The start to 2018
Globally, 2017's momentum continued into January, especially in the USA. The US market (S&P500) reached new records, and finished up 5.6% for the month of January (even after the breather in the last few days of the month).
By contrast, market conditions were weak in Australia. The All Ordinaries finished flat (actually -0.3%) for January.
Outlook for the remainder of 2018
Market valuations, both here and in the USA, indicate a correction should not be unexpected in 2018. The current forward P/E of the US market is 18.6x (source: Yardeni Research, Inc, Global Index Briefing: MSCI Forward P/Es, 17-Jan-18), i.e. expensive. The trigger for a correction is difficult to predict. We are conscious that the US bond market tightening could be quicker and more aggressive than generally anticipated, which would likely have ramifications – including for equity markets.
There are two notes of caution in relation to this though: Globally (not talking Australia) economic growth is quite reasonable. Growth projections in the US are robust, and will likely be further supported by the Trump tax cuts. The current US reporting season is delivering upgrades to future earnings expectations – it has been a while since upgrades have been the order of the day, instead of downgrades. It is easier to sustain a higher market valuation when economic growth and growing company earnings are coming behind to support it.
Additionally, markets could very well have a run of irrational exuberance before they do correct. Adding another, say 20% return in this situation would not be surprising.
Given this, doing something like ‘cashing up’ now is dangerous.
In regard to Australia, the market isn’t as overvalued. But there are some challenges (e.g. softer housing market feeding through to banks, nominal GDP per capita). And it isn’t cheap (forward P/E 16.2, source: Yardeni Research, Inc, Global Index Briefing: MSCI Forward P/Es, 17-Jan-18). This means the correction risk cannot be dismissed here either.
Given the uncertainty as to how markets could play out in 2018, how do we manage your investments? The same approach as always. We invest in individual companies, which are on favourable valuations. These are more resilient in a downturn – i.e. will usually fall less than high P/E stocks. Additionally, we have a high cash balance (~17.9% as 31-Jan-18) so we can take advantage of opportunities that a correction, or any other situation, may present.
Please note that the high cash balance is not driven by fear of a correction. Rather, by it being difficult to identify opportunities that meet our investment criteria, especially in the large-cap space. But it is symbiotic – it is harder to find the opportunities when the market is overvalued.
Over time, we are confident our investment approach will continue to deliver favourable equity returns (noting short-term volatility in both prices and performance should be expected).