Overpriced assets are no insurance against adverse economic developments
The priciest stocks, tech ones, have alarmingly become ‘safe havens’
Any review of the holdings of global pension funds, unit trusts, hedge funds, passive exchange traded funds (ETFs) and retail investor portfolios shows that almost all are heavily exposed to a narrow group of securities.
Few global portfolios are not dominated by stocks that represent the winners of the past three years: US large caps, technology, growth and quality. We are also witnessing a global capitulation, out of what has not worked in recent times — especially cheap stocks, value funds, emerging markets, and contrarian investment strategies.
Chasing what has worked in the past at the expense of what has suffered is a predictable feature of investment markets. Yet it is rare that consensus and the market are positioned in such a narrow range of stocks and themes. There is immense pressure to invest in what has worked well in the immediate past: the performance gap between the narrow group of winners and the broad universe of underperformers has been extraordinarily wide.
The 10 largest constituents of the FTSE/JSE all share index (comprising 62% of the weighting) returned 49% (on average) over three years. The other 127 shares in the index — comprising only 38% of the weighting of the index but representing 93% of the number of stocks in the index — declined by 29% on average over the same period.
This discrepancy in performance has been replicated in markets worldwide, though the JSE is more distorted by the relative size of Naspers and Prosus in our market, which masks the fact that the average SA stock has been among the poorer global performers.
Analysis of the top holdings of the largest SA unit trust funds reveals high levels of overlap and substantial exposure to the 10 largest local stocks, the recent winners. Similarly, the largest holdings in actively managed US funds are Microsoft, Amazon, Alphabet, Facebook and Apple. Most managers are making an explicit bet that the experience of the recent past will persist. On the JSE, this assumes most companies will never recover from their deep bear markets.
This discrepancy in recent performance by popular mega-caps can be explained by superior earnings growth and a widening gap in valuations between the mega caps and the balance of the market. The impact of the Covid-19 pandemic on cheaper, more cyclical stocks has been severe.
Conversely, the lockdown measures have enhanced the relative profit performance of higher-quality businesses, especially the tech stocks that benefit from the accelerated move to digitisation.
Bad macroheadlines — such as a rise in Covid-19 infections in the US — have caused the Nasdaq to rise when ‘risky’ assets such as cyclical equities decline
The share prices of secular growth stocks such as Amazon, Microsoft and Tencent have increased dramatically in the past few months, as investors rushed back into equities after the March sell-off. Tech-heavy indices such as the Nasdaq, S&P 500 and the all share index have thus staged remarkable recoveries — the S&P 500 recouped all its 2020 losses in June while the Nasdaq was hitting record highs.
While tech stocks are rare beacons of growth in 2020, the rise in their share prices is almost entirely attributable to shareholders paying more per dollar of earnings.
Secular growth stocks are long-duration assets — investors take a view that long-term growth compensates for higher valuations — and hence compete for capital with bonds. In a world of ultralow global bond yields this has had a dramatic impact on equity valuations. A company such as Tencent trades on 49 times earnings.
It is alarming that the most expensive stocks, tech ones, have become “safe havens”. In recent times bad macro headlines — such as a rise in Covid-19 infections in the US — have caused the Nasdaq to rise when “risky” assets such as cyclical equities decline.
We argue that buying overpriced assets such as developed market bonds and expensive equities is a poor way to insure your portfolio against adverse economic developments.
Investors have also sold out of cheap underperformers if risk is perceived to be high. They are concerned about the lack of visibility about near-term earnings in a Covid-ravaged world. This fear is being felt most acutely in emerging markets such as SA, which lack the capacity to use stimulus to counter the effects of the lockdown. As with expensive “safe havens”, little reference is made to price paid for cheap stocks.
We would argue that many securities are discounting long-term outcomes that are overly pessimistic. Economies will eventually recover from the Covid-19 shock, even if the recovery is stop-start and it takes many sectors a few years to reach 2019 levels of activity.
There is a growing consensus that global equity markets have moved too fast and are pricing in an aggressive “V-shaped” recovery that is unlikely to materialise. While time will tell whether this is the case, we think this narrative is overly simplistic. It fails to appreciate that share price recovery has primarily taken place in stocks (such as tech) that outperform in a low-growth environment. Cheap cyclical stocks that are more dependent on global growth have languished and have incurred sharp losses in 2020.
While the tech-heavy Nasdaq is hitting fresh highs, the average stock on the S&P 500 is lower than at the end of 2017. This discrepancy is even more pronounced in a comparison between the Nasdaq and more out-of-favour parts of global markets such as small caps, emerging markets, financials and energy.
Again, most market participants are positioned in a way that assumes this relative price-performance persists. As contrarian investing becomes scarcer its value rises, particularly as a hedge in portfolios that are heavily weighted in crowded, expensive assets.
• Le Roux is a fund manager at PSG Asset Management