Investment markets are rarely in perfect balance. There’s almost always something that feels off – asset classes that look overvalued, others that are out of favour, some delivering above-average returns and others lagging behind. That’s what I would call a normal market. Markets are never fully rational all the time.
That said, there are periods when markets make even less sense than usual. In those moments, it pays to be especially cautious. I’m not suggesting you take drastic action, like selling down large portions of your portfolio or avoiding new investments altogether. The reality is that no one can predict short-term market movements with any consistency and reliability.
What I am saying is that there’s nothing wrong with sitting on some cash or holding back unused borrowing capacity for a while. Building wealth is a marathon, not a sprint.
Many markets are trading at all-time highs
So far this calendar year, every major asset class has delivered positive returns. In fact, many markets are currently trading at or near all-time highs.
One of the most puzzling developments this year is that the two best-performing assets are gold and bitcoin. That’s unusual because gold is typically seen as a risk-off asset – something investors flock to in times of uncertainty – while bitcoin is generally considered a risk-on asset, favoured when sentiment is more optimistic. So, seeing both perform strongly at the same time feels contradictory.
That said, there are logical explanations that might explain some of this performance. Gold has rallied more than 20% this year. Many commentators suggest that is largely driven by strong demand from central banks looking to reduce their reliance on US dollar reserves amid growing concerns about the dollar’s long-term stability.
Meanwhile, bitcoin has also surged, thanks to President Trump’s vocal support for crypto and increased regulatory clarity, with digital assets now falling under the oversight of the Commodity Futures Trading Commission. To top it off, in July, Trump Media & Technology Group, of which Trump is said to own over 53%, announced a US$2 billion investment into bitcoin, giving the crypto market an additional boost.
Do ETFs add to price momentum?
Some commentators argue that the growing popularity of market-cap weighted index funds is fuelling share price momentum. In 2024, more than $30 billion flowed into Australian ETFs, and most of these are market-cap weighted. That means as a stock’s price rises (CBA, for example), it naturally attracts a larger share of new monies, simply because its weight in the index increases.
While this logic holds in theory, the real-world impact is more limited. Index funds account for a relatively small slice of daily trading activity – estimated to be just 1% of total ASX turnover.
Let’s return to CBA. I spoke to Vanguard, which estimates that its own daily trading volume in CBA is around 2%, and that total index fund industry trading activity accounts for no more than 5% of volume. That means 95% of CBA’s trading is driven by non-index investors – a level of activity that is far more likely to influence the share price. For example, on the buy-side, offshore investors have been buying CBA heavily in recent months and years because it’s viewed as a relatively safe and attractive investment. However, on the sell-side, a lot of retail investors hold CBA and don’t want to sell due to CGT. Hence the price increases.
Rising prices do result in higher index weights, but this does not necessarily distort the market. Market-cap indexing is just a mechanism for owning the market as it is. By definition, every dollar invested is allocated according to each stock’s existing market weight. It doesn’t generate excess demand for any one stock – it simply reflects what’s already there.
That said, market depth matters. In highly liquid, widely held stocks like CBA, index flows are absorbed easily and have little price impact. But in less liquid or tightly held stocks, even modest index demand can move prices and amplify short-term momentum.
In summary, while index fund flows might have an impact on momentum at the margins, they are not a major driver. Active trading, speculation, short-selling, and narrative shifts play a far greater role. The real impact of index flows depends on the liquidity and structure of the underlying stock, not the theory behind the index.
Are investment markets disconnected from reality?
As I have said before, it’s unusual for all asset classes to deliver positive returns in any given year. Typically, there are winners and losers. But in 2025 so far, it’s been all winners. And given the current political and economic backdrop, that does not quite add up.
- While the Australian economy appears healthy at a macro level, most of the growth has been driven by government spending. In fact, over the past two years, 82% of new jobs have been created in the public sector or non-market (i.e., government-funded) sectors. Over that same period, government spending has accounted for 55% of Australia’s GDP growth. Total government expenditure is now approaching 39% of GDP – an unusually high level for a developed economy.
- In the US, President Trump has created significant political and business uncertainty in 2025. His aggressive stance on tariffs and trade, pressure on other nations to lift defence spending, strained relationships with NATO and the EU, increased tensions with China, renewed focus on fossil fuels, and withdrawal from the Paris Agreement have all contributed to instability and unpredictability.
- Meanwhile, US government debt has ballooned to nearly US$37 trillion. This, combined with Trump’s unpredictable approach, has led many countries to reduce their reliance on the US dollar. As noted above, this has spurred increased demand for gold, but it’s too early to know if this marks the beginning of a deeper shift in global monetary policy.
- Two major conflicts in Gaza and Ukraine are ongoing, with little sign of resolution in the near term.
- The US share market looks stretched. The S&P 500 is trading at a forward P/E ratio of around 23x, well above its long-term average. That’s not to say every company is overvalued, but the index as a whole certainly is. The CAPE ratio is now at its second-highest level in history – surpassed only during the dot-com bubble of the early 2000s.
These are just a few of the many issues investors could reasonably be concerned about. Against this backdrop, it’s hard to rationalise why markets are trading at all-time highs, or why the US equity market priced at such a high premium.
It’s ok to be conservative
I’ve spoken to a few clients recently who feel they are perhaps being too conservative by sitting on cash, underutilising surplus income or borrowing capacity, and wondering whether they should be doing more.
But sometimes, the smartest move is to not invest to your full capacity. There’s a famous Warren Buffett quote that reminds us to be “fearful when others are greedy.” And right now, in 2025, all major asset classes are doing well, perhaps too well. That smells a lot like greed.
In times like these, holding back is not a missed opportunity for long-term investors. It’s a strategic one. My advice? Keep some of your powder dry. That way, you will have the flexibility to be greedy when others are fearful. And that’s when wonderful opportunities emerge.
But don’t go to cash and it’s not a black or white decision
I’m not writing this blog to incite fear – far from it. My aim is simply to reflect rationally on the current state of markets. This is not a call to make sweeping changes to your portfolio. As I said at the outset, no one can predict what markets will do in the short term. It’s entirely possible that markets could continue to rise for some time yet. Anyone can make negative predictions, but you can only profit from them if you can also predict when they will occur (h/t A Learning a Day).
That said, here are a few sensible steps you could consider:
- Reassess your portfolio’s risk exposure. Are you holding too much in high-risk indices or sectors? If so, consider rebalancing. For example, blending value-oriented index strategies with market-cap indexing may help reduce overall risk and exposure your portfolio to better long-term returns.
- Prioritise quality at reasonable prices. If you are investing new money, focus on index methodologies, sectors, or markets that are rationally priced and better accommodate known risks.
- Stay the course but adjust if needed. If the current economic and political uncertainty makes you uneasy, do not stop investing altogether. Instead, you might reduce your regular investment amount. Long-term success comes from doing ordinary things consistently well over extraordinary periods.
