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Simon Thompson’s equity market roadmap

Simon Thompson offers an insight into the road map ahead for equity markets on both sides of the Atlantic.

Simon Thompson’s equity market roadmap

I have been waiting patiently for the past few months in anticipation of the customary summer drift in equity markets, and perhaps even a decent market shake-out, having decided earlier this year to top-slice profits on a raft of recommendations, and bank profits entirely on others where I believed the upside was limited at best.

For example, I banked a 138 per cent gain on Safestyle (SFE), a maker of uPVC windows ('Value opportunities', 30 Jan 2017); a 313 per cent return on online gaming group 32Red (TTR) ('Full house', 28 Feb 2017); a 263 per cent gain on AB Dynamics (ABDP), a UK designer, maker and supplier of advanced testing systems to the car industry ('Taking profits', 18 Apr 2017); a 100 per cent plus gain on Somero Enterprises (SOM), a Florida-headquartered company specialising in laser-guided concrete levelling equipment for commercial floors; and a 134 per cent gain on software and IT services business Sanderson (SND), ('Running profits and banking gains', 5 Jun 2017).

I also advised top-slicing some of the massive gains on holdings in support services group Renew (RNWH), cinema operator Cineworld (CINE), and defence group Cohort (CHRT) ('Taking profits', 18 Apr 2017); top-sliced a 513 per cent gain on litigation finance group Burford Capital (BUR) ('Top-slicing and running profits', 26 Jun 2017); and banked some of the 332 per cent gain on engineer Trifast (TRI) ('Hitting target prices', 2 May 2017). I have run profits recommendations on literally dozens of other companies.

With the exception of Burford Capital aside, it has paid to derisk these investments because although equity markets have continued to melt up over the summer, gains in these holdings have been harder fought following the hefty share price rises seen earlier this year.

That’s not to say that I haven’t been successfully recycling some of the cash into new investments, having initiated coverage in online columns on a host of small-cap companies offering significant potential upside including: Kromek (KMK:25p), a radiation detection technology company focusing on the medical, security and nuclear markets ('Follow the smart money', 27 Feb 2017); Lombard Risk Management (LRM) a compliance software products company ('Banking on regulation', 13 Mar 2017); Cambridge Cognition, a technology company that has developed a suite of computer-based cognitive assessments ('Positive thinking', 19 Apr 2017); and financial services group Ramsden ('A jewel in the north', 12 Jun 2017). All these holdings are showing decent gains and I expect a similar result from the two recent IPOs I advised buying into: GYG (GYG), a global leader in new build and refit superyacht painting (‘Floating a profitable passage’, 4 Jul 2017); and Strix (KETL), a global leader in the manufacture and design of kettle safety controls (‘Tapping into a hot IPO’, 7 Aug 2017).

Bearing in mind my strategy to target new small-cap investment opportunities, and highlight repeat buy recommendations on my existing watchlist, some readers have been asking for my view on equity markets for the months ahead. It’s timely as UK equity markets are still pretty close to record highs even after a sell-off last week driven by geopolitical concerns over North Korea. As always, we have to look to the US for a lead, as it has led the merry dance of global equity markets higher. 

 

Looking for direction

A key reason why equity markets have been melting up this year has been down to the collapse in market volatility: the 10-day rolling volatility of the S&P 500 fell to a five-decade low at the start of last week, and Wall Street’s gauge of fear, the CBOE Vix volatility index, was trading close to the lows last seen at the end of 1993. It’s not just on Wall Street that market volatility has collapsed.

Emerging markets equity implied volatility — a measure of the expected short-term turbulence of the MSCI emerging markets index as reflected by the prices of stock option — has more than halved in the past three years to a record low. The index is up 23 per cent this year, even outpacing the eye-watering gains on the trail blazing Nasdaq 100 technology index in the US, which is up by around 20 per cent.

And the reason why investors have become more complacent is because the world’s major central banks have kept the easy money punchbowl full, thus depressing government bond yields below their natural rate and forcing investors up the risk curve in search of higher returns in what can only be considered to be a favourable economic environment. As a result, equity valuations have become extended. In the US, the trailing 12-month trailing earnings multiple on the S&P 500 is now around 24.5, well above an average of just over 17 for the past 70 years, and 50 per cent higher than five years ago. Using the cyclically adjusted PE ratio (CAPE), as defined by Nobel-prize winning economist Robert Shiller, the ratio is now above 30, around two-thirds higher than its long-term average and a level that has only been exceeded twice: at the time of the Wall Street crash in 1929, and in the dot.com boom in the late 1990s.

Of course, bullish investors will point out that the earnings yield – the reciprocal of the PE ratio – is still attractive relative to long-term bond yields. For example, in the US a trailing 12-month earnings yield of 4.1 per cent is almost two percentage points higher than the 10-year US Treasury yield. They will also point out that earnings expectations suggest the index is trading on a less stretched 19 times forward earnings, although whether companies deliver the growth required to drive the rating down to that level is open to debate.

Moreover, the problem with that argument is that it’s based on the assumption that government bond yields will remain subdued for some time yet, even though the US central bank is set on a course of raising rates, having achieved its employment target rates, and seen the US economy recover strongly since the depths of the 2008 global financial crisis. What this means is that with the earnings yield so low, valuations are far more sensitive to a tightening of monetary policy above the market’s current expectations.

Bearing this in mind, we are in unknown territory as we have yet to see how investors react to a winding down of the Federal Reserve’s $4.47 trillion (£3.44 trillion) balance sheet, which has risen fivefold in size since the autumn of 2008 when financial markets went into meltdown and drastic action was needed by the world’s leading central bank to prop up its financial system. Guidance given at the end-July meeting of the Federal Open Market Committee (FOMC) pointed to balance sheet normalisation beginning ‘relatively soon’, as opposed to sometime ‘this year’, which was the previous timeframe, so we may not have long to wait as the next FOMC meeting ends on Wednesday 20 September.

Personally, I believe the Federal Reserve should leave an unwinding of the assets on its balance sheet resulting from its asset purchases programmes well alone for now, and look to normalise interest rates first, so that it has some buffer in place for the next time the economy goes into a downturn. The combination of rising short-term rates and a shrinking Federal Reserve balance sheet adds unneeded risk, a fact that some equity investors seem to be ignoring.

It also goes without saying that with equity market valuations already extended, they are more vulnerable to any external shock such as an escalation of tension between the US and North Korea.

 

Nagging issues

Another concern I have is that this year’s rally in the US is not broad-based. Over three-quarters of the gains racked up in the S&P 500 are down to the performance of less than 50 stocks in the index. That’s great news if you have been holding the so-called FAANG stocks – Facebook (US:FB), Amazon (US:AMZN), Apple (US:AAPL), Netflix (US:NFLX), and Alphabet (US:GOOG), – but not if you have been invested in any of the other 160 companies in the index that are in negative territory for the year.

I would also flag up that investors have been using exchange traded funds (ETFs) as a way to gain exposure to the best-performing markets, and in record levels: according to analysts, around $391bn has been invested into ETFs in the first seven months of this year, a sum that exceeds last year’s record annual inflow, and means that around $2.8 trillion has been invested since the nadir of the US market in 2008. It’s a great way of playing the upside, and has undoubtedly been a contributing factor in momentum trades, but the flip-side is that if investors want to take their ETF money off the table in a risk-off environment, then a spike in redemptions could have a detrimental impact on the underlying markets these ETFs track.

I have also been waiting patiently to see how the S&P 500 would react when it achieved the 2,486 price level, representing a 200 per cent extension of the 910 point loss incurred between hitting its October 2007 bull market high of 1,576 and its March 2009 low of 666. Interestingly, this 2,486 price level is also close to a 200 per cent extension of the last major correction, a 324 point loss on the index between hitting its May 2015 bull market high of 2,134 and its February 2016 low of 1,810. The 2,486 price level was tested on Tuesday 8 August when the S&P 500 made an intra-day record high of 2,490 before reversing all the gains and ending down on the day, before selling off heavily later in the week on mounting tensions over North Korea.

According to Fawad Razaqzada, a market analyst at Forex.com, the 2,086 price level is pretty close to the resistance upper trend line of the long-term bull channel of the eight-year plus bull run. The point being that if enough traders are aware of these factors, then they can act as a psychological barrier. I am sure many are.

Add to that the fact that equity markets have already rallied strongly to record highs on incredibly low volatility, and I have concerns that the US markets may struggle to make meaningful progress above the 2,490 record high between now and the end of next month, a period that encompasses the next FOMC meeting in September, and the German elections on Sunday 24 September.

Either way, I don't expect much from European markets, and neither do analysts at Deutsche Bank who are pencilling in a minuscule 3 per cent rise in the German Dax index by the year-end, have an underweight stance on Italian equities and are only a tad more enthusiastic about those in Spain. The strength of the euro has been a factor in their relatively lacklustre performance this year, given the negative implications this has for export trade.

That’s not to say that I am overly bearish because, even if equity markets only move sideways, there are ample special situations to exploit among the UK small-cap companies on my watchlist. And several of them are benefiting from a currency tailwind on sterling's weakness unlike their European rivals.

In such an environment, I expect stock-pickers to come into their own, a challenge I am relishing already. On that score, I will be publishing an article on Thursday this week, highlighting some interesting small-cap buying opportunities for you to take advantage of.

 

Small-cap updates

Last week, I made a case to invest in the high-yielding shares of Manx Telecom (MANX:192p), the incumbent telecoms operator on the Isle of Man (‘High-yielding opportunities’, 8 Aug 2017). A few days later the company revealed that its finance director, Danyal Bakhshi, was the subject of criminal proceedings unrelated to his duties at the company and had been suspended on a precautionary basis pending investigations being carried out.

It transpires that Mr Bakhshi appeared before the deputy high bailiff on the Isle of Man on Tuesday last week charged with being unlawfully concerned in the production of a Class B substance after a package containing a quantity of cannabis, worth almost £200, arrived on the Isle of Man from Amsterdam, and was intercepted by a customs official. He pleaded not guilty and was bailed until Tuesday 3 October. The company’s chief executive Gary Lamb is an able deputy in the meantime, having previously held the role of finance director.

Investors seem pretty chilled out about the matter as Manx’s share price is 7 per cent higher than when I recommended buying the shares a week ago. I do too, and still rate the shares a high-yielding buy for the reasons I outlined last week.

Finally, small-cap publisher Quarto (QRT:158p) has announced that it has received a bid approach “at a price the board considers to be attractive and reflective of the inherent value of the business as a global publishing platform – and hence worthy of due consideration”. Given Quarto’s share price has tumbled by a third since the company warned on profits six weeks ago, then it’s fair to say that if an offer is forthcoming it will represent a decent premium to the current share price, especially as guidance is to expect a strong finish to the year, a belief backed up by one of the company’s strongest autumn publishing programmes.

So, having rated Quarto’s shares a hold at 140p ahead of last week’s half-year results (‘Exploiting value plays’, 25 Jul 2017), it makes sense to continue to hold onto them and await developments. Hold.