by Dion Hershan – Head of Australian Equities
With the market at ~7,600 (ASX 200) – up a stunning +67% (excluding dividends) from the nadir in March 2020 – it’s pretty clear that complacency is creeping in. In fact, FY2021 the ‘pandemic year’ saw the ASX 200 up +24%, its strongest financial year on record.
Complacency is observable in so many ways, and not just through SPACs, crypto, Robin Hood IPO’ing and becoming ‘meme stock’ etc. We are in a glass half full (arguably of Red Bull) environment where everything is perceived as ‘good news’. Inflation is viewed one day as a sign of a strengthening economy, and the following day the lack of inflation is seen as a catalyst for more QE.
In some respects, the lack of volatility in the market is unnerving. The VIX in the US is at 17, well below the 20-year average (19.7) and the 2020 crisis level (peak of 82). The S&P 500 is up +18% this year, with only two drawdowns of more than 4% (at -4.2% and -4.0%).
With the economy and the consumer in good shape, it’s difficult to make the case for a collapse or even a major correction. Clearly, though, there are headwinds emerging for markets. These include inflation, interest rates, stretched valuations and fading levels of government support.
We are selective rather than bearish, we are mindful that there are some ‘easy ways to get hurt’ in the current environment:
- Buying mining companies purely for their dividend yield
With iron ore prices roughly three-times the 10-year average, mining companies are like ATMs at present. But as iron ore goes from US$200/tonne (vs <US$45 to produce, incl. freight and royalties etc.) to a long-term average around US$65, dividends could fall by 33% from current levels.[1]
- Ignoring valuations, or basing them off today’s interest rates
Valuation seemingly hasn’t mattered for the last three years, evidenced by the top-quartile of the ASX 200 going from a P/E of 28 times to 44 times forward earnings. With momentum feeding upon itself, this period may well prove to be the exception to a long standing norm. If/when the wind changes, that top quartile of the market is likely the most vulnerable.
Additionally, while almost everything looks cheap when interest rates are close to zero and investors are using 2-3% discount rates, it clearly won’t always be this way. Valuations for a range of companies simply won’t stack up when rates begin to move higher.
- Extrapolating what happened in 2020 either favourably or unfavourably
For so many reasons, 2020 wasn’t a year that was in any way representative. Toll road traffic declines of up to 80% and supermarkets growing sales at >10% shouldn’t be extrapolated.
- Ignoring Chinese policy directives
As a command economy, China’s government tends to follow through on policy. There were clear signs of overheating in China in 1H21, with recent directives to cut steel production, curtail property price growth, tighten credit, curtail speculation in commodities and cut emissions. These factors are an ominous lead indicator for commodity prices, which are largely being ignored.
- Buying things that are shiny & new (IPOs)
While IPOs can represent compelling opportunities, they are one of the most asymmetric aspects of public markets. IPO candidates are invariably spruced up and over-hyped, with investors forced to make quick decisions based on limited information and rationed access to management. There are more than a few examples of high profile IPO duds which should be burnt into investor memories.
- Speculating on M&A targets
With the flurry of recent M&A activity (e.g. Spark Infrastructure, Sydney Airport, Afterpay etc.) it’s tempting to speculate and invest on who might be next. That’s like long-range weather forecasting: you might get one right but it’s probably more luck than genius. You need to buy businesses on fundamentals; it’s dangerous to assume there is a ‘greater fool’ who will buy out a weak business at a large premium.
- Slavishly following benchmarks
The ASX 200 is narrow; at this point four banks and the three iron ore miners are 61% of aggregate earnings. Both groups rely very heavily on unsustainable factors, with iron ore prices three-times normal and bad debts at their lowest levels on record. It’s critical to look beyond the majors and be able to tactically shift where required.
Our strong advice is to enjoy the moment but don’t extrapolate it. There is a graveyard full of commentators that have tried to call turning points – I won’t attempt to! – but we would encourage investors to take a more balanced view.
At Yarra we aren’t getting caught up in the hype of a bull market driven by a narrow group of factors. The coming years might well be defined by what you chose to avoid owning. We continue to be excited about long term holdings in the portfolio with great medium to long-term potential such as TPG, Link and Worley.
[1] Source: GS Investment Research, Jul 2021.
