By no means do I follow the Eugene Fama line of thought and insist that markets are fully efficient nor consistently rational. However, just maybe, the current situation isn’t as irrational as one might imagine judging by the headlines, some of which include the S&P hitting all-time highs, the ASX not factoring in the full impact of the economic lockdown, recovering close to 35% from its lows, and all this despite quite possibly the worst growth numbers since The Great Depression.
Take a look at the following graphs which might help explain why markets are not as irrational as they appear at first glance. The first showing the 2020 returns of the top 5 S&P500 stocks versus the remainder of the S&P500 (quite telling when you look at it in this fashion). The second shows the ASX All Ords year-to-date, compare this with the returns on technology stocks (XTX) and ASX All Ords Gold. The third showing the ASX All Ords Gold Index returning about 32% year to date.
What is immediately evident has been the outperformance and, in fact, the lifting of the overall index by the NASDAQ tech giants. So much so that their cumulative market capitalisation is the equivalent of the entire NIKKEI. In Australia the story is similar, the performance of tech stocks and gold producers have been the primary drivers of our own index. The rest of the market has not really gone anywhere (and is still very much in the red). That said, yes we do currently hold the likes of Adairs and other consumer discretionaries that have seen significant year-to-date returns. Even here, if you consider what has been happening in terms of earnings and reduction in costs via JobKeeper, their returns are not that abnormal.
Why is this not a sign of an irrational market?
Over the long-run it is important to remember that the tech companies that have seen stellar returns and wild expansion of P/E multiples are torch-bearers for trends that are fundamentally shifting the way we shop, communicate, live and all the rest (I would go far as to say every aspect of our lives, including our love-life). What Covid has done is bring forward and catalyse this inevitable outcome. To bring it back home, how many of us had actually heard of Zoom before this crisis? How many since? If you haven’t still, congratulations on taking isolation to the literal extreme but wait until reporting season and with AGM’s likely going fully online later in the year, you will soon. Furthermore, once we get used to it, are investors likely to prefer to stay at home without the hassle of physical attendance? My bets are in the affirmative.
In other words, their growth prospects have just been boosted exponentially depending on where you look. Consider the fact that Amazon now employs close to 850,000 people globally and has continued to hire at a rapid pace to now become the second largest private employer in the US (just behind Walmart). Similarly, Apple has put out stellar results including the services revenue growing to approximately 29% and, with 5G just a year away, we will see another earnings boost as customers upgrade. Although Alphabet is lagging behind since, in our view, they still haven’t figured out what their company actually wants to be and currently subsidizes all their other divisions from the earnings derived from the Search platform, they still benefit from these fundamental shifts. Microsoft has benefited immensely from Azure and the move to the cloud under Nadella, they are a cloud first company, again immense catalysts ahead.
That said, there is a certain part of us that is somewhat concerned. With Amazon tracking at a P/E of 120 and most of the others above mid- to high-30’s, from a historical standpoint they are overvalued. But even here, you may just have to think again.
If you suppress the yield on risk-free assets far enough, and as the cost of capital trends towards being theoretically zero bound, valuations could go toward infinity. Let me explain a little more bluntly. The trade off is between three choices 1) cash; 2) fixed income and 3) equities risk. For simplicity, let’s take out alternatives as an asset class (which, by the way, are also the beneficiaries of this brave new world as I’m sure the chaps at Bain would accept with their Virgin Australia buyout). If you suppress the yield on fixed income towards the 0-bound through constant downward pressure on interest rates and suppression of yield on “risk-free” assets like treasuries, then there is very little choice but to go towards risk and it would be a rational choice.
Your present value (of future returns) keeps going higher as the interest (i.e. discount) rate gets reduced until at zero your PV is the same as your FV (Future Value)? At negative (as is the case in Europe), it makes absolutely no sense since your PV would then exceed your future value.
PV = FV/(1+r)^n
The trade off then is investing in fixed income where your maximum return is your principal and your coupon rate or equities. If your coupon is increasingly towards zero then it makes more sense to take on equities risk. And you would be doubly incentivised if the cost of capital is also 0 since theoretically it is now mathematically impossible to go bankrupt (in theory). Worst case you might end up with a zombie company but still wouldn’t lose your principal (about the same risk as a 0-yielding bond).
However, here is the big caveat, the r above can also be the rate of inflation and, given the deflationary shock, the tech giants are effectively behaving as bond-proxies. If inflation does come back into the equation, then mayday, mayday, we have ourselves a problem. Because all of a sudden, you have a value for r. At which point you will likely see a revaluation. How do the markets handle this situation? Well it seems the markets are one step ahead of us over-thinkers.
For herein is why we have the other top performers locally. Gold producers. You effectively have your equities acting as bond-proxies (at least your tech stocks) and your inflation hedge in the form of gold. The irony of it all is, in one way we’ve created a weird universe where your growth stocks have become the substitute for your fixed income and cash. If you’re uncomfortable or uncertain about the world and the amount of money being printed, it is downright illogical to hold cash, rather you would hold gold.
Is this the ideal portfolio construction however? We don’t think so. Nevertheless, these outperformers and the returns are not the sign of an irrational market.
Is there a more effective way to allocate?
The most frustrating part of this entire scenario is that cash is already losing and it will be the first to lose further. If we can take interest rates to be 0.25% and medium term inflation to be 1-2% (granted we did have deflationary shock for the second quarter) then we’re already in the negative before we even begin. Right now it's okay since CPI currently stands around -1.4% for the June quarter but you only need for it to tick higher to 0.26% by Q1 next year to start on the negative trajectory.
The flip side is, this would still be fine since theoretically the monetary policy would then try to control inflation. But the official target is 2-3%. So we’re looking at an interest rate policy that is targeting an inflation rate of 2%, at the very least, and a cash rate set at 0.25%. Go figure.
Is this cash rate likely to change? Not likely, the more important question to consider from a policy perspective is if I was a central banker and I’ve just pushed a whole lot of money, including pension funds and insurance companies (not to mention passives and retail investors) into risk assets, can I actually let the markets take their due course? The answer, at least in my case, would definitely be a resounding no. Given (as we mentioned in previous articles) that the top 3 passives globally control close to 16tn USD, even a 10% drawdown in equity markets is a massive call on the financial system to the tune of 1.6tn USD. If it does happen, we have more worrying things to consider than whether the FAANG’s are overvalued or not.
So at the very least we have a liquidity backstop and a marked incentive to inflate away the real value of the debt.
So starting on that premise, where do we allocate? The dislocations in the market are easy to see, what we have to be prepared for is that the composition of aggregate expenditure is likely to change. In Australia the consumer accounts for 60% of GDP and the figures are similar across the OECD, but if the consumer is a lot more conservative all of a sudden and business investment is not picking up the slack, it will be up to governments to do so. The easiest things to do in this instance are direct interventions in the form of infrastructure spending and cash injections into the real economy (already happening in the US), that should see a lift in discretionary spending and the rapid monetisation of debt. This, given the vagaries of election cycles and the fiscal multiplier effect, is likely to be sooner rather than later.
In terms of debt monetisation, I know that it is a rather big call but trust me, there is very little appetite from private investors any longer for treasuries. There’s a reason why the RBA intervenes at auctions to buy up any excess and keep the yield as close to the cash rate as possible.
Can investors be blamed? With fiscal deficits the way they are and the unlikeliness of them ever being paid back (in real terms as opposed to nominal)? If you think this is not likely to be the case, please feel free to point us to one political actor across the western world, or in fact across the planet, who has the wherewithal to take a tax increase to the electorate. The outcome is that in the long term we will see this fiscal expansion funded by the central banks. Simply put, don’t bother with risk free assets. The best plays and substitutes will be infrastructure allocations that will at the very least keep up with and benefit from spending.
Utilities and industrials are also important segments to look through. Not least because we have a reasonable idea as to what their earnings look like and the earnings growth numbers are typically built into their revenue streams. US utilities are especially interesting given the amount of greed that has been built into their revenue streams, not great as a consumer but certainly interesting as an investor.
Similarly, diversifying across geographies will yield much better long-term returns and benefits than sectoral diversification in-country. The easiest way to think about this is, you wouldn’t necessarily buy an insurance company in Australia like QBE but could you buy one in China (one of our biggest holdings is Ping An Insurance), certainly. You wouldn’t necessarily go outside the ASX for your materials exposure, you’ve got your Rio, BHP and the FMG’s right here at home.
Should you sell your tech exposures? Absolutely not. Most of the big giants are giant for a reason. Amazon, for example, is not a retailer. Their main USP is their infrastructure, AWS (Amazon Web Services). The ability to hoard data and be able to experiment and make sense of it puts their monetisation potential next to none. Similarly with Alibaba. Even here, stay diversified, the key will be to see who wins the race in AI (Artificial Intelligence), the Nirvana of knowing the likelihood I might get diabetes or cancer and when I might have a child, and the ability to do so before even I know, will have incredible monetisation potential. A company like Amazon could move into health care, which they are already doing in a rather stealthy mode, insurance, financial services etc.
However, when valuations reach levels that feel uncomfortable, trim the profits (with emphasis on trimming not selling) and look for alternatives that might not be as sexy.
Last but not least, have the ability to be nimble. This market is full of crowded trades, probably because nobody is actually doing any research (most big firms have figured out that the equity research teams aren’t as lucrative as they once were). You come across a thematic like BNPL, hold on for the ride and understand that you have to be disciplined about taking profits along the way. A portfolio should be well diversified geographically and sectorally by country (i.e. different sectors in different countries, as opposed to different sectors in one country or geography). Long term holdings should be constant and these should ideally be good inflation hedges but also have shorter-term holdings where you can trade momentum, jumping on thematics in the short-run but taking those profits when appropriate and reinvesting in the long-term holdings.
If you’re looking for yield in equity markets. Short answer, don’t bother. The only way you get it is by buying sold-off companies and if the market with this sort of liquidity isn’t touching something, there is probably a reason. We’ve all fallen into enough value traps in our time to have learned this the hard way. This isn’t an irrational market but neither is it a forgiving one.
Markets & Commentary
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TAMIM Asset Management provides general information to help you understand our investment approach. Any financial information we provide is not advice, has not considered your personal circumstances and may not be suitable for you.