Valuations and volatility

Doomsayers are finding their voice again...

Click on any financial news website and you are likely to come across at least one article predicting that global stock markets are about to collapse.

Numerous experts, including bond guru Bill Gross and seasoned investor Jim Rogers, have pitched in with glum predictions over the past few months.

Many of them say that the days of global indices surging into record territory on a weekly basis are no longer sustainable as aggressive stock buying activity has led equities to be priced for perfection.

Frothy valuations: A ticking time bomb?

Lofty valuations don’t automatically result in share prices declining, although they do often lead investors to reevaluate their positions and contemplate cashing in on gains.

Once price targets are met, rational investors will generally seek to establish whether there is enough earnings potential on display to power another rally and justify the high showing of confidence in the stock.

Usually it is that cautious mentality that leads markets to suffer a fairly big correction every eight months or so. It’s generally been that way since the war, although this time around investors appear to be defying that popular logic.

Most equity markets have been in full on bull mode since Donald Trump won the US presidential election over 10 months ago and, despite the odd blip, show little sign of giving in – if readings from the various volatility indices are
to be believed.

Fear gauges are hovering at strikingly low levels, indicating that investors are confident there are enough growth prospects in sight to continue powering the global economy and company profits.

Complacency

“Investors are currently pricing in not just a stable pricing environment for the S&P 500 for the next few months, but basically the most benign risk environment in the history of the index,” say James Luke and Mark Lacey, commodity fund managers at Schroders. “To us, this is odd from many angles.”

Sceptics have taken this strong show of faith as a sign that investors foolishly believe that the market is risk-free – and argue that global economic trends are about to prove them wrong. If history is anything to go by, they may have a valid point.

In the high-flying US stock market, the PE 10 ratio, a valuation measure that uses real per-share earnings over a 10-year period, currently stands at about 30, the third highest on record. The last two times the ratio surpassed this point was in 1929 and 2000, right before disaster struck.

Black Tuesday and the dot-com bubble, two of the most devastating stock market crashes of all time, occurred when investors realised that the hype buoying the stocks they heavily bought into was misplaced.

All it sometimes takes is a minor setback to trigger a correction. When speculation leads valuations to as high as they are today, sell-offs can be particularly aggressive.

"An unforeseen rise in volatility could lead to quantitative strategies like trend followers or risk parity funds amplifying the rise, panicking retail investors who have pumped cash in over the course of the past year,” says Bill McQuaker, manager of Fidelity’s multi asset open range of funds.

Central Banks reach turning point

Mr McQuaker reckons that a rise in interest rates could serve as one of those triggers of panic. “Higher inflation, possibly driven by an acceleration in wage growth, would bid goodbye to the ‘Super Goldilocks’ environment of strong growth and low inflation,” he says.

“Central banks would almost certainly be compelled to raise interest rates, which would force a re-assessment of the outlook, and the low discount rates upon which high equity valuations have been justified.”

The Federal Reserve (Fed) recently announced that it plans to continue increasing the cost of borrowing in the US.

Several other countries have similarly warned that interest rates could be set to rise, owing to a steep increase in inflation.

Central banks also hinted that they are keen to phase out quantitative easing, another tool that has been credited for boosting stock markets in recent years.

Should monetary authorities finally put an end to years of pumping money into the financial system and lowering borrowing costs, appetite for equities will likely take a hit.

Alastair George, an investment strategist at Edison, is shocked that these developments, coupled with an uncertain global economic outlook, have yet to cause panic across equity markets and believes that greed has caused investors to lose sight of the basic fundamentals.

“We believe there remains a significant degree of uncertainty in the economic outlook at present,” he says.

“However, because of the long period of asset price gains in this decade, investors are currently reluctant to demand increased risk premiums for risky assets for fear of missing out.”

US bubble set to burst?

Mr George is particularly concerned about the direction of the US economy, despite the Fed’s best efforts to ensure investors that it is on the mend.

“The staff turnover at the Fed makes policy even harder than usual to forecast,” he says. “Trump’s policy agenda appears stuck in politics and would now require an astonishing turnaround to become a meaningful positive for investors.”

Mr McQuaker agrees that Trump’s government will struggle to implement its agenda and warns that the president’s popular policies, such as tax reform, have been misinterpreted as good for all companies.

To add to these risks, he argues that many of the tech companies - such as Netflix or Google - responsible for powering the US stock market rally will struggle to live up to the lofty expectations held by investors.

“Super companies could easily disappoint investors, through failing to execute business plans properly, incurring the wrath of anti-trust regulators, or over-promising on the benefits of new technology,” he says.

China, Brexit and North Korea

Worryingly, the world’s second biggest economy and largest global consumer is also not immune to risk. As Neil Woodford has been quick to point out, rising debt levels in China could easily derail the country’s banking system and entire economy.

Other major concerns at this stage include North Korea’s nuclear weapons threat, frequent terrorist attacks in the West and the mysterious outcome of Brexit.

"There’s more political uncertainty now then I think we’ve ever seen,” says Robin Keyte, director of Keyte Chartered Financial Planners.

Mr Keyte has been surprised by the stock market’s response to warnings of global economic turmoil. He claims that investors are regularly ignoring potentially devastating developments, preferring instead to cling onto positives.

One example he gave was the boost the depreciation of the pound has given to UK equities.

"There’s no doubt that the UK markets have been given a large boost by the devaluation of the pound, but that is a one-off hit. That is not something that is going to continue,” he says.

How should advisers be positioning clients now?

In an environment where hype overpowers alarm bells of uncertainty, Mr Keyte prefers to invest in “as boring a way as possible”.

He claims that investing in non-equities is not an option right now, mainly because commercial property and fixed interest, his first port of calls, are gripped by fund suspensions and paltry returns, respectively.

As a result, he’d rather stick his clients’ money in equity income funds.

“Even boring old-fashioned equity income funds are still quite highly valued, so they are not immune to a correction in the market,” he says.

“But when there is a drop, at least there is an income yield of three to four per cent to soften that blow. It’s as dull as that.”

Value can always be found

For other investors, including Minesh Patel, chartered financial planner at Finchley–based EA Financial Solutions, funds that target undervalued equities currently represent one of the most sensible options.

Headlines regularly point out that global indices are rising, yet fail to mention that only a handful of companies are often responsible for these surges.

“Investing in equities is investing in companies that have listed on stock markets throughout the world,” says Mr Patel.

“While equity markets as a whole are highly valued on measures such as price earnings ratio, there is still value to be found across different sectors and, therefore, investing in active funds where stocks which still offer value are identified are likely to produce positive returns going forward.”

That type of approach is currently favoured by Fidelity’s Bill McQuaker, who claims that companies in the energy sector, as well as some solid US stocks, have been overlooked in favour of racier growth prospects.

Value strategies also tend to fare better in volatile markets, although it is a style of investing that might not suit all clients, particularly those approaching retirement.

Cash and gold

“Portfolios should always reflect the clients’ objectives as a priority, with the market landscape and positioning a derivative of that objective,” says Tanguy De Lauzon, head of capital markets and asset allocation at Morningstar Investment Management, Europe.

“It is therefore never as simple as saying ‘the US market is expensive so we avoid that asset. Russia is cheap so we invest heavily in it’.

Instead, advisers should be concerned with ensuring that the clients’ objectives are best reflected via a holistically considered portfolio that contemplates valuations on a risk-adjusted basis.

“With this in mind, valuations are generally stretched and the valuation-implied return expectations are commensurately lower than what could be considered under ‘normal’ conditions", Mr DeLauzon says.

"This implies that prudence is warranted across the entire portfolio range. As the allocation between cash, fixed income and equities are ultimately the biggest driver of performance, a willingness to preserve capital takes precedence and we have advocated increased cash levels to provide protection and ammunition."

Another potential insurance policy against stock market turmoil is gold. "Gold could turn out to be an under-owned and well-priced insurance policy,” say Mr Luke and Mr Lacey at Schroders.

“Gold’s perceived ‘safe haven’ status is well-supported with hard evidence. For example, if we look back at gold price performance between 1961 and July 2017, it is very clear that gold price annual returns were positive, particularly during periods of high inflation, while stock market returns were negative", they add.

Daniel Liberto is a freelance financial journalist