Caroline Cai from Pzena Investment Management speaks to The Inside Network’s James Dunn for our IN60 series. The Inside Adviser
The historic outperformance of big tech stocks in the US may look like a global outlier, but many developed markets (including ours) have high levels of concentration risk. That may not be the case for long, with a likely softening interest rate environment set to re-order indexes around the world.
Bubble mania – The cause and solution
It’s not hard to find commentary about market “bubbles” on a daily basis, where you can take your pick on traditional bond prices, property, growth equities and now extend the topic to bitcoin, gold or many other financial markets. At best it’s a welcome relief from COVID-19, but ultimately it resembles the virus chatter in the largely pointless effort to create a simple coherent argument that will survive scrutiny in the years to come.
On a macro level the conditions are brimming with support. Low rates for as long as necessary, fiscal stimulus everywhere and household savings well above historic levels. A vaccine rollout only adds to the sense that economic growth can bounce back strongly later this year and tone-up corporate earnings to justify equity valuations, while also buoying household income and therefore house prices.
Accompanying the big picture are a multitude of fun facts on why markets are frothy. Home sales occurring pre-auction, high clearance rates and demand for residential mortgage-backed securities (RMBS) override any chatter on affordability, capital repayments, low-income cash flow stress and the potential impact from lower migration.
Similarly, earlier concerns on corporate defaults and “zombie” companies with high debt has been tossed out as spreads between A and BBB-rated credit grind to the lowest in a decade. Record levels of issuance and high gearing is just a passing comment rather than a concern. Yield-hungry investors have taken the yield on the junk bond index to below 4% for the first time ever, encouraging even higher-risk issuers to market.
For equity valuation the justification is simple, the risk premium and the prospect of a bounce in earnings this year may be enough to bring high P/Es towards acceptable levels. It is therefore only of passing interest that a large swag of listed companies has no earnings, and none really in prospect.
Around 30 per cent of the mid and small-cap Russell 2000 index constituents are currently loss-making and forecast to remain so for the next two years, yet within that, the speculative start-up pharma/biotech sector is up 50 per cent in 2020 – all on a hope and promise. A screen of developed market companies with capitalisation of more than US$2 billion ($1.6 billion) and negative earnings accumulates to a total value of US$1.6 trillion ($1.26 billion) and 30X EV/Sales. Within these groups there are bound to be gems of the future, but the collective valuation is quite likely to be lower once investors want to see real money.
SPACs (special purpose acquisition companies) have blown in, a US version of our local cash box companies in the 1980s. And the same phenomena can be observed, investors paying above NAV for a cash vehicle that can buy anything (and take a hefty fee along the way). Some IPOs are trading up hugely in the days after listing. You would assume the investment banks would have aimed to maximise the price based on a glowing assessment of their future, but no, the investor market knows better, and the company is clearly worth a lot more.
Where does this end? The well-worn path that markets can stay irrational longer than one can stay solvent, or perhaps more appropriately, sane, still applies. Valuation is not a good indicator; a trigger is required. The most likely spoiler, aside from an unexpected event, is yet again the central banks.
Historically, a rise in rates from inflation or overheated conditions ends the party. Today, central banks are championing higher asset prices and are unwilling to even hint at any reason to curtail events. If fundamentals, be that house-price-to-income ratios, appropriate spreads for high-risk credit and earnings for equities are no longer important in asset prices as central bank obsession with managing expectations takes over, they are then in effect controlling financial markets.
The question then is how far they are willing to ride the current wave, and if they do have any concern, just exactly what can they do? Any hint of ebbing support could be calamitous.
