Schroders warn of frothy markets despite ASX highs

August delivered one of the more remarkable months for Australian investors. Despite another season of patchy earnings - including disappointing results from blue-chip stalwarts such as CSL Limited (ASX: CSL) and James Hardie (ASX: JHX) - the ASX smashed through 9,000 points, rising 3% in the month. Small caps performed even better. 

At first glance, this strength might suggest a market underpinned by robust fundamentals. But as Martin Conlon, Head of Australian Equities at Schroders, and his deputy Andrew Fleming point out, the reality is very different. 

Momentum investing and quant-driven strategies are dictating short-term price moves, while fundamentals are often relegated to the back seat. For patient investors, this may be unsettling - but it also creates opportunity. 

In Schroder's webinar Broadcast Australian Equities: It's only a flesh wound, Conlon and Fleming unpack the sharp share price swings seen during reporting season. They separate justified moves from overreactions, highlight opportunities arising from the volatility, and share their outlook heading into year-end. 

Below, I summarise the highlights of the webinar. 

Momentum's grip on the market 

"What's obvious from results season," Conlon explains, "is that price reactions were savage in both directions. Few stocks were flat." 

The culprit, he argues, is that fundamental managers are no longer setting prices. Instead, computers and momentum funds are dictating the action, and even long-term investors are tempted to mimic their short-termism. 

This distortion is not confined to trading. Fleming notes that companies themselves are succumbing to short-term incentives, with management using price hikes and buybacks to appease momentum-focused markets. 

"The prevalence of underlying EBITDA metrics in remuneration is impacting allocation decisions," he says. "The losers we saw this reporting season, like CSL and James Hardie, reflect years of capital misallocation." 

A risky backdrop

If the market looks frothy, that's because it is. Bond yields are climbing as deficits balloon, yet equities remain near record highs. 

"Bond investors have a more pessimistic outlook compared with equity investors. This is usually a signal to be cautious," Conlon observes. 

Fleming agrees: "Much future capital growth is already imputed into prices. The odds are probably stacked against you as an investor today." 

For Schroders, the test is simple: if the market shut for five years, would they still want to own their current holdings? "It’s doubtful speculators would feel relaxed," says Conlon.

Healthcare scars but long-term value

Healthcare was one of the reporting season's bloodied sectors. Ramsay Health Care and Sonic Healthcare sold off heavily, while ResMed (ASX: RMD) bucked the trend with strong earnings. Fleming and Conlon remain constructive. 

Fleming noted, "They're good examples of companies possessing hidden assets. In the case of Ramsey, some of the best private hospital assets in all of Australia with very high land values attached to them and currently pretty low returns on those land values with a system where demand is only going to increase." 

Conlon added: "Margins on private hospitals and pathology are low because the government has squeezed the health industry. If you focus on earnings momentum, you would avoid these stocks. Our longer-term view says otherwise. There is no notable investment heading into the health industry. That means health companies will soon enough have the market power to raise prices for users, if the government won’t pay appropriate prices. This means longer-term margins will recover."

Optimism in pockets

Not every earnings season tale was bleak. The team sees opportunities where the market has gone too far in rewarding "momentum winners". 

Schroders highlighted several bright spots:

• Origin Energy (ASX: ORG) - its three earnings streams, including UK-based Octopus Energy, are firing. "Management's capital allocation has been excellent," Fleming notes. 
  
  
• Coles (ASX: COL) vs Woolworths (ASX: WOW) - the market rewards Coles' momentum, but Conlon argues Woolworths' larger scale and profit base make it the better long-term bet. 
  
  
• Brambles (ASX: BXB) - an example of latent pricing power. "Volumes may fall, but margins rise," Fleming explains, though he cautions that over-reliance on price hikes can backfire as seen with Qantas. 

Commodities - momentum and mispricing

The momentum distortion is most visible in resources. Rare earths and lithium stocks soared on tiny shifts in sentiment and policy support, with valuations quickly factoring in prices well above long-term sustainable levels. 

"By definition, commodities have no pricing power," Conlon says. "As soon as price trajectory (lithium) starts to rise in an earnings momentum-driven market, all people care about is the direction of earnings". 

The team prefers exposure to alumina and aluminium, where prices are depressed and fundamentals are better aligned with China's investment trends. They remain wary of iron ore, where new West African supply looms, and are cautious on pure-play miners. 

AI - promise or productivity mirage?

If resources are overhyped, so too is artificial intelligence. "The conversation has shifted to ROAI - return on AI," says Fleming. "For all the spending, there's little evidence of productivity gains."

Conlon is blunt: "Companies may save some labour, but the benefits often flow straight to US tech giants via expensive contracts. Many are stuck in deals that raise costs without boosting efficiency."

Gold and behavioural assets

Gold's surge above US$1,500/oz reflects not fundamentals but fear. Conlon calls it a "human-behavioural asset," noting that central banks, wary of US sanctions and debt levels, are diversifying reserves. While Schroders won't rule out further gains, they admit their comfort lies in commodities with clearer fundamentals. 

CSL, CBA, and the limits of pricing power

CSL remains a quality business but faces headwinds. "It's no longer the lowest-cost producer," Fleming points out. "Losing that edge makes it vulnerable," Conlon adds that while management acknowledges bureaucracy and missteps, only operational improvement - not spin-offs - can restore pricing power. 

On banks, Schroders is underweight, with the Commonwealth Bank (ASX: CBA) its largest underweight. "It's an exceptional business with outstanding management," Fleming concedes. "Since the stock is expensive, the bank is not an attractive investment." Competition from Macquarie and limited earnings growth compound the challenge.