Right now, investors are facing two options: invest in the market’s momentum, while acknowledging that low returns are likely; or step aside, given the risk of low returns and higher volatility. Of late, we’ve chosen the latter option, as we are convinced it is the rational approach. But many investors seem to disagree.
Over the past six months, Montgomery funds have broadly matched the market’s return despite very high levels of cash. But, over 18 months, we are a way off. The result is that investors are punishing managers, like us, who are acting rationally. To us, it’s a sign that investors are willing to accept too much risk (more about such signs in a moment).
The economic backdrop is currently very supportive for equities. The conditions the Reserve Bank of Australia reported at the board’s most recent meeting – accelerating economic growth at above trend rates, improving labour conditions, low wage and price inflation (3 per cent in the UK and 2.2 per cent in the US) and a de-risking of the household debt picture – are also being experienced in many developed economies. Unsurprisingly, equity markets from Germany to South Africa have been on a tear.
All assets seem to be held up by goldilocks conditions, including accelerating economic growth – the US is now growing at an annualized rate of 3 per cent declining unemployment and an absence of wage inflation thanks to competitive forces, particularly in the retail sector. Notwithstanding double-digit falls in the resale prices of properties in a variety of inner Sydney suburbs (something we have warned readers about for a while), asset prices remain elevated and implied returns have reached historic lows.
Indeed, and as an aside, the work we have done reverse engineering current share prices to arrive at the implied expectations embedded in them has revealed, in many cases, expectations that are simply impossible for companies to meet. By way of example, CSL’s current share price can be justified only if double-digit earnings growth occurs, without interruption, for the next decade, and then continues to grow at rates above global economic growth rates, forever. That would mean that CSL would eventually have to be rebranded ‘Earth’ because it would have taken over Google, Amazon, Apple, Facebook, Exxon Mobil and many other companies as it continues to expand at rates above the rest of the world. Similar expectations can be said to be supporting a variety of well-known large and mid-cap companies.
Share prices today are buoyed by the aforementioned goldilocks conditions which are expected to translate to even stronger earnings growth than is being achieved currently. And currently US corporates are growing earnings at rates above expectations. But strong earnings growth has existed prior to previous market highs. Earnings were growing strongly prior to the global financial crisis, prior to the tech wreck and prior to the great crash of 1929, and share prices today have run even faster than the earnings growth rates currently being accomplished. There are now 28 companies in the S&P500 trading on a multiple of more than ten times revenue, and there are more than a dozen companies in the Nasdaq 100 trading at more than 240 times earnings. That’s not a typo. Indeed, it seems that the most popular companies are those that are losing more than a billion dollars per year. Tesla, Uber and Twitter make no money and collectively their market capitalization is over US$130 billion. The American Airlines CEO was recently quoted saying, “I don’t think we’ll ever lose money again”.
In Australia, we aren’t immune to the emerging exuberance either. Companies that are ‘pre-revenue’ are trading at nearly three quarters of a billion dollars. The listed property relocation start-up, Updater, generated revenue of just over US$500,000 in the six months to June 30 and its market cap can be counted in the many hundreds of millions.
Of course, high prices are not themselves a sign that the market is at imminent risk of a correction, but when the correction does occur, investors will look back on those high prices and wish they’d paid more attention to them. It’s only on the other side that we see signs for what they are – shots over the bow.
Perhaps most importantly, it is worth noting that there is no correlation, in any year, between economic growth rates and stock market returns. Goldilocks conditions in the economy don’t necessarily generate goldilocks returns for investors and, with implied returns already low, the risk-adjusted returns from cash are becoming much more attractive.
The Montgomery Global Funds own shares in Amazon, Apple and Facebook
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That quote from the American Airlines CEO reminds me of my favourite quote of the year , from the WeWork CEO: "Our valuation and size today are much more based on our energy and spirituality than it is on a multiple of revenue."
I agree. At the moment I’m more worried about return of capital rather than return on 😊
Preservation of capital is number one for my clients (all retirees). We are increasing our allocation to equity funds who share that priority. All my clients agree that they would much prefer to underperform in momentum driven markets, than get 100% of the downside when markets revert.