As we approach mid-year it’s worth reviewing the outlook for shares particularly with numerous warnings of corrections and crashes. Our view for this year has been that share market gains would be positive, but more constrained than seen in the last two years, and that volatility would increase – including the likelihood of a 10-15% correction along the way. In the event gains in shares have been more constrained, with global shares (in local currency terms) up 4.5% year to date and Australian shares up 1.5%. However, volatility has been relatively low.

Most concerns regarding the share market outlook relate to US shares. It invariably sets the direction for global share markets including Australia’s but many contend that at record highs it is overvalued and at risk of a crash.

Common concerns about US shares

There seem to be three commonly expressed concerns regarding US shares: record highs, valuations and complacency. Looking at each of these in turn: US shares are at record highs. Does this mean they are due for a bust? The following chart shows the US S&P 500 since 1990. It broke out to record highs last year and is now up 190% from its Global Financial Crisis (GFC) low in 2009.

Source: Bloomberg, AMP Capital

However, just because US shares are at a record high does not mean a crash is on the way. The breakout seen last year came after a 13 year secular bear market, which saw US shares stuck in a huge range. Our assessment is that US shares have entered a new secular bull market helped by a range of factors including an energy boom, a manufacturing renaissance and a return to better health for US debt measures. And as can be seen in the chart the surge in the share market has been supported by a surge in profits to record levels.

Are US shares way overvalued? Proponents of this view typically cite the following:

To be sure, these are valid concerns but while such valuation measures are useful they need to be treated with caution.

Source: AMP Capital

Is the decline in volatility a major concern? The next chart shows the VIX index, which is a guide to expected volatility in the US share market implied by options.

Source: Bloomberg, AMP Capital

It is clearly very low and is consistent with the US share market having traded in a relatively narrow rising trend since mid-2012. There hasn’t been a 10% or more correction in US shares since mid-2012. In many ways this is a good thing. It is far better than the extreme volatility seen through the GFC and its aftermath and worrying about it is perhaps a bit like worrying that there is nothing to worry about! The concern, though, is that periods of low volatility can lead to a false sense of investor security and excessive risk taking, eg using high levels of gearing to buy overvalued assets.

However, the low level of volatility is arguably a rational reaction to the more stable macro-economic environment seen in more recent times. It is doubtful that risk taking has reached the extremes seen at previous major market tops and, as the 2004-07 period showed, volatility can remain at very low levels for a long time before it runs its course.

Broad cycle view

More generally, our view remains it’s too early in the investment cycle to expect a new bear market or crash. The normal play out for a cyclical bull market is as follows.

Our assessment remains that we are still in Phase 2. We still don’t see the signs of euphoria that become evident in Phase 3 as precursors to a new bear market. 

Source: Thomson Reuters; AMP Capital

The gap between earnings yields and bond yields, a proxy for the excess return shares offer, remains above pre-GFC norms. This is reflected in our preferred valuation indicators, which show markets slightly cheap. 

Source: Bloomberg, AMP Capital

Concluding comments

None of this rules out a short term correction in shares and a return to more volatility. Numerous possible triggers for a correction exist including: a continued run of stronger US economic data raising concerns about an earlier Fed rate hike; risks around Ukraine and Iraq; maybe a return of worries about Europe on the back of European Central Bank bank stress tests and independence referendums later this year in Scotland and (possibly) Catalonia. And in Australia, we need to see confidence levels pick up. However, we still seem a fair way from a major market top in shares. As such, the cyclical bull market in shares likely has further to go. Our year-end target for the ASX 200 remains 5800.

Dr Shane Oliver
Head of Investment Strategy and Chief Economist
AMP Capital

Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.