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What to do when bull markets become bubbles

In 2017, Apple stock hit repeated new highs as its star product, the iPhone X, smashed sales forecasts
In 2017, Apple stock hit repeated new highs as its star product, the iPhone X, smashed sales forecasts
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The key question for investors centres on exactly when equity bull markets become bubbles, primed to fall into bear territory? Let’s explore together what unlikely, but feasible, events are not priced by markets for this year.

First, US inflation returns with a bang, forcing the five rate rises, ending 2017 with Fed Funds rate of 3 per cent. Whilst everyone expects it to be slow and steady, inflation could well be fast and furious.

US equities hit record highs in 2017, but the difference between ten-year and two-year US government bond yields has dropped below 0.60 per cent for the first time since November 2007 as short-term yields are moving up as the Fed raises rates, but a subdued economic outlook is keeping long-term yields anchored. Few analysts see much shift in this paradigm, with eyes glued to see “when” the spread enters negative territory, a harbinger of recession.

But consensus view is not pricing in the fact that markets may well be missing the woods for the trees. With the Trump administration finally getting tax cuts passed, infrastructure spending may be soon to follow. All of this could well see inflation surge to 3 per cent, forcing “soft-spoken” Jay Powell to overcompensate with a roaring monetary correction.

Second, will this year mark the decline of the world’s most powerful company? In 2017, Apple stock hit repeated new highs as its star product, the iPhone X, smashed sales forecasts. Apple experienced 2017 gains of 50 percent, and its market capitalisation now exceeds $900bn, by far the world’s most valuable publicly-listed company, worth more than Exxon Mobil, Procter & Gamble, Coca-Cola and Goldman Sachs combined.

What’s not being priced in is that sheer momentum, excitement, and short-sightedness have left the market complacent. Apple owns virtually no physical assets, relying solely on intangible design and software assets, two of the most difficult strategic beachheads to defend. For Apple to defend its position would be a remarkable feat, particularly as it has not innovated much beyond the iPhone. The history of Blackberry and Nokia provide plenty of precedent that companies in this space can appear impregnable, while being anything but.

Finally, oil price. One of the areas of consensus in markets is that oil prices will oscillate between $50-$60 and it is perfectly logical. Higher prices will draw in more US shale production, leading to oversupply and falling prices. The falling prices will help correct the oversupply. The supply and demand dance should keep oil prices steady.

However, the International Energy Agency (IEA) has lowered its oil demand forecast for this year, attributing this to a 60 per cent rally in prices since June. The IEA expects non-OPEC production – mostly from US shale producers – to increase again next year by 1.4 million bpd. A rightward moving supply curve and a leftward moving demand curve lead to a lower equilibrium price, particularly in tight, elastic markets.

Furthermore, a pillar of the crude rally through 2017 has been the OPEC-led production agreement.

Prices were languishing in the mid-$40s when it was initially agreed; now they are in the mid-$60s.

Its success was predicated on two critical factors. One, the participants not cheating. The other, US shale producers not increasing production in response to higher prices to mitigate the cut. The latter has already happened. The former may well happen this year – with Russia, Saudi Arabia and others running huge budget deficits, the urge to cheat on the agreement may well prove irresistible.

To conclude, markets may be surprised by these hypotheticals this year, or in fact by innumerable others.

There are reasons to remain optimistic and expect the current momentum in equity markets to continue, supported by a strong global economic backdrop.

However, current valuations should temper expectation, making a well-grounded and well-diversified portfolio desirable.