Investment warnings – What might have been and still could be

We keep a folder of ‘red-flag market indicators’ – developments that make us very uneasy indeed – and it has seen quite a growth spurt in recent months

09/12/2020

Andrew Williams

Andrew Williams

Investment Director

The future is unknowable and impossible to predict – at least on a consistent basis – meaning all forecasts are fraught with danger. Even so, with the benefit of the more reliable resource of hindsight, anyone lining up this time last year to read the runes for 2020 was on a particular hiding to nothing, given the pandemic-induced market crash, the lightning-quick rebound and – to some, most improbably of all – the recent value rally.

As we noted in A shot in the arm for value?, investing is no place for extremes of emotion in either direction and the champagne will remain on ice for a while yet – for the same reason we have managed to resist turning to anything even stronger during value’s prolonged period in the wilderness. And it is this desire to avoid complacency, here on The Value Perspective, that has led us to keep a folder of ‘red-flag market indicators’.

These are developments that make us very uneasy about markets and, in the weeks before news of Pfizer’s breakthrough in the hunt for a Covid-19 vaccine appeared to prompt markets to reappraise the value of some of the world’s most unloved stocks and sectors, that folder saw quite a growth spurt. Given nobody really knows which way markets might head next, it is well worth highlighting some of the newer and redder flags.

The first comes from late September when a solar technology business listed on the tech-oriented Nasdaq market in the US announced plans to raise $550m (£429m) from institutional investors through a placing of convertible senior notes – a type of security that takes priority over all other debt issued by a company. Set to mature in 2025, the notes promised to pay their lucky holders a regular interest rate of precisely 0%.

Ant-y climax

To our eyes, the prospect of a tech company merrily expecting the market to lend it $550m for quite literally nothing, needs no further comment but, should that flag leave you unmoved, let’s turn to what was set to be the world’s largest ever initial public offering – the postponed $37bn floatation of Ant Group, the online finance spin-off from Chinese ecommerce giant Alibaba.

Valued at the time at more than $300bn, Ant Group had been due to make its debut on the Hong Kong and Shanghai stock exchanges on 5 November but, with just a few days to go, the regulators unexpectedly raised the prospect of new guidelines that could affect the company’s future profits. The fact Alibaba founder Jack Ma had criticised China’s financial system a couple of days before may or may not have been a coincidence.

Clearly the fact the ambitions of China’s richest man can be derailed at such short notice is an investment lesson in itself but the most flag-worthy aspect for us, here on The Value Perspective, had been investor behaviour in the days leading up to the planned floatation. According to this Financial Times piece from late October, for example, retail bids exceeded the value of the shares on sale by more than 870 times.

That works out as equivalent to $2.8tn (£2.2tn) – or roughly the UK’s gross domestic product in 2019. The FT quoted one private investor as saying: “I don’t really know what the Ant Group is doing – but you will always win from subscribing to new stocks.” Elsewhere, as individuals borrowed so they could subscribe to more shares, another stand-out quote was: “I’m all in with Ant. It’s absolutely a must-have regardless of the price.”

‘FAAMG’ FOMO

This ‘herding’ behaviour – where investors follow the crowd because of fear of missing out (FOMO) or being left exposed – is symptomatic of the sort of asset-price bubble we saw in the technology, media and telecoms sectors at the turn of the millennium. Then again, “It’s absolutely a must-have regardless of the price” could be the mantra of investors for what are apparently now known as ‘FAAMG’ stocks over the last five years.

These ‘big tech’ stocks of Facebook, Amazon, Apple, Microsoft and Google’s parent company Alphabet have grown immensely in that time, with their combined weight in the S&P 500 index of US shares more than doubling from 8% in 2015 to 20% in June this year. That means these five stocks account for a larger slice of the market than the five largest stocks at the peak of the dotcom bubble in 1999.

In a similar vein, we were astonished to discover recently that 99% of the returns generated by the MSCI World index over the three years to the end of September came from just one market – you read that right, 99% – with the US responsible for 24.85% out of the total of 25.10%. That level of concentration rarely bodes well for investors over the longer term.

Some interesting commentary on this state of affairs – both from a technical and a behavioural point of view – can be found on one of our sister sites, where Sean Markowicz and our occasional podcast collaborator Stuart Podmore address the question, Is this the end for US stockmarket dominance? “Although the US has been the best performer this decade, it was one of the weakest performers in the previous decade,” notes Markowicz.

Cyclical leadership

“Investors often forget that performance leadership tends to be cyclical. What has happened now is the gap between relative returns and earnings expectations has widened. It suggests investors are willing to pay a premium for US equities, even though analysts’ forecasts for earnings no longer support that. In other words, US share prices have a lot of optimism baked into them.

“The price you pay, which you can measure through various stockmarket valuations, is often used by investors as a guide to future returns. At the moment, valuations would suggest that things do not bode so well for US equities. They have  stretched to levels which would have historically foreshadowed low returns for US equities versus the rest of the world.”

On the behavioural side, meanwhile, Podmore says: “We can very clearly see some herding at work. Our brains work very much as comparison machines, so people will be investing and comparing that to what other people do. That is very often one of the reasons why a herd or momentum is created. Investors are probably making that comparison without even realising.

“That leads to the development of that herd in the marketplace and for people to believe or extrapolate that will forever continue. And once they have acquired some of those US stocks, we have the idea of endowment effects – people will often demand far more to give up those assets than they would be willing to pay to acquire them. With over a decade of holding those stocks, they will be quite reluctant to relinquish them.”

We may be flagging furiously here on The Value Perspective but, when it comes to buying overpriced shares, sectors and countries, investor appetite shows no sign of doing so.

Author

Andrew Williams

Andrew Williams

Investment Director

I joined Schroders in 2010 as part of the Investment Communications team focusing on UK equities. In 2014 I moved across to the Value Investment team. Prior to joining Schroders I was an analyst at an independent capital markets research firm. 

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