Bull markets are said to climb a wall of worry. Since early 2009, this has been the case as equity markets have been grinding their way higher, two steps forward, one back. The underlying trend has been up, supported by valuations and economics, but investors are still mindful of the crash of 2007/9 and unforeseen events (e.g. the Russian/ Ukraine conflict, collapsing oil and commodity prices, the sharp appreciation of the Swiss Franc etc) can undermine confidence in and have an adverse effect on markets from time to time.
These events generate fear and uncertainty across the investment community and prompt nervous investors to sell while many others suspend buying as they assess the impact of the latest crisis. This leads to a temporary supply/demand imbalance in the market – more shares are being sold than bought and lower prices result. But once the dust has settled, investors revert to fundamentals and focus on those investments, up to now equities, that offer the best long-term returns.
Some investors are concerned that the current bull market is now quite long in the tooth but there are good reasons to believe that it can continue, as rest rates and depressed oil prices help economies and companies in turn to grow.
Aside from fostering a better business climate, low interest rates allow large companies to raise long-term finance at very attractive rates, circa two per cent and this opens up all kinds of investment opportunities through organic growth and takeovers. Companies can also boost earnings per share through financial engineering – by replacing expensive debt with cheaper debt or through buying back their own shares. In summary, the prospects for profit growth are excellent.
Then you look at the alternatives open to investors. The biggest home for investor funds is the world bond markets – approximately twice the size of world equity markets. What do these bond markets offer today? You can invest in a ten-year German Government bond and receive a meagre fixed income of 0.3 per cent per annum – well below the ECB inflation target of two per cent. Alternatively, you can invest in a basket of European blue chip companies, which are reasonably valued, and receive a dividend of circa three per cent per annum, which should grow over time as profits increase.
This is a very unusual situation – historically bond yields exceed dividend yields. Today, it is the direct opposite by a country mile, particularly in Europe, and this is very supportive of equity markets. Are long term investors going to favour German bonds in preference to stocks paying decent dividends? In reality, bond markets make equities look good.
Equity markets will, undoubtedly, suffer further setbacks as new crises emerge, but, after the dust has settled, investors always return to the basics – where can I get the best risk adjusted return? Unless the crisis is of such magnitude that it alters the underlying economics currently supporting the equity markets, the upward trend should persist. The speed with which markets have bounced back in the past two years indicates the underlying strength of the market. In each case, buyers saw the crisis as an opportunity to buy.