The major trends that have hurt returns so far in 2019 are, we believe, clearly cases of market prices moving ever further away from fundamentals.
Here, it has proven useful to take a historical perspective to see how the behaviour of markets today compares with their behaviour two decades ago.
I am lucky (or old) enough to remember what came to be called the TMT (tech, media & telecommunications) bubble of the late 1990s, and fear the current market is beginning to bear some striking similarities.
In June, Chewy.com, an online provider of pet food, medicine and toys, went public to a 59 per cent first-day move, yielding a $14bn valuation. Aside from the wisdom of investing in a money-losing company that has broad product overlap with Amazon, this is reminiscent of the Pets.com IPO (initial public offering) that came to epitomise the TMT bubble of 1999-2000. Pets.com went public in February 2000 and wound down its operations that November after spending most of its capital on TV commercials featuring a sock puppet.
A more important similarity is in the narrowness of the market. In 1999, the very largest stocks were driving the market higher to the exclusion of all else. The same is happening now, both globally and in the US. Today, the press generally talks about stocks as being in a long bull market and for headline indices like the S&P 500, that’s true. Yet investors are behaving as if we are in the middle of a bear market. Long-term bond yields are low, and according to the Bank of America Merrill Lynch Global Fund Manager Survey, by June investors had reduced their equity allocations to the lowest level since the global financial crisis. Recent data indicates that allocation has only increased slightly since then. If we are in a bull market, why are investors so depressed? Because focusing on headline indices hides something important: the average stock globally is in a prolonged bear market.
The headline indices are dominated by the largest shares, and they’re doing fine. The top 50 shares in the US set new record highs last January, again in October, again this April, and again this July.
But if we look instead at an equal-weighted index of global stocks, we see that the average stock remains mired 18 months into a bear market that started on 26 January 2018.
Once again, non-fundamental drivers appear to have taken the steering wheel. If 1999 was all about big tech and ‘anything.com’, 2018-19 is all about momentum and low volatility. The US stock market is home to the largest concentration of momentum and low-volatility shares, and the stocks deemed to carry either of these characteristics have trounced the wider market.
Today, minimum volatility and momentum shares trade at a 26 per cent and 53 per cent premium to the market, respectively – near their richest levels since late 2013.
What does this tell us? It suggests that investors are willing to pay up for stocks that are comfortable to own – stocks that don’t move around much, or that have recently been popular.
Note that neither of those criteria is based on a company’s fundamentals. Whether a stock’s price fluctuates, or has gone up more than the prices of other stocks, is purely based on, well, its price. A low-volatility or momentum stock is just a really well-behaved share certificate. While such shares are well-suited to factor-driven funds, neither of these price criteria are primary considerations for fundamental investors.
In the current environment, it’s clear that, as ever, investors don’t take the same degree of comfort from all quality shares (shares with high and stable profitability and strong balance sheets). If we compare the relevant MSCI indices, quality shares in the US trade at a 38 per cent premium to those in emerging markets, despite trading at similar valuations just three years ago. To us, that suggests a mispricing, and it’s a kind of mispricing we have seen over and over in different parts of the market where good businesses with hard-to-see risks trade at great company prices, and good businesses with easy-to-see risks trade at bad company prices.
To sum up the current environment, we have been experiencing a historic multi-year bull run in “safe” securities – government bonds and deemed equity proxies – to the exclusion of all else.
However, this current run cannot last forever. We believe that the divergence among securities is extreme and at irrational levels, and while it lasts it will continue to open up new opportunities in areas overlooked by other investors. Unfortunately, irrationality doesn’t correct on any set schedule, and it will require patience to wait out this current distorted market and for these opportunities to bear fruit over the long-term.
Alec Cutler is manager of the Orbis Global Balanced fund. The views expressed above are his own and should not be taken as investment advice.