Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 246

Unwinding is warning of late stages of boom

Last year in Cuffelinks, I wrote an article entitled ‘Fear of missing out trumping fear of loss’ in which I highlighted the overwhelming demand for Argentina’s 100 year bond issue, despite the country’s litany of defaults, military coups, and bouts of hyperinflation over the last 90 years. The demand for Argentina’s bond issue was the tip of an iceberg representing investors’ insatiable appetite for returns above cash.

'Fear of missing out' driving markets

From post-80s American art, to low-digit number plates, stamps, coins, wine, and collectible motor vehicles, 2017 saw auction records smashed just as the appetite for Bitcoin, KodakCoin, and any company that added Blockchain or Nodechain to their name, fuelled a fear of missing out that usurped the fear of loss.

Then last month I wrote; “I do not know with any useful accuracy when the US market will turn down more meaningfully than it did last week …”, and I listed many problems facing markets.

The recent enthusiasm for higher return and higher risk alternatives, which always defines the late stages of a boom, has begun unwinding. And the unwinding will have serious implications for equities, especially those companies whose earnings multiples can only be supported by an uninterrupted period of high growth rarely achieved in the business world.

One useful signpost, following a period of unbridled optimism, that an unwinding has begun, is investors in credit markets pulling back, even while equity investors continue to party.

First, let's look at equities

In late January and early February, volatility spiked but investor bullishness and complacency were largely unwavering, especially when it came to tech stocks – enthusiasm for which was reflected in new March highs in the Nasdaq.

One of the most crowded trades has been US technology stocks. Today the Nasdaq 100 is dominated by a few names as investors have piled into index funds that care little about future prospects or value. Apple (NASDAQ: APPL) alone accounts for 12% of the Nasdaq 100 index. Alphabet (NASDAQ: GOOGL) at 9.4%, Microsoft (NASDAQ: MSFT) at 8.2%, Amazon (NASDAQ: AMZN) at 6.9% and Facebook (NASDAQ: FB) at 5.5% are the next four largest companies. A significant part of the gain in both the Nasdaq 100 and the S&P 500 indices over the last year can be attributed to an extremely narrow band of tech stocks.

Immovable bullish sentiment toward a narrow band of similar companies is reminiscent of the heavily-crowded positioning that has marked important market tops of the past.

In the week ending 23 March 2018, investors poured $3.3 billion into the PowerShares QQQ Trust Series 1, the biggest exchange-traded fund tracking the Nasdaq 100 index. It was a cash injection into technology shares not seen since the peak of the tech bubble. J.P. Morgan also reported the biggest weekly inflow ever into equity ETFs in the week ending 16 March of US$34 billion.

Now to credit markets

Meanwhile, US corporate bonds are sending investors a warning. Investment grade bond spreads now sit near their widest level in six months and yields have risen to their highest level in six years. Corporate bond investors are pushing yields higher, signalling the greater risk associated with investing, while their equity counterparts continue to accept a high P/E and prices that imply ultra-long-term growth rates that few businesses have ever achieved.

Elsewhere, current forecasts for US federal government borrowing needs, expected to exceed 100% of GDP by 2028, are brushed aside. By contrast, we have been reminded of the 1980s, when federal publicly-held debt hitting nearly 40% triggered fears of an apocalypse. According to some analysts the demographics were more favourable in the 1980s, and tailwinds existed in the form of productivity growth, financial-sector deregulation, and benign inflation. Today, these could now be headwinds and yet complacency over rising debt and deficits persists.

We agree with analysts who suggest the jump in the TIPS (Treasury Inflation-Protected Securities) market and in Libor spreads to levels last seen in the GFC should be setting off alarm bells because it is a sign that monetary policy has tightened considerably.

LIBOR rates since 2008

Quantitative Easing has been inflationary for property and financial assets including equities, bonds and bond proxies. Quantitative Tapering will at least generate heightened volatility in the same markets. And as volatility increases, cost-of-capital assumptions increase, opportunity costs rise, price-earnings multiples contract and credit stress or merely fears of credit stress become more frequent.

The 12-month annualised Sharpe Ratio for the S&P 500 reveals that the combination of very high returns and very low volatility in recent times is an anomaly last observed in the 1950s. The combination of higher volatility and lower returns is likely to return.

12-month annualised S&P 500 Sharpe Ratio to Dec.31, 2017

Source: Gestaltu, ReSolve Asset Management

The figure below shows that when volatility (risk) as measured by the VIX index, picks up, P/Es (price to earnings multiples) contract. Investors are simply less willing to make optimistic assumptions about a company’s prospects, and therefore less willing to pay higher multiples, when a fear of loss replaces the fear of missing out.

Volatility as measured by the VIX Index versus P/E ratios for S&P 500

Source: Bloomberg, ETF Daily News

There are of course many arguments that suggest portfolios should be fully invested. We agree that in the long run, being fully invested is preferred. But it is also true that the higher the price you pay the lower your return, and holding long-term just means locking in a low return on a long-duration asset.

Prices today are factoring in all of the bullish arguments with little room for setbacks, hiccups, or speed bumps. In the bond market, some investors are already leaving. Those who are patient will be well rewarded for making additional investments only when there is blood in the streets.

 

Roger Montgomery is Chairman and Chief Investment Officer at Montgomery Investment Management. This article is general information and does not consider the circumstances of any individual. 


 

Leave a Comment:

     

RELATED ARTICLES

Should you be a value or growth investor?

To zig or to zag?

High or low price, future returns will be low

banner

Most viewed in recent weeks

Stop treating the family home as a retirement sacred cow

The way home ownership relates to retirement income is rated a 'D', as in Distortion, Decumulation and Denial. For many, their home is their largest asset but it's least likely to be used for retirement income.

Two strong themes and companies that will benefit

There are reasons to believe inflation will stay under control, and although we may see a slowing in the global economy, two companies should benefit from the themes of 'Stable Compounders' and 'Structural Winners'.

Welcome to Firstlinks Edition 433 with weekend update

There’s this story about a group of US Air Force generals in World War II who try to figure out ways to protect fighter bombers (and their crew) by examining the location of bullet holes on returning planes. Mapping the location of these holes, the generals quickly come to the conclusion that the areas with the most holes should be prioritised for additional armour.

  • 11 November 2021

Reducing the $5,300 upfront cost of financial advice

Many financial advisers have left the industry because it costs more to produce advice than is charged as an up-front fee. Advisers are valued by those who use them while the unadvised don’t see the need to pay.

Welcome to Firstlinks Edition 431 with weekend update

House prices have risen at the fastest pace for 33 years, but what actually happened in 1988, and why is 2021 different? Here's a clue: the stockmarket crashed 50% between September and November 1987. Looking ahead, where did house prices head in the following years, 1989 to 1991?

  • 28 October 2021

Why has Australia slipped down the global super ranks?

Australia appears to be slipping from the pantheon of global superstar pension systems, with a recent report placing us sixth. A review of an earlier report, which had Australia in bronze position, points to some reasons why, and what might need to happen to regain our former glory.

Latest Updates

Investment strategies

Are they the four most-costly words in investing?

A surprisingly high percentage of respondents believe 'This Time is Different'. They may be in for a tough time if history repeats as we have seen plenty of asset bubbles before. Do we have new rules for investing?

Investment strategies

Firstlinks survey: the first 100 tips for young investors

From the hundreds of survey responses, we have compiled a sample of 100 and will publish more next week. There are consistent themes in here from decades of mistakes and successes.

Strategy

What should the next generation's Australia look like?

An unwanted fiscal drain will fall on generations of Australians who have seen their incomes and wealth stagnate, having missed the property boom and entered the workforce during a period of flatlining real wages.

Shares

Bank results scorecard: who deserves the gold stars?

The forecasts were wrong. In COVID, banks were expected to face falling house prices, high unemployment and a lending downturn. In the recovery, which banks are awarded gold stars based on the better performance?

Exchange traded products

In the beginning, there were LICs. Where are they now?

While the competing structure, ETFs, has increased in size far quicker in recent years, LICs remain an important part of the listed trust sector. There are differences between Traditional and Trading LICs.

Shares

Should you bank on the Westpac buy-back?

Westpac has sent out details of its buy-back and readers have asked for an explanation. It is not beneficial for all investors and whether this one works for some depends on where the bank sets the final price.

Investment strategies

Understanding the benefits of rebalancing

Whether they know it or not, most investors use of version of a Strategic Asset Allocation (SAA) to create an efficient portfolio mix of different asset classes, but the benefits of rebalancing are often overlooked.

Shares

Six stocks positioned well for a solid but volatile recovery

The rotation to economic recovery favouring value stocks continues but risks loom on the horizon. What lessons can be drawn from reporting season and what are the trends as inflation appears in parts of business?

Sponsors

Alliances

© 2021 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.