One of the leading characteristics of a market bubble is when a small number of participants are driving market values higher. In this regard it is significant that the S&P 500 index (the top 500 companies in United States) grew by approximately 22% in the year to end of December. The technology sector was a key driver to this growth contributing some 39% uplift, however much of this growth was contributed by just six shares; Facebook, Apple, Amazon, Microsoft, Netflix and Google. What is also concerning is the fact that the average PE Ratio of these companies is around 120 times. A more normal PE ratio would be in the 15 to 20 times range.
This suggests that investors are expecting the earnings of the technology companies to grow rapidly; but at a PE ratio of 120 such income growth will need to be extremely strong to back up attributed value. In the event of any negative news these shares could prove quite volatile, the classic position of an asset bubble.
Many New Zealand investors have also enjoyed strong growth in the local markets with shares up by some 19% in the NZX 50. However just two shares Xero (until it delisted from the NZX!) and A2 Milk contributed increases of 77% and 300% respectively which suggests our market may also be captivated by a small number of out-performing holdings.
It is usually only with the benefit of hindsight that the experts confirm asset bubbles and the fall from grace in values that follows. However if you believe and agree that a bubble could be emerging, what indeed can you do with such knowledge?
Here’s what we are doing for our clients. We ensure that investment portfolios have a mix of assets that reflects our client’s personal attitude to risk and is also appropriate for their age. For instance the young can normally weather downturns much better than older clients who may be drawing down on their capital or soon needing to be.
For retired clients we place their income needs for the next five years in assets that are unlikely to be directly impacted by share market downturns. We maintain an appropriate balance of share investments diversified across Australasian and global shares. We also favour investments through managers who follow a “value” approach which is essentially buying shares that have a proven business model and dividend stream. From time to time such shares fall out of favour and a good value manager is often able to pick up discounted opportunities and wait for value to return.
At the moment in particular we are somewhat cautious about index based investing and exchange traded funds (ETFs). These investments are particularly popular because of their low-cost exposure to sharemarkets and while these may work well at the beginning of a cycle and/ or steadily rising market with no bubble like factors, when the cycle ends and values reverse, these funds are unable to adopt defensive positions. By their nature index funds are often overweight to the very companies that we are concerned about as we consider the market bubble conundrum. Equally index funds are required to mirror the chosen index and as such will follow the pricing of this index regardless of the peaks and troughs that manifest.
In our view, cornerstones of good investment portfolios require that they should be intelligently diversified, appropriate to the age and stage of the investor and aligned to their long-term goals and risk profile; rather than chasing short-term top dollar returns.
The old adage that shares take an escalator up, and an elevator down should always remain front of mind!
Call Hamish on 0800 379 325 or email on email@example.com