Last year saw investors shrug off numerous concerns and stock markets power their way to new record highs, but AJ Bell’s Russ Mould is wary of being so optimistic at the start of 2018. 
Mould, investment director at AJ Bell, said: “Such optimism could leave investors exposed to the danger of ‘sliding down the slope of hope’ in 2018.
“Markets can be at their most dangerous when making money looks easiest so a selective approach is likely to be best for the year ahead.
“It would be unwise to call the top in markets, as timing them precisely is impossible, but for the long term it makes sense to take less risk when markets are running hot and more when they are running cold, so for the moment some caution may be warranted.”
In the following article, we look at five areas of the market that might fill investors with hope but Mould thinks they should maintain some caution around.
US equities
The first area that AJ Bell thinks investors should approach with a degree of caution is the US stock market, which has surged over the decade since the end of the financial crisis. The S&P 500 has posted a 229.09 per cent total return over the past 10 years, outpacing the MSCI AC World index by a wide margin in the process.
Performance of indices over 10yrs
Source: FE Analytics
Mould conceded that short-term momentum around the US looks good, owing to the progress made on president Donald Trump’s tax reforms, GDP growth above 3 per cent and a string of record highs for its stock market. However, he added that earnings growth was only modest in 2017 and US stocks now look expensive as a result.
“The market cap-to-GDP ratio is north of 130 per cent, above the 2007 peak and very near the 1999 one, while a 31x cyclically adjusted price earnings [CAPE] ratio has only been exceeded twice in history, in 1929 and 2000, and disaster followed on both occasions,” he said.
“Even if CAPE is a poor near-term timing tool it has been a good guide to returns on a 10-year view – and buying US stocks at current CAPE levels in the past has locked in negative returns on a 10-year time horizon.”
‘Quality’ stocks
So-called ‘quality’ stocks – or businesses high margins, high returns on capital, strong cashflow and relatively predictable earnings – are another area of the market that has performed strongly in the wake of the financial crisis.
However, Mould said that ‘quality’ should not be confused with ‘safety’, as safety is usually the product of paying low-to-fair valuations for securities, not high ones. He noted that quality names like Reckitt Benckiser and Whitbread underperformed in 2017, because they did not exceed expectations at a time when they were already richly priced.
Performance of stocks vs index in 2017
Source: FE Analytics
“There will almost certainly be a time to own such firms again but it might not be yet, especially as some big consumer staples names are looking to acquisitions to create growth,” the investment director said.
“Pfizer’s plan to sell its consumer healthcare business could launch a bidding frenzy, with names including Reckitt, Nestlé and even GlaxoSmithKline rumoured to be interested. Investors in the ‘winner’ in the bidding contest need to be careful they don’t end up owning a ‘loser’ because it paid too much for the asset.”
Technology and momentum stocks
Technology companies have enjoyed a meteoric rise in recent years. Indeed, the world’s seven biggest-cap stocks – Apple, Alphabet, Microsoft, Amazon, Facebook, Alibaba and Tencent – are all technology names.
While their valuations are not looking as stretched as those reached in the dotcom boom, Mould cautioned that there are still “lofty” and would look vulnerable if their earnings were to disappoint or investor enthusiasm for them start to wane.
Performance of indices over 5yrs
Source: FE Analytics
“There has been a clear rotation over the past months out of momentum and growth names into more value and cyclical plays, such as financials, to suggest equity investors think interest rates may surprise on the upside thanks to what is increasingly being seen as a synchronised global recovery,” Mould said.
“If growth does come through, then investors may be tempted to buy cyclicals – where valuations are lower – rather than tech or biotech – where multiples are way higher – not least as there is less need to pay a premium for tech-style growth if earnings are moving higher more widely across a range of industrial sectors.”
Central banks
The years since the global financial crisis have seen western central banks use zero interest rates and quantitative easing (QE) programmes to drive up the prices of assets and help shore up the economy. While the wealth effect has been clear, critics say the trickle-down benefits are less obvious.
Mould noted that this loose policy regime seems to be coming to a close. The Federal Reserve is already hiking rates and moving from quantitative easing to quantitative tightening, the European Central Bank is tapering its own QE scheme and the Bank of Japan has hinted that it may ease the aggressiveness of its stimulus plan.
“Any faster-than-expected removal of central bank liquidity could be a shock to a range of asset classes – stocks, bonds, cryptocurrencies, art, you name it – which have feasted off cheap money,” the investment director said.
Sources of ‘safe’ yield
The final ‘slope of hope’ that investors need to be wary of, according to AJ Bell, are the remaining sources of attractive yield.
“In a world where interest rates remain near zero in the West and are rising only slowly – if at all –many investors are still scrambling for yield and the danger of over-reaching for a yield that is seen as attractive remains," Mould said.
He pointed out that the premiums offered by investment grade and sub-investment grade corporate bonds relative to government bonds are “very thin” by historic standards, leaving little room for protection if inflation spikes and central banks have to lift rates faster than they planned.
“In this scenario bond price falls would more than likely offset any yield benefits, so investors need to approach fixed income in particular selectively and with caution,” Mould concluded.
“The same can be said for equities where a number of high-profile dividend cuts in the UK (Pearson, Provident Financial, Carillion) or the fear of one (Centrica) crushed share prices and inflicted losses on shareholders in stocks which had looked to offer an attractive dividend yield.”