SINGAPORE (Dec 18): I have a friend, Tommy, who is very happy right now. At end-2016, he invested his year-end bonus in a mix of equities and bonds. Since then, stocks have been on a tear, with double-digit gains in most markets. Bonds have also done unexpectedly well, despite the spectre of interest rate hikes on the horizon. Time to stuff that Christmas stocking!

I have another friend, Sean, who is not quite so happy. Unlike Tommy, he decided to hold on to his cash last year, wait for US President Donald Trump to start a trade war and then buy in. Since then, he has watched in frustration as markets breached record after record with remarkably little volatility. Sean is now faced with a dilemma: Jump in knowing full well he is late to the party, or tough it out and hope for a correction soon?

Tommy and Sean might have had very different investment experiences last year, but they are actually in the exact same situation. What is past is past: The only thing that should matter to either of them right now is the future outlook on prices. In this regard, every investor is grappling with the same problem: After a fantastic few years, is it time to hold cash (or, in Tommy’s case, take some profit) and wait for a correction before re-entering the market?

Market timing is a devilishly difficult exercise, and I do not profess to have a special crystal ball in which to make stock-market predictions. Many studies have shown that it is almost impossible to predict market movements reliably in the short term. In the longer term (on the scale of five to 10 years), however, empirical evidence has shown that in general, the more expensive an asset is from a valuation perspective, the lower its long-run return is expected to be. Therefore, a useful starting point would be to consider how expensive stocks and bonds are compared with historical norms.

The valuation question is easy to answer for bonds. Thanks to quantitative easing by central banks in response to the 2008 financial crisis, bonds are pricier now than almost any other time in history. Table 1 shows the average yields for various classes of bonds and, more importantly, the yield percentile — that is, how low the current yields rank compared with yields in the past. US government bond yields are at eighth percentile, which means that yields were lower than the current level only 8% of the time in the past. Investment-grade and high-yield bonds have even worse yield percentiles, at 5% and 7% respectively. On average, it is quite safe to say that bonds are expensive and subject to significant downside risk.

The situation is more nuanced for stocks. Using price-to-book ratio as an illustrative proxy for equity valuations (see Table 2), we can make a few observations. First, equities have indeed become more expensive since the start of the year, with valuations rising across all three regions. Second, while the US is more expensive than 80% of the time in history, the eurozone and Asian stocks are still reasonably priced even now, with percentiles of 57% and 53% respectively. Certainly, equities are not at the same overinflated level as bonds.

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So, what do current valuations tell us about asset allocation? Right now, I would remain mostly invested in equities, holding only a minimal amount of cash. It is true that prices have run up and valuations are not as low as they were last year. But neither are they outrageously expensive outside the US. Certainly a correction will come at some point, but valuations are not so high that we should expect that correction to bring prices far below what they are now, given that equity prices tend to increase in the long run. Therefore, it is probably better to stay invested and earn relatively lower returns than to hold a large amount of cash and potentially wait forever for a better entry point.

Besides, the world is experiencing a period of global growth that it has not seen since the 2008 financial crisis, which should be supportive of equity prices. As Forbes discusses

in its article “Synchronized Global Growth May Have Arrived” on Nov 20, world manufacturing activity is at its highest in 78 months. Business optimism is at its highest in three years. The Eurozone Purchasing Manager’s Index is at an 80-month high, and China’s economy looks more stable than it did at the start of this year. Of course, there are risks — North Korea, Trump, China’s debt overhang — but nothing so major or imminent as to justify holding a large defensive cash position.

Certainly, there are asset classes I would avoid (or at least tilt my investors’ portfolios away from). Being long-only on bonds is problematic because of high valuations and the risk that inflation may spike, given low unemployment, especially in the US. Many parts of the US equity market are also trading at high valuations, so I would shy away from those. Also, it goes without saying that everyone’s financial situation is different — if you are retired and have passive income needs from your portfolio, you should have a very different asset allocation and cash position from that of a young professional with 30 years to retirement.

Leaving aside these caveats, there are enough fairly valued investment options worldwide to remain mostly invested in equities. For my friend Sean (and for anyone still holding on to a large amount of cash), this unfortunately means having to invest a large amount of money now, after missing a double-digit rally and with no guarantee that next year will not bring a crash. Timing the market has always been notoriously difficult, but on balance, it is probably better right now to be invested with the expectation of low-ish returns in the long run, than to stay in cash and expect absolutely nothing.

<i>Herbert Lian is an Independent Financial Advisory Representative at IPP Financial Advisers. The views expressed here are solely those of the author in his private capacity. This article should not be regarded as professional investment advice or as a recommendation regarding any particular investment.</i>

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