In our last update, following a significant move upwards in global equity markets, we struck a note of caution. In the past fortnight stock markets have risen even further with the S&P 500 rising an astonishing 31.53% (in dollar terms) since the low on 23rd March (Source: FE Analytics as at 29/04/20). Meanwhile, there has been no significant breakthrough with regards to the virus and its spread, other than the fact that the lockdowns do appear to be working. But lockdowns cause economic standstill and the economic data that is starting to trickle in after the March quarter end makes for dismal reading. Estimates of US GDP for the first quarter were released on Wednesday 29th April and showed that the US economy shrank by an annualized 4.8 percent, the steepest pace of contraction in GDP since the last quarter of 2000 and worse than the market consensus of a 4.0 percent slump.
The fundamental question remains how, in the absence of a vaccine, do the authorities attempt to restart their economies without risking a second wave of infections.
It is often said that stock market hate uncertainty but right now they appear to be ignoring the very obvious fact that no one yet knows the depth and length of the downturn nor what consumer behaviour and the global economy will look like once we are through the worst. The markets also seem to have shrugged off a rapidly declining oil price which at one point went negative as the world ran out of space to store it, following a precipitous collapse in demand. Perhaps this is less surprising when one considers that, after a decade of underperformance, the entire energy sector now makes up only 3% of the S&P 500. In fact, the four big internet stocks (Alphabet, Amazon, Apple and Microsoft) individually account for a greater percentage of the index. In other words, the performance of these companies is significantly more important to stock market performance and a lot of the bad news for energy sector is already priced in.
Another investment mantra is “Don’t fight the Fed” and this has served investors extremely well since the Global Financial Crisis of 2008-9. What does this mean? It means that when the US Federal Reserve and other Central Banks are pumping liquidity into the system then it must go somewhere, fuelling the rise of investable assets. This time around not only have Central Banks restarted their intervention programmes on an unprecedented scale but many of them have announced that they will be buying assets further down the risk curve than ever before providing a backstop to investors.
In previous updates we have described how the market sell-off which began in mid-February was one of the fastest in history. The subsequent recovery has been almost as rapid. One explanation we came across this week was that the speed and magnitude of the decline was exacerbated by the amount of money in highly leveraged, quantitatively managed funds. When volatility rises then these funds are forced to de-lever and sell assets. Once there has been a change in sentiment, the reverse scenario plays out, leading to the possibility that technical factors have contributed to a market that has become overheated, at least in the short term. A potentially worrying statistic is that the forward price earnings ratio of the S&P 500 at 19.8x, is higher than at any point last year.
However, tempting as it is to try to justify a market move after the event and to attempt to predict the next, the bottom line is that we just do not know what that will be.
We know that trying to time markets is a fool’s errand, but we can try to think about different market scenarios. One of the areas we are trying to get grip with is the growth-value conundrum.
Schroders define value investing as “the art of buying stocks which trade at a significant discount to their intrinsic value. Value investors achieve this by looking for companies on cheap valuation metrics, typically low multiples of their profits or assets, for reasons which are not justified over the longer term. This approach requires a contrarian mindset and a long-term investment horizon. Over the last 100 years a value investment strategy has a consistent history of outperforming index returns across multiple equity markets.”
However, in the past ten years value has underperformed a growth investment style. This is perhaps not surprising given that, post the financial crisis, growth has been relatively anaemic so companies which have been able to demonstrate consistent earnings growth have been rewarded. There has also been a digital revolution such that growth companies like Amazon and Alphabet have grown rapidly and generated huge profits which they have reinvested in their own growth. Inflation and interest rates have been low which has disadvantaged traditional value sectors such as financials, commodities and energy.
In the recent sell-off, one could reasonably have expected less expensive, value-oriented shares to have held up better on the downside. Usually in bear markets investors sell expensive shares and hang onto the ones that have not done as well but many so-called value shares are in sectors which have borne the brunt of the economic fallout from the virus and it makes sense that shares in technology companies have fared relatively well. Value shares also include many companies which pay dividends and income funds typically fare better in falling markets as the income provides a cushion. However, during this downturn, the highest yielding companies have been among those which have performed worst and yesterday Shell cut its dividend for the first time since World War II.
Many commentators have pointed out that the valuation gap between growth and value is now greater than it was at the height of the 2000-2001 technology bubble, which is a cause for concern. On the other hand, Peter Hargreaves, founder of Hargreaves Lansdown, was quoted in the press yesterday as saying that traditional value investing is now an “outdated” strategy.
We are loathed to say, “this time is different” and are very conscious that selling low and buying high rarely works as an investment strategy. So, it does not seem right to capitulate now and sell all your value-oriented investments. On the other hand, it does seem likely that investors will continue to pay premium prices for those companies which will not only survive this crisis but also benefit from it.
Perhaps a better way to think about it is to try to discern those companies which will survive, those which will thrive and those which will die. This cuts across sectors and geographies. It means that stock-picking, for those investors willing to pay the additional cost, can add value. There will be companies in each category where the price already reflects the future potential. The key is to identify those companies, whether they be in sectors traditionally thought of as growth or value, where there is scope for the share price to exceed current expectations. This is why in our recommendations to our clients we aim to include a spread of different investment styles. This means that at various points in time, the performance of different funds will look strong or weak on a relative basis but our hope is that, over time, these differences are smoothed out and each portfolio is able to meet a client’s investment objectives in a risk-adjusted way.
We hope that all our clients stay safe and well. We remain as committed as ever to maintaining our high levels of client service in these challenging times and would like to remind you that we are all available to speak with you on the phone/conference calls/video link, so please do get in touch if there is anything you would like to discuss further.
1st May 2020
RiverPeak Wealth Limited