There are some strange things going on in financial markets. In December of last year, an original 2006 screen-print by Banksy entitled ‘Morons (White)’ sold for $95,000 at auction. In the print, a Christie's auctioneer points at framed paintings in a crowded auction room. Next to him is a framed image accompanied by the phrase: “I can’t believe you morons actually buy this s&*t."
So far, so Banksy; and in and of itself, this is not overly concerning. After all, even art mocking art collectors, is in the eye of the beholder. What happened next, however, shines a light on the current willingness of markets to embrace all things new.
The purchaser of ‘Morons (White)’ was an art collective called Injective Protocol. Once purchased, they scanned the screen-print into their computer, digitally stamped it to prove it was a one-off (aka turned it into a Non Fungible Token – don’t ask), and mirroring the KLF’s stunt of 1994, burned the original screen-print. With the original burned, they sold the digital copy for $380,000, four times what they paid for the screen-print only three months before! The piece no longer exists except on a computer screen, but to some investors it is now worth 4x what it was worth when you could do things you might actually want to do with art, such as hang it on a wall. What is going on?!
As further evidence of market mania, Jack Dorsey, the founder of Twitter, recently sold his first ever tweet for $2.9m. A group of retail investors pushed the price of Gamestop, a financially struggling US computer games retailer, up 1700% in one month. Only 16 sports cards have ever sold at auction for more than $1m. Of those, 14 were sold within the past year (yes, you really should have kept your mint condition Chris Waddle from the Italia 90 Panini album).
Tesla bought $1.5bn of bitcoin early in 2021; within a month they had made more profit on their bitcoin position than in their entire history of making cars. In 2012, 10 year Greek government debt yielded 44% as investors rushed to exit. The most recent auction for Greek government debt was 10 times oversubscribed, and it now yields less than 1%. Same country. Same issues. Same tenor. But a fundamentally different appraisal of the risks.
It feels as though serotonin and animal spirits are coursing through financial markets. It is impossible to directly measure the risk tolerance of the market, but by looking at investor’s behaviour we can gain an understanding of it. The examples above may be anecdotal, but suggest risk tolerance within financial markets is bordering on extreme.
A less anecdotal way of measuring risk tolerance is to look at buyout multiples used in Private Equity transactions, or the amount of leverage used in transactions. Both are at record highs.
It is fair to summarise the above as saying the majority of our warning indicators are flashing red. That does not mean, however, that we expect imminent collapse. Whilst there are most definitely bubbles brewing in some areas, the financial health of the UK consumer is, thanks to government support, relatively strong. Credit card and unsecured lending by the high street banks has been significantly paid down and cash held on UK deposit accounts is up by c.30% compared to last year. An extension of the stamp duty holiday supports the UK housing market, which is perhaps the most important contributor to the health of the UK consumer. The US is the second largest market for UK exports, and has recently signed one of the largest stimulus bills ever seen, with potentially more to come. The combination of economic recovery and growth, on top of continuing low interest rates, current animal spirits, some better weather and the end of lockdowns is a heady cocktail which could support a significant rerating of the UK market.
It should be said, however, that you don’t need to believe any of the above to be relatively positive on the outlook for either the UK, or value investing as a style. Academically, the best predictor of future returns for a market is not a narrative about the trajectory of the economy, or the risk tolerance of markets, but its starting valuation.
When we look at the UK market today, its valuation is most definitely not flashing red. The current CAPE valuation of the UK market is 13.6x, which is almost exactly in line with the post 1980 average. There is no sign of stress at a headline level, no signs of overheating, and indeed history would suggest that returns from today’s level, over the medium term, should be healthy.
Similarly, when we think about the prospects for value investing as a style, there is little evidence to be concerned. Since Pfizer’s announcement of a vaccine on November the 9th, there has been a significant bounce in the performance of value. However, despite this improvement late in the year, 2020 was still the worst year in 50 years for the performance of value vs growth. Until November, the headwinds for value had lasted 10 years, so it would be surprising if the renaissance of value was all over in the space of four months. As a team, we cannot find any evidence of value being stretched. Ultimately, the prospects for value are best indicated by the level of relative valuation when compared to alternative investment styles, such as growth. When viewed through this lens, the valuation disparity remains far wider than fundamentals would suggest is justified. Some companies within the value cohort have used the crisis to fundamentally adjust their business models, and there remains significant upside for long term orientated patient value investors as these changes are reflected in share prices over time. We should however, expect the pace of outperformance to slow.
Although the prospects for the UK and for value investors appear robust, we do need to be selective. There are definitely some extreme behaviours, and some bubbles, within global markets. Even within the UK, there are areas where both risk tolerance and valuations are high. It is investments in these areas which can be most damaging to your financial health. Our focus on lowly valued companies, and our heightened sensitivity to risk, will hopefully help us avoid the worst of any issues, whilst benefitting from the opportunity that remains within the UK for our unit holders.