Before the recent ‘Brexit’ wobbles our market has had a strong recovery since the lows of February, partly it would seem because the world isn’t perhaps as bad a place as it might have appeared, and partly because things aren’t that good either and lower interest rates (in Australia at least) have seen investors driven to higher risk assets!
We have seen a recovery in most of the major sectors of the market but little change in market leadership from the companies that have led the way through the recovery from market lows in 2009. Industrials (particularly the defensive and yield related names) are front and centre in that regard and the median price earnings (P/E) multiple is now approximately 20 times – at record highs and not far off 2 standard deviations above the average. It is also worth highlighting in the chart below that the current bull market for industrials has taken the multiples from record lows in 2008/09 to record highs in 2016 – which is the largest move in over 25 years.
P/E multiple for Industrials returns to all time high
Median forward P/E of ASX 100 non-resource firms
*Next twelve months (NTM)
Source: Goldman Sachs Global Investment Research, data to June 2016
It is our strong view that these moves have lulled investors into thinking that we have a new paradigm in place, one built on the foundation of low interest rates and low inflation “forever”. In his first quarter newsletter, describing these types of extreme events, Jeremy Grantham writes: “the fear is always, “Are these new high prices permanent? Is it a paradigm shift?” Every major bull market is called a paradigm shift but they almost never exist. Almost never.” Having written that he then goes on to say “in 1999 we presented 28 major bubbles of the past and were able to call the score Mean Reversion, 28; Paradigm Shift, Nil!” [1]
Unsurprisingly, value investors such as ourselves become concerned when we see these valuation extremes. A number of strategies present themselves as we seek to protect our clients against the risk of a significant setback. Firstly, we can hold additional cash and we have done that to a limited extent. Secondly, we can seek to invest in the less expensive companies in the industrial space. The second strategy has been a sure way to lose money in recent years as the spread between the expensive stocks and the cheaper stocks has widened. Not only are the expensive stocks trading at near record multiples as already highlighted, but the cheapest stocks are trading at low multiples. Thus, the spread between the P/Es on expensive and cheap stocks is far wider than usual (nearly two standard deviations!). On average over the past 15 years, the most expensive quintile of stocks have traded at a 5 P/E point premium to the cheapest quintile of stocks, but the current market has priced the most expensive quintile of stocks at a 13 P/E point premium. This dispersion has compounded the performance impact of being at the value end of the P/E spectrum. Indeed, this is the by far the widest spread that we have seen since the Tech Bubble – and that was not a situation that ended well for the over-priced stocks.
So what does this all mean? Is “now” the new “norm”? And are we on the edge of a bubble bursting? Our view is that value stocks are offering substantial opportunities, whilst also noting that many of the momentum stocks are still trading around all-time highs. Only time will tell.
Dougal Maple-Brown,
Head of Australian Equities
[1] Jeremy Grantham GMO Quarterly Letter: 1Q 2016
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