“Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria” – Sir John Templeton

 

With the volatility from February now tamed by Q1 earnings, a pervasive belief among portfolio managers has clearly emerged: it is phrased roughly as, “we should keep dancing, but with our eyes on the exit”.

To me, the most bothersome aspects of this are the obvious group-think risk, and the fact that I nevertheless find myself to be of the same mindset. Having lived through this phase of previous economic cycles in an institutional trading environment, I found the following discipline to be important to profitable survival:

1. Double down your research efforts to truly bulletproof your beliefs;
2. Articulate your resulting, unwavering market thesis; and,
3. Rigorously review every position that you own to ensure that it harmonizes in all aspects with your thesis.

At first glance, this list looks like what you would expect a good portfolio manager to always be doing. In fact, it is very different – good managers generally form their theses, and then constantly use new developments and market feedback to try to prove themselves wrong. By contrast, during periods like the one that we have entered, I find that you need to define your thesis with high confidence, and then ignore the feedback.

 

The reason is that the transition from Sir John Templeton’s optimism to euphoria is bumpy. I am not the only portfolio manager who is aware of the group-think risk that surrounds my beliefs; all of us are (or should be) aware, and that very naturally leads to jittery decision-makers. After all, aren’t our eyes supposed to be on the exit? The inevitable result is sharp, equity market moves that lure less confident investors into crystalizing losses in the late stages a strong market. Excellent examples include the Asian crisis in 1997, Long-Term Capital Management in 1998, and Black Monday in 1987.

 

So, my belief? Equities will continue to run until US rates are at a minimum 1% higher, together with the Fed signaling an intent to continue hiking, and with moderately higher inflation levels than today.

 

The most recent evidence for this view is the now-completed earnings season. Almost all S&P 500 companies have now reported, with over 75% reporting better-than-expected earnings and sales growth (i.e. it was not a simple tax-cut story). Recall that analyst estimates for this quarter were already very high. In the event, Q1 earnings gained 25% YoY, and interestingly, global companies reported even better growth than domestics. As a result, the 12-month forward P/E for the S&P has fallen to 16.5x, which while above average is certainly not yet euphoric by historical measures.