“Hi David Hope you are well. You have been clearly flagging this pick up in volatility over recent weeks based on the deteriorating breadth, lack of a 10% correction in the SPX for close to 2 years, other exogenous headwinds, etc. Are you concerned more fundamentally about the high cyclically adjusted P/E ratio of the S&P 500 (only historically higher in other instances which led to significant bear markets), and secondly the lack of economic growth in most areas? Also, what is your view on credit spreads? Is this a risk factor to keep an eye on as peripheral bond spreads in the Eurozone, and emerging market bond spreads have benefited from this super easy liquidity environment. Aside from buying autonomies, the growth of India and Vietnam into corrections (maybe also gold as a neglected out of favour asset class), are there any other strategies to look at?”

David Fuller's view

I am very well and thank you for the important questions, certain to be of interest to other subscribers. 

Wall Street valuations have been a concern for the last two years, although they were not high across all sectors and did not affect the broader market trends until more recently.  Additionally, sector corrections reduced some of the earlier excesses but we have now moved into a different environment. 

A frequent earlier theme of this service has been that many corporations were doing much better than the US or any other economy, not least because they did not have to deal with the worst problems, including unemployment.  Global Autonomies did best of all because they were benefitting from technological innovation and stronger GDP growth in some emerging economies, plus demand from their expanding middle classes.  Their earnings were also flattered by share buyback programmes. 

Today, many pundits remain quite bullish of earnings prospects for US and other multinational companies - too bullish in my opinion.  Yes, input costs from commodity prices have mostly declined, not least for crude oil.  However, we are experiencing at least a temporary slowdown in global GDP growth.  Europe is extremely weak and China is proving to be less of a vast opportunity, as previously perceived, since the government is increasingly squeezing out foreign (mainly US) companies, in favour of Chinese firms in which ruling officials have considerable personal stakes.  Also, a stronger Dollar is now a headwind for US corporate earnings. 

Regarding credit spreads, we should always keep an eye on them because they provide early warnings.  They do not appear to be much of a problem today, but we know from market history that this can change very quickly.  In fact, Greek 10-Yr Bonds yields are now rising.

I would only buy equities that you really like on a cautious basis, because this correction could easily morph into a cyclical bear market, somewhat bigger than we saw in 2011, which was little more than a correction of just over 20% for the S&P 500.  Leverage (margin debt) - thanks to Doug Short for this chart -is a much bigger problem today, not least in the US.  Costly geopolitical events from Russia tit-for-tat sanctions, to a lengthy war against Isil, and the scary Ebola outbreak will lower confidence and slow GDP growth.  The main counters to these problems are lower prices for crude oil and accommodative monetary policies.  However, the West is already overly dependent on central bank policies.

As for preferred investment candidates, Autonomies are an excellent, diversified choice but I would only buy when valuations are competitive.  I would not pay up for India but it remains an excellent long-term prospect, thanks to Narendra Modi.  China is a more developed and important investment vehicle than Vietnam.  I also like Japan following a shakeout, as we are currently seeing.  Gold, silver and platinum are indeed “a neglected out of favour asset class”, and also have hedge qualities. 

Lastly, I would hold some cash reserves because if we do see a cyclical bear market, we will be spoiled for choice.