Notz Stucki Investment Conference Notes
Most financial markets were strong in 2017, adding to what has been a strong decade. This begs the question of how long it can continue. Since the crisis only commodities have performed poorly. Equities have continued to defy the sceptics, in particular the US, and within that market technology has been the best sector by some margin. In 2017 tech stocks’ performance started to go parabolic. In the past this sort of move has often been the precursor to a period of poor performance as valuations become so stretched that financial gravity forces them back to more normal ratings, and they enter a long period of consolidation. The weighting in the technology sector has become a large part of the indices so judging what happens to this sector has become of prime importance. An analysis of the world’s largest companies shows a list dominated by big tech names. This is also a danger sign. At the end of the 1970’s the equivalent list was dominated by oil stocks; at the end of the 1980’s by Japanese companies; the end of the 1990’s by technology stocks; and the end of the 2000’s by China and oil names. In each case subsequent stock price performance of these companies disappointed. Clearly as a company gets larger growth becomes ever more challenging. Do tech stocks today face the same fate as their leviathan predecessors? In their defence on many valuation metrics they are better value than the tech names that rose to the top in 1999. However the problem can be illustrated in Alphabet (Google) and Facebook. Their profits derive from the $500bn global advertising market. $240bn of this is online of which these two companies command $120bn. To continue to grow 30% a year in this market when they are already a quarter of the total and half the online becomes harder and eventually impossible, but that is the growth rate that investors have come to expect of them. In general terms the massive outperformance of growth over value is showing some signs of mania now, and this is clearly evident in some other cases like biotech and bitcoin. Above all, as has been frequently commented on before in previous meetings, there is also a monumental misallocation of capital in bonds. We have reached the unprecedented situation of investors buying BBB bonds in order to secure a loss. However manias also create opportunity in the areas that have been ignored.
One big difference in this bull market from all previous ones is the lack of new issues. Usually a bull market engenders a flood of IPOs. Yet this time the number of companies are shrinking. In the US the number of listed companies has shrunk from 8000 in 1995 to 4300 today. In Europe it is a similar story with a decline from 14,400 in 2007 to 7600 now. The exception is Asia (mainly due to China) where new listings have boomed. Since the Asian crisis the number of listings has risen from 8000 to 17,000. Is this the reason that the Asian stock market’s performance has been so pedestrian in the last decade compared to that of the US? There has been too much supply of equity in China which has soaked up liquidity, while in the West equity is becoming a scarce resource, particularly when share buybacks are included.
The other unusual quality of this market was that despite synchronised global growth Central Banks did not remove the punch bowl. Instead they added vodka. With the combination of $2 trillion of liquidity injections from them and no new listings, it was no wonder that markets rose. However there are signs of change. The Fed has started to tighten, and now the People’s Bank of China is withdrawing liquidity. The PBOC’s move could be the more important one. For twenty years China has pursued a strong growth policy, but in November Xi Xinping’s speech changed the emphasis of policy from growth to a focus on education, health and curbing pollution. The risk becomes that instead of China’s growth surprising on the upside it surprises on the downside. The ECB and Bank of Japan are still printing hard. Might this change? In Japan the domestic sector is complaining about the flat yield curve. Banks will go bust if it continues. With the yen competitive and exporters flourishing, it is hard to see who benefits now from their aggressive monetary policy. It would be a shock but Japan might raise rates before long. The consensus view is that we will have deflation forever, and that Central Banks will remain active. The bond market is priced for this scenario. If this is proved wrong it will be a profound shift of direction.
Tightening liquidity and higher interest rates will make owning growth stocks with expensive PEs dangerous. It looks as though companies are likely to depend on their earnings to grow rather than PE expansion. Some de-rating is likely. This makes judging the inflation outlook crucial. For twenty years there have been tremendous structural forces creating disinflationary pressure – China, the internet, an ageing population. Some of these forces may be abating. The German PPI is now running at 3%, Japan’s is also 3%, and China’s is 7% so it is no longer exporting deflation. Recently there have been price breakouts in energy, metals, shipping prices and even semi-conductor prices. Labour markets are tightening everywhere. The lack of capex globally, now exacerbated by China closing capacity for pollution related reasons, means that, as the world recovers and demand grows, those manufacturers with spare capacity are growing volumes, which combined with some pricing pressure is a potent mix. Last year Asian markets were up sharply and this probably reflected their role as the marginal producer in a number of industries. Japan is a particular beneficiary of this trend. The recent outperformance of cyclicals could be a sign that inflation is starting to come through. If that is true then investors need to alter their position because there will be a dramatic change in leadership.
With the bond market at such extreme levels investors have little alternative but to invest in equities, and balance those positions with as much cash as suits their risk profile. But within their equity allocation they need to start thinking about shifting from growth towards value. The more that economic growth takes hold globally the more neglected sectors will be supported, and the shine will come off the highly rated growth stocks whose growth has been so prized when growth was scarce, though true growth companies can be held with confidence for decades. Stock markets have advanced without a significant fall for so long that a setback is almost inevitable soon, and this could provide an opportunity for investors to reallocate. Nonetheless there is a caveat, which is there is little margin of safety anywhere. There is so much debt that the stock market requires the world to continue to have steady growth. The tightrope is higher than is comfortable.