The past week has been a turbulent event for investors, stopping the bull market in its tracks and serving as a reminder that equities are a risky asset class.
An outbreak of bargain hunting on Friday and signs of buying in the US market were not enough to shift the mood from one of relative caution as investors gravitated to safe-haven gold stocks at the same time as opportunistically eyeing some beaten-down growth darlings.
Fund managers say there were good reasons for stocks to sell-off, taming some of the euphoria that emerged with prices reaching lofty levels in the dominant US technology space and elevating the multiples of tech darlings worldwide. Many companies subsequently looked expensive, but that hasn’t been enough to halt the rise of the FAANG (Facebook, Apple, Amazon, Netflix, Google) stocks and their imitators – until now.
“We have observed an unusual divergence in performance this year where higher-multiple stocks have sharply outperformed low-multiple stocks,” Tom King at Nanuk Asset Management said.
“The multiple got out of whack,” agreed Greg Bundy at Federation Asset Management. “I’ve never seen that kind of spread,” he said, referring to the gap between the most expensive and least expensive companies in the market.
The questions for investors now are whether they should start to build up positions in their favourite companies, wait to see if there is a better entry point further down the track, rotate sector preferences, or think about cashing in their equity holdings and taking profits.
“A sell-off was not a surprise to us. It’s healthy and what we would expect,” said Pengana’s chief investment officer for international equities, Jordan Cvetanovski. “There was a lot of positivity around. Stocks got very expensive.”
The fund manager moved to his maximum cash weighting of 20 per cent this year and is now selectively deploying that back into global equities.
“We’re finding value in European industrials, and Asian stocks are very cheap by and large,” he said. “We have a list of 100 stocks that we are watching. We are planning to build positions in quality businesses that have been sold off.”
Any signs of buying in high-multiple stocks will be a good barometer of whether investors are still bullish overall on equities, said Mr Bundy at Federation. “You can’t let the volatility cloud things. If you’re a fan of a company, it’s great if you can buy at cheaper levels,” he said.
But, investors need to remember that the environment is changing for markets over the longer term, warned Nadar Naeimi at AMP Capital.
“We are moving from quantitative easing to quantitative tightening,” he said with reference to the US Federal Reserve’s measures to drain liquidity from markets. “There’s a cost to better growth and that’s higher inflation and higher interest rates.”
In such an environment, the companies that will perform well will be those that are leveraged to improving economic growth, such as energy companies and financials, he said.
Resource companies with strong, free cash flow, strong dividends and growth also tend to do well when the underlying economy is growing, the AMP Capital investor said.
At the same time, stronger economic growth doesn’t necessarily correlate with stronger stockmarket performance. And finally, Mr Naeimi concludes: “I think that the tech stock story is over.”
Competing with headlines around Donald Trump, China, and the fixed income market is a subtle shift in markets, Mr Bundy said.
“The headlines are Trump, China and bonds but the fundamental picture has changed.”
US rates key risk
Historically in times of higher uncertainty Australian investors would be buying up the high-yielding big four banks but there’s likely to be some caution around repeating that trade in the current market.
“Now you have to think twice about that,” he said, given the Hayne royal commission and changing credit environment.
Without the option of investing in the banks, investors may now gravitate to taking some profits and holding cash, he added.
“We don’t think there’s panic in the market,” said Elizabeth Tian, investment director at Citi, who is positive on the banks. “Coming out of reporting season, we saw bad debts at record lows and they have plenty of capital. We prefer the banks that are less exposed to retail banking, however.
“The silver lining [of this week’s sell-off] is that the Federal Reserve may slow interest rate hikes,” she said.
US interest rates are a key risk for markets, she believes. The mid-term elections in the US in November may also trigger some more volatility, and the US earnings season starts on Friday. “Earnings expectations are quite stretched and could be pared back,” Ms Tian said.
One benefit of holding cash is certainty of value. “As interest rates go up and corporate bonds are looking a bit precarious, bonds and equities could both sell-off,” observed Pengana’s Mr Cvetanovski. “If this is a proper sell-off, then it’s only the beginning.”