2020 was a confusing year for me – on one hand, the pandemic created unprecedented uncertainty for everyone; but on the other hand, by end of the year, stock markets emerged up or unharmed by the pandemic. And now, with the arrival of vaccines, all of us are hoping that the worst is over. More than that, many investors are expecting the low interest rate environment to continue at least for the foreseeable future, if not until economic recovery is truly underway. This expectation or hope means that many will look to take advantage of this favourable investment environment albeit one artificially induced by government policies and will likely continue to load up on their investments in 2021.
That said, investors are very conscious of the ‘rational bubble’ as Mohamed El-Erian succinctly described current market conditions. He goes on to explain, ‘This is a rational bubble. It’s rational because the US Federal Reserve and the European Central Bank keep on signaling that they will continue to inject massive liquidity, and as long as the market is confident that that’s the case, it will drive prices higher”. The smart money says that when government intervention is finally removed, the challenges of ballooning budget deficits and inflationary pressures amid excessively high equity valuations will increase the risks of sharp market corrections.
So what’s the investor sentiment out there?
The chart below is Yale University’s valuation confidence index* which measures the percentage of the population who think that the market is not too high. What this chart shows is that the number of investors that think current valuations are too high is at near historical – and significantly more than the Great Financial Crash of 2008.
And yet, the US crash confidence index, also from Yale, which measures the percentage of the population who attach little probability to a stock market crash in the next six months, is also at near historical highs in terms of the sustainability of the current market run.
People see an overvalued market but don’t foresee a crash – it shouldn’t make sense; it’s a rational bubble.
In the questionnaire, Shiller asks: What do you think is the probability of a catastrophic stock market crash in the U. S., like that of October 28, 1929 or October 19, 1987, in the next six months, including the case that a crash occurred in the other countries and spreads to the U. S.? (An answer of 0% means that it cannot happen, an answer of 100% means it is sure to happen.
In this context, and as one exasperated investor said to me, “What do you do? I think the crash is coming. I have sat out of the market for most of 2020 and missed the run up in stocks”. I agree with him. Like many people, I think a major crash is coming. I believe the trigger will be when major governments stop pumping liquidity into the financial system. But I don’t know when they will take that step. So in the meantime, as I wrote In an earlier blog, I have suggested to my kids a 15% allocation to gold.