In any financial market, the key to understanding its dynamics, outlook and potential performance is to get a handle on the different types of participant and what drives them.
In a financial assets market, one can classify participants into three broad categories:
Buyers: They are buying assets in the hope that their price might increase.
Sellers: They are selling assets in the belief the price of the asset will fall or that the risk associated with holding the asset has increased beyond what they consider reasonable. In some cases, assets might be sold to fund purchases seen as better options.
Holders: These normally take the form of long-term investors who hold assets through the cycles and believe that short- and medium-term price fluctuations cannot be accurately predicted. In some cases, assets are held because of a lack of alternatives, not because of conviction in the asset itself.
Using these descriptions, let’s look at who these people might be in today’s market, using US stocks as an example.
US stock buyers
Assuming our participants are today buying a broad-based portfolio of US equities, they must believe the market/stock will increase in value. For this to be true, they are likely to believe one of the following:
- The market is undervalued and should go higher to reflect true value. These types of decisions are referred to as fundamental or value based.
- The market is ignoring valuation and moving higher for other reasons. These types of purchases are called speculative or momentum trades.
- Corporate activity in the form of stock buy-backs or merger-and-acquisition-type purchases are the motivations for stock purchases.
Whichever valuation method one chooses to use, and there are many, it is hard to find any that suggest the US market is cheap. A number of valuation methods – such as those that use historic and forward price/earnings ratios – suggest the market is fair value. Others that use averaged earnings or market-cap-to-GDP measures suggest the market is overvalued.
What is fair to say, though, is that buyers entering the market today on valuation reasoning are either looking for selective parts of the market that are cheap or are happy to accept fair value without any margin of safety as an entry point. These investors fall into one of three camps:
- Those who have missed the bull market that has been in place since 2009 and can no longer tolerate interest rates of 0% or close to that offered on US dollar cash. They have capitulated to the view that equities are better long-term investments than cash and that starting valuation is not of absolute importance. Their possible mistake was not to buy in earlier; buying now may compound the error.
- Exchange-traded fund (ETF) buyers who, in some cases, are not well educated in the risks associated with stocks that make up the ETF and unaware of the underlying valuation dynamics. The rallying call here is to buy the index and go along for the ride.
- Those who argue historic valuations measures are no longer valid and, in the world of Goldilocks where underlying growth and interest rates are neither too hot nor too cold, valuations can hold at higher levels for longer periods.
Buyers who understand the difference between investing and speculating and who are in the market believing it will go higher for reasons other than valuation can be forgiven. They are not trying to make a valuation case and are either long-term buy-and-hold investors or traders.
Share buy-backs by companies have been a big part of buying in the past few years. This may have more to do with the low cost of capital (interest rates), earnings improvements via corporate engineering, and a lack of real-world investment opportunities in a low-growth environment than with valuation. There is nothing wrong with share buy-backs in a company’s lifecycle, but one should be aware of the reasons and recognise they are not always done at attractive equity valuations.
US stock holders
These can be broken down into long-term institutional and retail investors who hold equities as part of long-term mandates. In addition, there are the asset allocators and risk parity investors who almost always have a core of equities around which they rebalance. Long-term equity investing is sensible and, if this is your plan, you should stick to it – as long as the period is sufficient. In today’s market, there are two other types of holders that are normally present but not to the same extent. They are characterised by:
- investors who see no other alternative and are not prepared to accept the low interest rates on offer; and
- investors who have moved their exit valuations higher, based on any number of factors but mainly on low interest rates.
(There is a third type of holder, whom I call “the dancer”. Dancers have been successful to date and already realised this party can last longer, given its low starting point and the injection of fuel in the form of liquidity and low interest rates. They know it’s close to or past midnight but there is still some partying to be done and are happy to risk a late exit.)
US stock sellers
For every buyer there must be a seller, but desperate sellers have been absent in the past few years. Sellers have been those who see valuations as no longer justifying the risks. They may also include more risk-conscious asset-allocation programmes. Most short sellers have been losers for a long time and are not as active in markets as might normally be the case. Mutual funds have seen some sales, with monies being rotated into ETFs.
Conclusion
The past couple of years have seen low volatility and few opportunities to buy into the US markets at lower levels. Dips have generally been shallow, as return-starved capital has entered the markets early on falls. Patience has not been rewarded and bears have been frustrated by low interest yields on unallocated capital.
It is possible the “believers“ will turn out to be right and that the Trump reflation trade will keep driving US markets higher in the wake of tax cuts and infrastructure spending. Valuation should, however, remain an investor’s main concern and prudence should be shown when allocating capital to US equity markets.
Some strategies that investors might consider when managing risks associated with markets that are not cheap:
- While guarantees don’t change market valuation, they can reduce risk and minimise capital loss. Guaranteed structured products may play a role here.
- Cautious asset allocators are able to downweight higher risk assets. Active asset-allocation funds should look at correlation risks and may be able to minimise downside risks.
- Value managers may be able to build a portfolio with lower valuations and a reduced risk of permanent loss of capital.
- Adherence to long-term equity investing and patience while looking for reasonable entry points should keep delivering inflation-beating returns.
Investec Wealth & Investment advises many of South Africa’s foremost families, trusts and charitable foundations in the preservation and appreciation of their wealth. Click here for more information.
Neil Urmson is a wealth manager at Investec Wealth & Investment. The views expressed are those of the author and do not necessarily reflect the views or portfolio positioning of Investec Wealth & Investment.
This article was paid for by Investec.
Would you like to comment on this article?
Sign up (it's quick and free) or sign in now.
Please read our Comment Policy before commenting.