Global equity markets have treated investors excessively well over the past 15 months since hitting pandemic lows on 20th March 2020. Fueled by unprecedented monetary and fiscal support, and rapid development of effective Covid vaccines, equity markets worldwide have surged, in many cases to significant record highs. The MSCI World Index, measured in US dollars, has sky-rocketed by a massive 157%. The US S&P 500 index by 94%. It is time to stand back objectively and take some profit or at the very least to rebalance portfolios, to lock-in the stellar growth.

The outlook for the global economy is bright. Even after monetary policy starts to normalise and fiscal stimulus is gently removed, economic growth is likely to subside to a much stronger trend growth rate than we were accustomed to in the decade which followed the 2008/09 Global Financial Crisis. The 2010s were marked by a painful deleveraging process across developed economies. Banks, households and businesses were all affected. The situation now is vastly different. Following years of repair, bank balance sheets are robust, and households enjoy substantial household savings. There is scope for credit expansion rather than credit contraction, and companies are more willing and able to invest.

There are ample reasons to feel confident about the next decade. However, much has already been discounted in equity markets. The sugar high from ultra-accommodative monetary policy and Covid relief handouts is all too plain to see in excessive market valuations. TINA is an acronym for the phrase “There Is No Alternative”. With interest rates so low and bond yields earning negative real returns (after adjusting for inflation), equities remain a compelling alternative with dividend yields in many cases above bond yields. As central banks are committed to keeping interest rates at the zero bound for some time to come, the TINA trade is alive and well, but investors also need to closely examine RISK, which is the other side of the ledger. Due to excessive valuations, risk levels are flashing Red.

Some of the charts are scary, particularly if you suffer from vertigo. Although the valuation of some markets is less stretched, including emerging markets, Japan and UK, all markets are expensive, in particular the US. The US market deserves close attention. It comprises 60% of the MSCI World Index and as the adage goes, “when America sneezes, the world catches a cold.” US valuation indicators are in most cases at the same peak levels that preceded the dotcom bubble, which burst at the turn of the millennium. The Tobin Q (measuring the market value versus replacement cost), the Shiller CAPE (cyclically adjusted price-to-earnings ratio) and price-to-book ratio are all at the same level as in 2000, in other words equal to the record high. The stock market capitalization-to-GDP ratio is off the scales at 2.0 well above the year 2000 level of 1.5. Investment guru Warren Buffett, the sage of Omaha, doesn’t get excited about making investments unless the value-to-GDP is less than 1.0.

Technical and sentiment indicators are also emitting warning signals. The value of share portfolios comprises a higher proportion of US household wealth than ever before. The exuberance for new investment fads is also a red flag. For example, the insatiable appetite for crypto-currencies and for initial public offerings (listings) of companies that are yet to make a profit. A new phenomenon is the SPAC (special purpose acquisition vehicle), which only has cash upon listing and often trades at multiples of its cash value before even making a single acquisition.

Contrary to conventional wisdom, the time of greatest risk in equity markets is not after a massive sell-off, correction or a stock market crash but before the event when valuations are at their peak. Once markets have lost ground, risk levels are diminished. Although contrary to the optimism currently pervading markets, which are clocking-up successive record highs on an almost daily basis, it is wise to lock-in some of the market’s gains. This can involve either taking profits or implementing a milder rebalancing of portfolios. Where the opportunity arises, it may be a good time to prune weaker holdings or those that have made outsized gains and no longer offer value. A disciplined proactive approach is far better than a reactive approach, which may often result in a knee-jerk response to market declines and the sale of shares after steep declines, when in fact one should rather be buying at this point. Keeping ahead of the curve with an active management process allows for the gradual accumulation of a healthy cash balance before a steep market decline.

In the current environment, investors may be well advised to raise cash levels at a moderate pace, which can be used to buy shares at cheaper prices once valuations revert to their longer-term average. However, cash returns in developed markets are almost non-existent and cash can be a drag on performance. An option is therefore to invest a portion of the proceeds from equity sales into safer alternative asset classes, which are less volatile than equity markets or in some cases offer negative correlation to equities and therefore provide excellent risk diversification. Some of these alternative asset classes such as infrastructure, renewable energy, real estate investment trusts and credit products have the added advantage of offering attractive income yields. Another option, probably best suited to investment portfolios with a more aggressive growth mandate is to recycle profits into other equity markets and sectors, which are cheap by comparison and offer better risk/return opportunities.