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June 23, 2014

Summer of irrational exuberance: what to do if there is a melt-up

“There is no training, classroom or otherwise, that can prepare for trading the last third of a bull market” – Paul Tudor Jones

Global stock prices at all-time highs, global bond prices at all-time highs, volatility across asset classes at cyclical lows and sculptures of inflatable dolphins are now selling for $5 million (though that probably still counts as a bargain since the same artist sold an inflatable dog last year for $58m). Signs of excess in many places are undeniable.


Why is that a problem? Because the Fed might be forced to act due to speculative excesses in financial markets rather than because the real economy is doing much better. The Fed is in a classic Catch 22 – if it doesn’t act (which is likey given the dovish statements from key Fed members) we could see a melt-up in the price for financial assets (and inflatable dolphins), if it raises rates, it risks killing off the feeble US economic recovery.

Where do we stand today in terms of valuation for the equity markets? At 1965, the S&P 500’s trailing operating P/E ratio is 18.1x. At the previous peak in October 2007, with the S&P 500 at around 1565, the trailing operating P/E ratio was 17.1x.

Most markets look expensive to us but it is important to point out that valuation in itself is not a good timing indicator. As David Merkel correctly remarked once „Valuation is rarely a sufficient reason to be long or short the market. Absurdity is like infinity. Twice infinity is still infinity. Twice absurd is still absurd. Absurd valuations, whether high or low, can become even more absurd if the expectations of market participants become momentum-based. Momentum investors do not care about valuation; they buy what is going up, and sell what is going down.“ Today, we view the equity and credit market as being in a typical momentum-driven phase.

What should investors do?

  • Be contrarian. Understand which markets are probably most over-bought and reduce exposure there. Generally all types of income vehicles fall into that bucket. What else has been popular? Frontier Markets, Biotech, low volatility funds. What’s still not on every investor’s radar screen? Japan or cyclical stocks for example.

BoA Fund flow high for credit and income producing equities

  • Move up the quality curve, i.e. buying quality large caps while reducing small-caps seems like a good strategy to us. Noted value investment company GMO for example forecasts a significant 7% p.a. return differential in their 7y forecasts for US high quality equities relative to US small caps equities. It is important to understand that we do not advocate investors to exit equity markets – howerver, we think they should be more selective.

GMO 7y May

  • Exploit relative value opportunities. European equities trade historically cheap relative to US equities as they have lagged the US market over the last few years.

BoA US Equities vs EAFE

  • Avoid illiquid investments – unless you get really paid for it. Central banks  are focusing their bubble watch on leverage and the banks, and will ignore others, but may miss vulnerability to liquidity. By migrating risk assets from levered, but liquid holders (banks) to unlevered, less liquid real money, the world has reduced leverage risk, but has raised liquidity risk. We continue to prefer liquid over less liquid risk assets.
  • Hedging. Typically only after the froth blows away and asset prices fall, will investors remember to hedge their portfolio. The better time is obviously before, since hedging costs much less during calmer times. The collective bet aka consensus currently is long liquidity and short vol, or expressed as an asset class, we would say long credit. Hence a good hedge would be short credit. The Barclays Euro Corporate Bond index has an effective yield of only 1.4% and a modified duration of 4.6x – carry costs would appear cheap to us,



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