- Investors are very optimistic in bull markets and allocate much of their portfolio to stocks, increasing their risk.
- Analysts and economists expect more spending which will consequently push GDP and inflation up, but low rates push people to save more for their retirement.
- If the GDP and earnings don’t grow as expected, we could see a bear market in 2017.
Stock markets keep going up while fundamentals keep going down and the economic situation isn’t that great either. The S&P 500 is dancing around new highs despite corporate earnings for Q2 falling by 3.6%, and the economy only growing by 1.2% on an annualized basis. Economic growth for the whole of 2016 is only at 1%.
So, what is pushing stocks higher? The simple answer is optimism. It is assumed that next quarter’s earnings will be exceptional and economic growth will blow off the charts. In this article we are going to elaborate on the forecasts and assess their probability in order to take a look at what optimism can do to investors.
Being an optimist is nice. Optimists are happier, have a more positive view of the world, are ready to take risks in life and optimism helps one to cope with life’s uncertainties. We can say that in life, it pays to be an optimist. On the stock market it also pays to be an optimist but it pays even more to be a rationalist.
An old research project (1999) by behavioral scientists Benartzi, Kahneman (Nobel prize) and Thaler explains perfectly how investors approach stock markets after a few years in a bull market. Based on 1,053 Morningstar subscribers of which 84% were male with annual household income averages of $93,000, they found that investors had an average allocation to stocks of 79%, and 95% of their pension contributions were directly allocated to stocks. This bullishness derives from investors’ optimism. When asked what they focused on when thinking about financial decisions, a staggering 74% of investors focused on positive returns.
Figure 1: Thinking about potential return or potential loss. Source: Behavioral Finance.
By being an optimist, you make bold investment decisions, but investors should also think about risks. Don’t forget, one of the most quoted of Buffett’s pearls of wisdom is: “Rule No. 1: Never lose money. Rule No. 2: Don’t forget rule No. 1.” The reason behind this rule is that if you lose 50% of your investment, it takes a 100% return just to get you even.
Yes, earnings have declined and the economy isn’t growing fast at the moment, but analysts are highly optimistic that in the next quarter or the one after that, everything will grow. On June 30, most analysts expected earnings to return to growth in Q3 2016. Now analysts expect a 2% earnings decline in Q3 2016 and don’t expect earnings to return to growth until Q4 2016.
Figure 2: Forecasted earnings growth for Q3 2016. Source: FACTSET.
The same analysts that consistently revise their estimations downwards as actual earnings results are released expect S&P 500 earnings to grow 13.3% in 2017. At the end of June, the expectation was at 13.5%.
Figure 3: Forecasted earnings growth for 2017. Source: FACTSET.
The expected increase in earnings comes from an expectation that oil and other commodity prices will inevitably increase and push earnings higher, and that no sector will see earnings decline.
Additionally, GDP is expected to grow at a rate above 2% from this quarter onwards. The current 1.1% yearly growth is just a temporary slowdown according to interviewed economists.
Figure 4: Forecasted GDP growth. Source: Wall Street Journal.
But not all economists agree on that rosy view. Economist Stephanie Pomboy stated that analysts and economists are wrong because they use pre-financial crisis frameworks to make their estimations and the world has changed a lot since then. Despite the fact that interest rates have severely declined, people spend less and save more. Less spending means inevitable declines or slower GDP growth.
Figure 5: Total saving U.S. deposits. Source: FRED.
Why are people saving more? Well, with lower interest rates you need to save more to reach a satisfying level of income for retirement. As the population is getting older, they will save more and more. This speaks to how low interest rates have been beneficial for businesses but very detrimental for savers and an aging population.
In such an environment we cannot expect GDP growth and earnings to increase just because interest rates are low as it is clear that low interest rates have not worked thus far to stimulate economic growth.
If the GDP does not reach the expected 2% growth rate and corporate earnings continue with their decline, Pomboy sees a bear market in 2017, especially in discretionary stocks.
Discretionary stocks have really high PE ratios and, yes, if the growth from the past 5 years continues, those ratios might be justified, but any kind of bad news could quickly send those stocks down. Amazon (AMZN) has a PE ratio of 188.4, Home Depot (HD) 23.8, Starbucks (SBUX) 30.9, and Nike’s (NKE) is at 27.3. All these stocks could easily fall more than 50% if a recession comes along or people spend less because of their high valuations based on optimistic future projections.
It is good to be an optimist, but in investing it is also good to be a realist, or a diversified optimist. A diversified optimist is an investor that is positive about his returns, fully invested but well diversified among various uncorrelated assets and prepared for any economic environment.
The main point of this article is for you to assess your optimism and look at the risks in your portfolio. When you look at each component of your portfolio, ask yourself how much you can lose. Write that number down and then go through the list again and ask yourself how much you can gain. Where the potential risk is much higher than the gain you might want to look for other assets.