher returns, they need to pay lower prices and so PE ratios fall.

It could be some time before the light turns from amber but investors might remember not everyone will be able to cross the intersection before it turns to red.

The Montgomery Global Funds own shares in Facebook and Alphabet. This article was prepared 03 April 2018 with the information we have today, and our view may change. It does not constitute formal advice or professional investment advice. If you wish to trade Facebook or Alphabet you should seek financial advice.