- Signs of bubbles in some equity sectors
- Monetary policy continues to support risk assets
- Portfolio diversification is key
It’s difficult not to get anxious about all the bubble hype. Google search trends for 'stock market bubble' are the highest they have ever been in the US, while a rush of new investors onto commission-free trading apps is reminiscent of the retail-investor-driven frenzy of the dotcom boom.
In order to make sensible investment decisions, you need to understand what is driving markets. While GameStop (US:GME) mania can be explained as an extraordinary tussle between the Reddit community and hedge funds, it didn’t happen within a vacuum. Shares in Airbnb (US:ABNB) and DoorDash (US:DASH) shot up on their first days of trading in December, and special purpose acquisition companies (Spacs) – vehicles that bring companies to market with less scrutiny – raised more money in America in 2020 than in the entire preceding decade.
One area that looks concerning is the spike in margin trading, the amount of money that individuals and institutions borrow against their stock holdings. Margin debt in the US spiked by almost $120bn (£87.6bn) in the final two months of last year, according to the US Financial Industry Regulatory Authority, the largest two month rise on record and up 60 per cent between March and the end of the year. Margin trading will accelerate stock prices on the way up – and also on the way down. Similar jumps in margin trading occurred in 2007 and 2000, neither of which ended well.
Wild swings in parts of the market make it difficult for more cautious investors to know what to do. Swathes of technology and ‘new economy’ stocks are now trading on very high valuations compared with recent years. An extreme example is Tesla (US:TSLA), up 610 per cent in the year to 1 February, while Apple (US:AAPL) and Amazon (US:AMZN) and were up 71 per cent and 60 per cent, respectively.
Despite signs of market froth, however, there are good reasons why internet stocks and other high-growth areas have done so well recently. A combination of record low interest rates and an enormous stimulus programme initiated last March have had the effect of inflating parts of the stock market which have coped successfully with the pandemic.
While technology-led companies have become more highly valued, some may simply have been underestimated. As Terry Smith points out in his latest letter to shareholders, the main assets of some of the best companies are intangible, and old-style valuation techniques can miscalculate the intrinsic worth of businesses.
Millions of people stuck at home with nothing to do and extra money to spend have also been drawn to the markets, with trading platform Robinhood attracting 3m new customers in the first three months of 2020 alone. According to data company Envestnet Yodlee, there was a significant increase in US trading as soon as a $1,200 stimulus check reached American citizens last May. About 20 per cent of Wall Street trades were made by retail investors last year, up from 10 per cent in 2010.
The markets welcomed Joe Biden’s plans to spend a further $1.9 trillion on Covid-19 response measures. But when the economy picks up, if the US central bank – the Federal Reserve – shows any appetite for a tightening of monetary policy, this is likely to lower the valuations investors are willing to tolerate in the more highly rated sectors.
Central banks face a dangerous bind: historically high levels of debt, both public and private, require that interest rates be kept low, while a return of inflation – an eventual consequence of excessive monetary easing – would require that they rise. This is an uncomfortable background for markets.
There are also fears that the Chinese market may be entering bubble territory, following a strong year for Chinese equities and frenetic churn in China’s rapidly growing mutual fund industry. The Financial Times reported that Shanghai-based consultancy Z-Ben estimates that between 20 per cent and 30 per cent of the cash raised by new active equity funds is redeemed within six months.
How to position your portfolio
Even if prices are unmoored from fundamentals in pockets of the market, no one knows when the market will correct itself. Economist John Maynard Keynes’ 90-odd year old adage holds as true as ever: “The markets can stay irrational for longer than you can stay solvent”.
That said, if you are heavily exposed to US growth stocks it might be worth reallocating to less highly rated parts of the market. The technology-heavy Nasdaq Composite Index had its strongest performance for 11 years last year, finishing up 41 per cent. If you haven’t rebalanced your portfolio recently, you might have more exposure to the US than you realise.
Ben Yearsley, investment director at Shore Financial Planning, thinks Asian markets will do well over the next decade and suggests that investors with the right growth and risk profile could have 20 to 25 per cent of their equity exposure in emerging markets. He says a lot of capital left emerging markets when the pandemic hit, but flows back in have significantly picked up in the last couple of months. This, alongside well documented fundamentals such as growing economies and rising middle classes, should help stock prices. Investors should be aware, however, that as in the US, valuations of some of the giant Asian technology and internet companies also look stretched.
While private investor portfolios often have too much of a home bias, Jason Hollands, managing director at Tilney, thinks the UK might be the “wild card performer” this year. Despite poorer long-term performance, the MSCI UK Index has kept pace with the MSCI World and MSCI USA indices over the past three months, and the UK is proving to be one of the better countries in terms of vaccine roll-outs. The cyclical-heavy UK market could bounce when the economy picks up and the UK might start attracting more investment now a Brexit deal has been achieved. Japan, meanwhile, has performed well over the past year and should be a beneficiary of a recovery in the global economy.
However, as we discussed in a recent feature on investment styles, growth companies concentrated in the US and North Asia may continue to dominate stock market performance, as they have for the past decade. It is important to make sure you have a diversified portfolio to be covered for whatever happens.
If you have a heavy bias to relatively lowly rated stocks you risk significantly underperforming the market in the long term. If you are overexposed to growth stocks, you might suffer some sharp losses in the near term if the investment mood changes. History suggests any rotation to value companies could happen quite quickly, but in the long term it is the growth companies that will shape our future.
Richard Champion, deputy chief investment officer at Canaccord Genuity Wealth Management, says he still favours growth companies, pointing out that timing is important if you are going to be a successful value investor – and that is extremely difficult to get right. He and Mr Yearsley also think the growth potential for small- and mid-caps is more attractive than for large-caps in the current climate.
In terms of overall asset allocation, wealth managers have not been reducing their equity exposure. Mr Champion says his medium risk portfolios currently have about 64 per cent in equities, 26 per cent in fixed income and 10 per cent in alternatives.
He says they would normally have more in bonds, but as bond yields are so low currently it is difficult to find good value. He favours short-dated bonds, as long-dated ones contain too much price risk. Mr Yearsley favours emerging market bonds, however, which tend to be longer-dated but are offering some more attractive yields.
In terms of alternative exposure, gold, index-linked bonds and infrastructure should offer some protection against inflation. While infrastructure investment trusts are currently on very high ratings, they have been the beneficiaries of extensive infrastructure projects both in the UK and worldwide.