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As markets have become ever-more driven by an ever-narrower group of shares with ever-larger index weights and ever-higher valuations, the risk is biting. The pain has not been shared equally. While shares outside the US fell only 4% in January 2022, and lower-priced global ‘value’ shares by only 2%, the tech-heavy Nasdaq fell as much as 16%. There was an end-January bounce but markets are again sagging at time of writing in February.
More recently, the market has been concerned about inflation, rising rates and the threat of war between Russia and Ukraine. But many companies, particularly in the speculative parts of the market, were vulnerable before these recent concerns as a result of stretched valuations.
The valuations of speculative stocks may have fallen, but only from the exosphere to the stratosphere. At year-end, there were 77 companies in the US trading at over 10 times sales (that’s sales, not profits). That is, 10 times all the money coming in the door before any expenses, effectively pricing the companies as though they will grow to be the next Amazon or Microsoft. After January’s turmoil, there are exactly 60 companies still trading at those rich levels. That’s fewer than the end of 2021, but before 2020, the record was 39.
The good news is that the market momentum of the past few years has left lots of good companies trading at reasonable prices, and on nearly any metric, the valuation gap between lowly- and richly-priced shares remains vast.
In other words, January’s market moves have simply brought valuation spreads from the mind-blowing extremes of 2020 to the merely mind-boggling extremes of 2019. The following chart shows the difference in expected returns from what we consider ‘cheap’ stocks in the top half versus ‘expensive’ stocks in the bottom half of the FTSE World Index, using our internal proprietary model.
Of course, if the trends of the last decade persist, we know what to expect. Having briefly wobbled, fast-growing US technology companies will resume their dominance of stockmarkets, benefitting from a combination of low interest rates and scarce earnings growth.
In the past two years, we saw a global pandemic that ground businesses to a halt, unprecedented transfers of money to individuals from government, limitless money printing from central banks, and the return of inflation high enough to frighten both central bankers and the markets that depend on them. When so much in the world has changed, it wouldn’t shock us if the drivers of markets did, too.
If they do, the future may look very different from both the pandemic and the years that preceded it, and the recent outperformance of less expensive shares may have a very long way to run.
While no two sell-offs are the same, it’s always useful to ask why the market is down. In recent years, stockmarkets have tended to drop due to some sort of economic crisis, such as the GFC in 2008, the Euro crisis in 2011, China’s currency devaluation in 2015, the oil and credit crash in 2016, fear of the Fed in 2018, and most recently the pandemic lockdowns. When the threat to markets comes from the economy, the companies most sensitive to the economy suffer most.
But stocks can also go down because they simply became too expensive. If expectations get too high, and would-be sellers can’t find ever-more-enthusiastic buyers, prices stall. If the market is down because overvalued stocks are getting less expensive, it is generally the most expensive stocks, not the most economically sensitive, that suffer most.
That could mean a lot more pain for richly-priced shares. In January 2022, the Nasdaq had its worst week since the initial Covid crash, falling 8% in five days. But in the aftermath of the tech bubble in 2000, the Nasdaq suffered 11 weeks worse than that in less than two years. Quick recoveries are not guaranteed.
In the long run, valuation always matters, so given the stretched backdrop and rapidly-changing sentiment, the shift within markets this month is in some ways unsurprising to us. But it is a very welcome un-surprise.
First published on the Firstlinks Newsletter. A free subscription for nabtrade clients is available here.
Analysis as at 23 February 2022. This information has been provided by Firstlinks, a publication of Morningstar Australasia (ABN: 95 090 665 544, AFSL 240892), for WealthHub Securities Ltd ABN 83 089 718 249 AFSL No. 230704 (WealthHub Securities, we), a Market Participant under the ASIC Market Integrity Rules and a wholly owned subsidiary of National Australia Bank Limited ABN 12 004 044 937 AFSL 230686 (NAB). Whilst all reasonable care has been taken by WealthHub Securities in reviewing this material, this content does not represent the view or opinions of WealthHub Securities. Any statements as to past performance do not represent future performance. Any advice contained in the Information has been prepared by WealthHub Securities without taking into account your objectives, financial situation or needs. Before acting on any such advice, we recommend that you consider whether it is appropriate for your circumstances.