And it’s whispered that soon if we all call the tune

Then the piper will lead us to reason

And a new day will dawn for those who stand long

And the forests will echo with laughter —Led Zeppelin,

Stairway to Heaven

On April 2 widespread panic ensued when the

United States imposed tariffs

on imported goods that were more severe than had been anticipated. Broad-based fears that tariffs would cause higher

inflation

, slower growth or perhaps even a

recession

in the country spurred a sharp drop in American stock prices, with the S&P 500 suffering a year-to-date loss of 15 per cent at its low point on April 8.

Fast forward to the present, and investors in

U.S. markets

believe that all is once again right in the world. The U.S. delayed many tariff deadlines, and those tariffs that have been imposed are below the levels that were initially announced. These better-than-expected developments have soothed markets, with the S&P 500 advancing about 35 per cent from its low point of the year, leaving its year-to-date gains at about 15 per cent as of the end of September.

Not all FOMO is created equal

Emotions and behavioral biases always exert a huge influence on investors’ decisions. Perhaps one of the most common among these is fear of missing out (FOMO). FOMO can be irrational and lead to poor decisions and results, but it can also be a positive force, spurring investors to act in ways that can bolster returns.

Historically, when markets have been saturated with an “it can only go up” mindset, returns over the ensuing years have fallen somewhere between subpar and negative. In such environments those who have tempered their FOMO have achieved better returns than those who have not. Conversely, when markets have been filled with a “the sky is falling” mentality, returns over the next few years have been significantly higher than average. In such circumstances, investors who have embraced their FOMO have reaped significant rewards.

If only things were so simple

History suggests that there is a reasonable proxy for estimating future returns and risks over the medium to long-term. At times when valuations have stood well below average levels, returns over the next several years have tended to be well above average. Conversely, at times when multiples have been materially above average, returns over the next several years have ranged from below average to negative.

Abnormally high valuations tend to be both the result of and accompanied by the most pronounced instances of FOMO. On the other hand, equities tend to go on sale during the tail end of bear markets, when feelings of despondence prevail and investors are generally concerned with preserving capital. In other words, FOMO is most likely to be embraced when it should be avoided and is most likely to be shunned at times when it should be embraced. This is arguably the single greatest cause of bubbles and busts. It is also perhaps the greatest source of opportunity for those who can control their FOMO accordingly.

Good is not the enemy of great

There are no sure things in markets. However, one thing of which I am confident is that if you alter your equity exposure in response to either excessively high or low valuations, you are almost certain to be wrong — at least over the short-term.

Nobody can time markets perfectly. This typically results in some regret when prices rise after you reduce your equity exposure in response to overly optimistic markets. Similarly, it almost always entails feelings of remorse when prices fall after you increase your stock holdings to take advantage of environments where stocks go on sale.

However, you need not have perfect timing to achieve better than average returns by making portfolio adjustments in response to extreme events at either end of the valuation spectrum. Good is not the enemy of great; you don’t need to pick exact tops and bottoms to add significant value through market cycles over the long term.

There are no bargains … but there are some relative ones

U.S. stocks currently stand near their highest valuations over the past 25 years, save for the peak of the dot-com bubble of the late 1990s and early 2000s. From 1987 to 2014, whenever valuations were at levels approximating those that currently prevail, average annual returns over the subsequent ten years were between plus two per cent and minus two per cent, without exception. In addition, investor

Warren Buffett

’s favorite indicator, the ratio of aggregate market capitalization of U.S. stocks to U.S. GDP, recently surged above 200 per cent, a level he once warned is like “playing with fire.”

Paradoxically, higher valuations have coincided with an investment environment that has become less hospitable. It is likely that current U.S. trade policies will have had a harmful impact on the multi-year trajectory of the economy. Corporate profits will on balance be hindered by lower margins, less demand for companies’ products, or some combination of both. In short, U.S. equities are expensive in the face of a less favorable growth backdrop, which does not bode well for future returns.

While stocks outside of the U.S. are by no means a bargain, neither are they unreasonably valued. Canadian, Eurozone (including the United Kingdom), and Japanese equities are currently valued at levels that are normal from a historical perspective. However, they are a bargain relative to U.S. stocks. While non-U.S. developed-world stocks have typically been valued at a 10 per cent discount to their U.S. peers, their current discounts are far greater. Canadian companies are currently priced at a 26 per cent discount, while Eurozone and Japanese stocks are even more of a bargain, trading at 40 pr cent and 36 per cent discounts, respectively.

Putting these discounts into perspective, Canadian stocks stand in the 16th percentile of their relative valuations to U.S. stocks over the past 25 years, while Eurozone and Japanese equities stand in the fifth and sixth percentiles, respectively. Although these historically wide discounts may prove meaningless over the short term, historical patterns strongly suggest that they foreshadow significant outperformance over the next several years.

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Noah Solomon is chief investment officer at Outcome Metric Asset Management LP.

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