Stock markets have begun the year in an exuberant mood, and for good reason.
Economic data are coming in strong around the globe and several years of superb returns, especially in the United States, have conditioned Main Street investors to expect more gains ahead.
Even notable grouches such as Jeremy Grantham of GMO LLC in Boston acknowledge that today's market seems determined to spike higher. An optimist (and everybody appears to be one these days) could well assert that this is a prime time to bet on stocks.
Fair enough. But a warning is also in order: It would take very little to reverse today's ebullience. Investors should consider not just how much money they could make over the next few months if things go right, but how much they're prepared to lose if anything derails the market's upward climb.
Mr. Grantham, who foresaw both the dot-com crash and the U.S. housing debacle, says there's more than a 50-per-cent chance of a melt-up, or frantic rise in stock values, within the next six months to two years. Such melt-ups often occur toward the end of market cycles.
However, Mr. Grantham says such a melt-up would nearly certainly be followed by a subsequent melt-down that would wipe out half the market's value.
To put it more succinctly, this is a treacherous time for investors. Stay conservative and you may miss out on big gains. Go all in and you risk having your portfolio eviscerated.
For now, people are embracing risk. According to TD Ameritrade, retail investors ended 2017 with the highest exposure to stocks on record. Institutional investors are "loading the boat on risk," Morgan Stanley says, and using levels of borrowed money that are "as high as we have ever seen."
One reason for the prevailing bullishness is U.S. tax reform. The cuts approved by Congress in December are expected to boost corporate profits and fuel more stock-market gains.
Wall Street strategists are nearly always an optimistic group, but several are now being forced to raise their S&P 500 price targets for 2018. They're doing so because the strong start to the year has already propelled stock prices close to where strategists figured they would be 11 months from now.
Yet, just as forecasts are headed higher, many of the drivers of this nearly nine-year-old bull market are losing strength.
One fading support is the notion that stocks are clearly better than any other investing option. Ever since the financial crisis, bulls have argued there is no alternative to stocks, especially for income investors, because bond yields are so miserably low.
That's no longer necessarily true: The S&P 500 features a paltry dividend yield of only 1.8 per cent, while the 10-year U.S. Treasury bond delivers a payoff of nearly 2.5 per cent.
In Canada, the situation is more attractive for equity investors, but only slightly. The S&P/TSX composite index pays a dividend yield of 2.7 per cent, compared with a 10-year Government of Canada bond yield of nearly 2.2 per cent. A cautious, income-oriented investor could reasonably choose either.
In both countries, exuberance is surging, often in questionable directions. The rush to buy bitcoin seems similar to the dot-com bubble. So does the stampede for marijuana stocks.
Previous market bubbles have ended with periods of spectacular acceleration, where prices on average shoot up by 60 per cent or more over the course of about 3.5 years, according to Mr. Grantham. Over the past six months, gains in U.S. stocks have picked up pace, perhaps setting the stage for such a crest.
"A range of nine to 18 months from today and a price rise to around 3,400 to 3,700 on the S&P 500 [which now stands at around 2,750] would show the same 60 per cent gain over 21 months as the least of the other classic bubble events," he writes.
The problem is that no two bubbles are alike. So what to do? Mr. Grantham recommends holding as much exposure to emerging-market stocks as you can stand, because valuations there look more attractive than closer to home.
In addition, you should beware the melt-up. If markets go on a tear in coming months, take it as an opportunity to reduce your stock exposure. Leaving the good times will hurt, but it could spare you from the pain that will follow.