Is it safe?

With recent equity weakness, investors have to ask themselves if supporting long equities is still a safe bet.

Marathon Man is one of my favourite movies. It fits into the genre of 1970s paranoia movies such as The Conversation, Chinatown and Three Days of the Condor. Those movies represented a cultural reaction to America’s unsettling status at home (Watergate) and abroad (Vietnam). The film’s central scene pits Laurence Olivier (as an elderly ex-Nazi war criminal) against Dustin Hoffman, (playing a student whose CIA brother has been hunting Olivier). Olivier kidnaps Hoffman and straps him into a chair to torture him with a dentist’s drill. Olivier asks “is it safe” for him to retrieve money from his illicit bank account. Poor Hoffman doesn’t know what Olivier is talking about. 

Today, in early 2019, equity investors are confronted by the same question: is it safe? Over the course of 2018, US equities dropped by 7%. Irish equities dropped by a startling 22%, which was met by indifference from the Irish media and political classes. This dramatic fall in Irish equity values has passed by with little public commentary. 
These are the same classes who populated the room on the night of 29 (to 30) September 2008 when the Irish government decided to guarantee the liabilities of Irish banks. That decision was based on the proposition that our banks were merely suffering a funding crisis rather than a solvency crisis (resulting from the market value of banks’ loans falling far below their book value). A cursory glance at the share price chart of the main Irish banks back then would have revealed that they had already lost three quarters of their peak value prior to Lehman Brothers becoming insolvent. Conclusion: markets often know more than supposed experts. 

Is it safe? All we can do is examine the possible reasons for recent market weakness and consider the balance of market forces likely to prevail in 2019. There are several factors that may explain recent equity weakness:

• High equity valuations – on several long-term measures, such as the cyclically adjusted price earnings ratio, equities look richly valued. However, two caveats must be noted. First, while valuation levels offer a good indicator of prospective returns over three years and longer, they are poor indicators of likely returns over shorter periods. Second, equities look reasonably valued based on some valuation metrics, such as prospective price earnings.
• Tighter monetary conditions – across the globe, central banks are tightening monetary policy whether through withdrawal of quantitative easing or outright interest rate increases. The danger is that central banks will overdo it and tip the global economy into recession. Recent comments from Fed chairman, Jerome Powell, suggest the Fed is alive to this risk.
• Recession danger – we are already very long into the current global recovery cycle. Several reliable American indicators (the unemployment rate and the yield curve) suggest the next US recession may happen by 2020/2021. But it may come even sooner. Just two months ago, JPMorgan reported a 60% chance of a recession within two years, and stated in early January that “US equity, bond and commodity markets appear to be pricing in on average close to 60% chance of a US recession over the coming year.” 
• Brexit – as the clock ticks down to 29 March, the prospect of a hard, no-deal Brexit is growing. That scenario could tip an already weak European economy into recession. This factor may be weighing especially (and probably mistakenly) on Irish equities.

Is it safe? No, it’s not. But I remain optimistic about the prospects for equities in 2019 for two reasons. One, this is not at all what a stock market top looks like: investors are frightened rather than euphoric. Two, the US economy continues to perform strongly. I sense the next US recession is still some years away. That’s why I’m still long equities.  
Cormac Lucey is an economic commentator and lecturer at Chartered Accountants Ireland.