Tuesday 20 February 2018

2018 Why Greece is the word and volatile markets are a certainty

Greece has been in a desperate place for many years and the stock market has plummeted — but the economy is slowly turning around. Photo: emk(c)
Greece has been in a desperate place for many years and the stock market has plummeted — but the economy is slowly turning around. Photo: emk(c)

Paul Sommerville

The financial markets have never been quieter. By any measures, the stock markets are booming - but what is very rarely brought to the fore is how the latest moves have been accompanied by exceptionally low volatility. The Dow closed at an all-time high 71 times in 2017, more than any other year in history. The S&P 500 has now risen for 14 months in a row.

This has never happened before.

The S&P 500 has not had more than a 3pc draw-down in over 13 months, by far the longest run in history. If the S&P 500 goes a couple more weeks without a 5pc pull-back, it will set a new record for longest in history. Over 95pc of trading days in 2017 in the Dow Jones had an intra-day range (high to low) less than 1pc, the least volatile year in history. At 2.8pc, the largest draw-down in the S&P 500 during 2017 was the second-lowest in history, trailing only 1995.

The volatility in stocks and bonds was lower than any one-year period.

The CAPE ratio - the cyclically adjusted price-to-earnings ratio - is near 33, according to Robert Shiller, Nobel prize winner and inventor of the ratio (also called the Shiller P/E ). This is in the 97th percentile - similar to 1929 and higher than the 2007 peak.

There have only been a handful of occasions when we traded higher - in early 1929 and during the dot.com bubble. Going back to 1871 when the data begins, the average CAPE Ratio is 16.80.

Please note this ratio does not signify that an immediate drop is around the corner. Long periods above or below the average are not uncommon but it does signify that if we were ever to retreat to the average, then it is certainly a long way down.

At 100 months and counting, the current expansion is already five years longer than the average expansion dating back to 1854. The average length of an expansion has increased notably over time. From 1854-1919, the average lasted a little over two years.

This increased to almost three years from 1919-1945. By comparison, recent decades have seen a golden era for uninterrupted growth. The last four US expansions have averaged eight years.

It must be noted that similar to overvaluation, an economic expansion that is longer than average is not a reason to expect a decline in stocks. These are not timing indicators, but rather warning beacons.

We have gone from fear to enthusiasm to greed and are now clearly in the delusional phase. The lack of volatility is lulling investors into preposterous complacency. Whether you believe stock markets have further to run up or are due some sort of pull-back, investors must be aware that 2018 is very unlikely to be as quiet as 2017.

You must prepare for an increase in volatility at the very least.

Real returns vs dollar returns

The US stock markets have outperformed their European peers in 2017 in percentage terms. However, we warned in the summer that Irish investors will need to take notice of the euro vs dollar exchange rate if trading US shares, as the exchange rate can play havoc with returns in real euro terms, once they transfer gains (apparently nobody makes losses any more in the stock market!) home. This will remain the case in 2018.

The exchange rate appreciated over 14pc in 2017. An Irish investor in US stocks or any dollar-based investment, such as oil, would have to have seen their investment rise by 14pc before they actually break even in real euro terms in 2017.

We suggested that Irish investors would be much better off sticking with EU equities, rather than their "overvalued" US counterparts in general terms (there may, of course, be certain companies you like, regardless of jurisdiction). That turned out to be a shrewd course of action if you chose it.

The percentage gains in European equities were lower but the real gains were higher for Irish investors. The exchange rate is harder to call at this juncture.

We closed the year at 1.20 and the consensus view is for more gains. My feeling is that we will likely test the downside this year at some point. If you see dollar strength (ie euro vs dollar lower), then it may be a good time to sell those US equities you are holding on to for dear life.

Greece is our tip for 2018 gains

People sometimes have a misguided view that those killjoys who suggest the US stock markets are wildly overvalued or who hold generally bearish views on markets are sitting under their desks, huddled between their guns and beans, waiting for the big one.

In order to dispel that scurrilously rumour, I we would like to share with you an investment theme that we have been putting forward to our subscription service for many months and one that we believe may benefit those Sunday Independent readers who would like to add a little risk to their portfolios in 2018 - to spice up their investment lives, so to speak.

It is not for the fainthearted and major volatility should be expected but ultimately we suggest it could be hugely rewarding. Okay, take a deep breath...

Our trading recommendation for 2018 is to buy Greek equities.

They have risen 40pc in 2017 and 14pc in the fourth quarter alone. We would suggest that they have potentially much further to go yet.

Greece has been in a desperate place for many years and the stock market has plummeted. But things are improving and the economy is slowly turning around.

We are not expecting miracles, but rather that the improvement will continue.

Greece is returning to the bond market and its bond yields have fallen dramatically, so confidence is returning.

The country can now borrow money for two years at lower rates than the US.

We do not consider that we are trying to pick the bottom in Greece. This trade has been on my radar for a long time but in my view it was better to wait and jump on board when the market was rising, hence we only felt comfortable recommending it in 2017.

The narrative on Greece is changing and it is possible that the harsh austerity imposed may be relaxed with new leaders such as Macron in place. Also, with Merkel having won again, she does not need to be seen as tough on Greece. It is a simple fact that Greece is just not as important or an interesting topic politically - that means the possibility of them being treated better improves.

Lastly, as readers already know, our view is that world equity markets may be in for a turbulent time over the next few years but we see this trade as relatively uncorrelated to global equity prices.

If the government collapses in Greece in 2018 (something I think is extremely likely) and the stock markets plummet, this would be the ideal entry point.

Keep an eye on Greece.

Paul.sommerville@sam.ie

Any investment commentary in this column is from the author directly and should not be seen as a recommendation from The Sunday Independent

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