Are investors overly optimistic? Share markets surge higher

Investors May Be Overly Optimistic

US and global share markets surged higher in December as traders anticipated tax cuts and a fresh boost to infrastructure spending would boost the world’s biggest economy.

However, January brought a rethink and the markets caught their breath after the new President and his administration were sworn in.

‘Make America Great Again’ went from being a slogan to a broad raft of policies. What these policies entail is still unclear.

Certainly the share markets are still on board the Trump train with all three major US indices reaching record highs in February. The broad S&P 500 index is up 13.6% since the November election.

Interest Rates

With interest rates remaining low, the share market seems to be the only place to generate returns.

The reason US investors have this optimistic frame of mind is based primarily on the prospect of Trump’s fiscal policies to cut taxes and increase infrastructure spending therefore kick starting the US economy.

Inflation, China and U.S. Interest Rate Hikes

Crucially, for monetary policy going forward, inflation has ticked up on the back of higher commodity prices. China’s transition from a manufacturing economy to a consumer economy also carries inflationary risks. The US Federal Reserve says it is preparing for a cycle of interest rate hikes.

The fiscal stimulus and infrastructure spending might actually boost risk and cause US Treasury yields to rise.

Currently, average valuations of US shares look stretched compared to forecast earnings.

Margin Debt

The extent to which US stock purchases are funded by margin debt is worryingly high.

As I said in my previous blog article, the level of margin debt in the US market is much higher than market peaks in 2000 and 2007. This means margins calls will be triggered when prices fall, and that will create further price falls, and then a snowballing effect.

When Everyone is Bullish…

I like to follow the Investors Intelligence reading of investor sentiment in the US Market. It’s above 85% at the moment, which indicates extreme bullishness. This is a warning sign because when everyone is bullish, markets are generally peaking. There is usually a correction from these levels.

Profits

When sentiment gets this stretched, investors need to be cautious and would be wise to take some profits off the table.