It is hard to imagine how we got to this strange point where the world order as we knew it has been upended. Markets are struggling and unemployment sits at 8.9 and 10.2 per cent in Australia and the US respectively, without including those people in receipt of JobKeeper and similar allowances.
There is no doubt the economy is looking grim, and the last time unemployment was this high in Australia was in 1993.
Why Markets Can Disconnect From Economic Reality
I also know that people are concerned about the seeming disconnect between the real economy and financial markets. It’s certainly true that the markets appear impervious to bad news, particularly in the US.
This disconnect isn’t entirely irrational, markets are forward-looking by nature. They price in expectations of future earnings, not current conditions. When central banks flood the system with liquidity and signal that interest rates will remain low for an extended period, investors have little incentive to hold cash. That pushes money into equities even when the underlying economy is hurting. It’s a dynamic we’ve seen before, but rarely this starkly.
In the US, markets have recovered all their lost ground since March and have actually powered ahead. It feels like US markets think we are still in boom times. Yet there are some interesting and very unusual things going on over there.
The Risk of Concentration in a Handful of Stocks
At the end of July, the YTD performance of the S&P500 index was being completely dominated by five stocks Amazon, Apple, Facebook, Microsoft and Google – these stocks are up an astonishing 35% for the calendar year to date.
That leaves the rest of the S&P500 index, a basket of 495 stocks, down by a combined 5 percent. This level of dispersion is very unusual and is testament to the reach and power of these tech giants.
Ben Carlson identified that the returns in the S&P500 are very closely correlated with the size of the companies with the largest companies performing best, and the smallest companies struggling the most. In times of uncertainty, this makes sense.
Why High Valuations Don’t Always Equal Strong Returns
But before you go and sell all your smaller companies, you need to be aware that the larger companies are now very expensive by any measure of traditional valuation. Amazon for example is trading at a price earnings multiple of over 120 times.
The danger, however, is that investors looking at the headline index number assume the market is broadly healthy. It isn’t. Index-level gains that mask significant underlying weakness are a warning sign, not a comfort. When a handful of stocks carry an entire market, the concentration risk is real — and if those stocks reprice, the index falls hard regardless of what the other 495 companies do.
Investors tempted to pile into growth stocks right now would be well placed to remember the tech crash of 2000 where tech stocks, having been pushed to unrealistic valuations, had a well overdue readjustment.
Where some of the tech companies, particularly the ‘Big 5’, appear expensive, they are also very good sustainable businesses, but that’s not the case for all tech companies. Take Tesla for example. The fabled electric vehicle manufacturer has just turned its first monthly profit, yet its market capitalisation is US$263Bn and it trades on a price/earnings ratio of 737 times. (For comparison, you can buy shares in Toyota Motor Corp for 12.87 times earnings).
What Six Decades of Data Say About Value Investing
Let’s take a hypothetical. I am going to give you two choices in building your portfolio. The first choice is to build using a portfolio of the cheapest, yet most profitable stocks. Option two is to build your portfolio using the most expensive, least profitable stocks.
Most rational people would choose option one.
Fortunately, the historical data is firmly in favour of the rational investor. While holding expensive low profit companies may have worked in the past few years, there’s six decades of evidence showing that the portfolio of cheaper, more profitable stocks will outperform the low profit growth stocks, in fact over the past six decades the rational strategy has created 132 times more wealth than the more speculative high growth strategy.
Why Fundamentals Still Matter for Long-Term Wealth in Australia
If we take out the performance of the major tech stocks from the S&P500 index, the picture for US market is far more sober than it first appears.
In Australia, the position is similar with the ASX300 index down 8.4 percent since 1 January 2020.
While some investors are finding comfort in chasing the growth stocks, the most compelling evidence lies in the corner of the rational investor whose exposure to value and smaller stocks positions them with an exposure to the highest expected return sectors of the market. Since 1975, value stocks have outperformed growth stocks in 27 out of 44 years, over 60 per cent of the time, and the average annual outperformance of value stocks over growth stocks for the period was 5.93 per cent.
Being patient and sticking to the strategy can be hard, but the evidence keeps pointing us back to a diversified portfolio of quality companies. Brian Chingono of Verdad Research puts the alternative succinctly: “it’s like a game of musical chairs where the speculative logic of buy high, sell higher seems fun until the music stops.”
Some will argue that it is all different now because tech stocks are changing the landscape of how we live, consume and interact. The latter is true, tech is changing our world, however the finance part doesn’t change. In Finance 101 we learn that the best estimate of the value of an investment is the present value of its discounted future cashflows, where the discount rate is based on the perceived risks around the certainty of the cashflows. To summarise, profitability and price really matter. Speak to a financial adviser today.
