Caveat emptor

We have just finished the fifth full trading week of the year, yet it seems an awful lot has been packed into the past 25 sessions. We started with the assassination of Qasem Soleimani which spooked markets – albeit only briefly – and followed this up with the accidental shooting down of a Ukrainian aircraft in Tehran which further inflamed Middle Eastern tensions. The current big source of concern is the coronavirus which prompted a market sell-off last week but which has subsequently been reversed. Add to this the bizarre spectacle of the Trump impeachment, his subsequent acquittal and the travails of the Democrats in Iowa and you have all the ingredients for a classic risk-off market.

But not a bit of it. The US equity market reached an all-time high on Thursday, taking the year-to-date gain on the S&P500 to 2.7%. If it carries on at this rate (which it won’t) we are on track for another 20%-plus gain following last year’s 29% increase. Whilst market measures of implied option volatility are off their recent lows reported at the end of last year, they remain far from elevated (chart above). The VIX measure of equity volatility currently trades at 15.6 versus a long-term average of 19.1. A similar picture is evident in the fixed income market where the MOVE index ended the week at 61.2 against a long-term average of 92.7. Despite the recent increases, the extent to which investors have expressed their concerns about the long-term economic effects of the coronavirus suggests that recent moves look fairly muted in a wider context

Markets have thus looked through the recent concerns and appear to have concluded that the only thing they have to fear is fear itself. To the extent that the initial reaction reflected fear of the unknown, selling was a natural response but now the shock has worn off. However, it feels like the recent equity surge reflects nothing more than a relief rally. And relief rallies can run out of steam. After all, we have no idea what the near-term implications will be for the Chinese economy but it is unlikely to be good for corporate earnings. Reports from China point to significantly reduced activity as people stay at home, either by choice or as a result of state directive. Burberry has already warned about the potential hit to earnings and has closed 24 of its 64 shops on the mainland whilst ripping up its earnings guidance for the current fiscal year. They are unlikely to be alone as companies with significant exposure to the Chinese economy begin to assess the damage (other luxury goods producers and airlines are sectors which spring immediately to mind). Meanwhile, supply chain disruptions might well become more pronounced and as the hit to corporate earnings materialises, so markets will be forced to revise their expectations.

That said, if the situation mirrors the SARS outbreak in 2003, markets will be expecting a big rebound in activity in the second half of the year with the result that they may simply be looking through the (hopefully) short-term disruption. But we cannot be sure what will happen. Consequently it would seem prudent for investors to take some risk off the table. The fact that they are not doing so reflects the great faith they have in central banks to keep markets afloat with exceptionally lax monetary policy. The rational economist in me does not share that optimism, but viewed from the perspective of the market, the absence of decent financial investment alternatives suggests that any market correction is likely to be brief. If you are a forward looking rational investor, this is a good reason to stay in the market because you avoid the transaction costs associated with selling and buying back in again.

Having been burned in the past with regard to calling the market top I am reluctant to do so again. But a market where valuations look stretched is always going to be vulnerable to unexpected exogenous shocks and it may be that the coronavirus effect turns out to be the catalyst for a rethink. Even if it doesn’t – and there are good reasons to believe that much of the current concern is overblown – it should act as a warning sign that good times do not last forever. So far, the fact that the US economy is holding up continues to support the bullish case and although I do not believe that the economy will crack this year, it may pay to dance near the door in order to beat the rush if the stampede begins.

If ever an indication were needed that something is afoot, take a look at the rally in Tesla stock. Investors have shorted it for the last year, believing the company would struggle to deliver on its plans. Yet since the start of the year its price has risen by around 80% and its market cap now exceeds that of Volkswagen (chart above). Such a sea change reflects more than a simple shift in attitude towards electric cars and Tesla’s ability to deliver – that is a bubble waiting to pop. My natural investor caution is based on the premise that if something cannot continue to forever, it will stop. There again, maybe this time really is different. But they said that in 2000 and 2007 as well. Caveat emptor!