Have markets reached irrational exuberance?

This year has been a vintage one for investors. Global growth has been at its strongest since 2010, with both China and the eurozone surprising to the upside. As economic volatility has fallen, so too has market volatility, increasingly tempting investors into risk assets and feeding a growing sense of confidence. Performance has been almost universally positive across risk assets in 2017, with many equity markets delivering double-digit returns.

While these conditions are welcome, they also make me a little nervous. Strong growth and low inflation is a good mix but bullish sentiment and extended positioning tend to be precursors to a correction, and benign conditions make investors complacent to the risks they are taking.

Experience has taught me the right thing to do in this environment is to fade the rally and try to find investments that have been overlooked by others. That said, there have also been times when markets continue to rally, with those investors who faded too early leaving significant upside on the table.

Equity valuations are undoubtedly high by conventional measures but if you use a simple four-factor model to adapt the cyclically adjusted price-earnings ratio of US stocks for today’s environment, it suggests US valuations could have a further 30 per cent upside.

No one should take that analysis too seriously. Nothing lasts forever and some of those factors will look vulnerable in 2018. But it does suggest the current optimism is not yet fully priced in, and investors might want to pause before cutting equities too quickly.

Fortunately, there are ways to adopt a more cautious approach without sacrificing too much upside. While I have dialled down risk in some parts of the portfolio over the past couple of months, I have also switched into new areas which can better capture the shape of equity returns going forward.

Equity exposure

In this kind of environment, the shape of your equity exposure can be just as important as the actual size of that exposure. For example, just four stocks account for two-thirds of the move in the MSCI Asia Pacific ex Japan index over the past year. If you have missed out on holding those companies, your returns will look pedestrian compared with the market as a whole, and you will be taking equity risk for little in return.

There is certainly potential for 2017’s winners to keep on doing well, with momentum a much stronger force now than it was in the past. Momentum has been embedded as a factor into a significant number of smart beta products and systematic trading strategies. These account for an increasing proportion of trades, with Goldman Sachs estimating around 80 per cent of trades are now driven by machines.

Beyond this year’s high performers, investors are also looking among run-of-the-mill stocks that might have technology businesses hidden within them. General Motors has been one example of this, with its stock price rising by 30 per cent in six weeks, as investors reassessed the potential of its self-driving and car-sharing initiatives.

If investors continue to look for businesses in technology or with “hidden” technological value – like General Motors – they will most likely find them in the US or Asia. But as well as that technology option, the US represents a fairly defensive equity market, tending to do better than global equities in a correction. It therefore offers some asymmetric exposure to portfolios: better upside if markets rally and the ability to play defence if equities perform poorly.

Bill McQuaker is portfolio manager of Fidelity’s Multi Asset Open Range