top of page

Danger flags are waving

  • apesutto
  • Jul 31, 2018
  • 4 min read





JASON TEH |


There are moments in life where unnecessary risk is taken despite the warnings signs. For example, swimming outside the flags at the beach when the surf looks exciting. The flags are there for a reason, it protects you from turbulent currents that could suck you out to sea. For the stock market, the warning flags are overvaluation and slowing growth and investors should take heed when they are waving.


The overvaluation flag has been flapping for some time. For example, the Shiller Cyclically Adjusted Price Earnings index (S&P500 price dividend by its trailing 10-year average EPS) has been flashing extreme valuation levels for the US stock market.


Chart 1. Shiller Cyclically Adjusted Price Earnings index is pointing to low long-term returns

Source: www.econ.yale.edu/~shiller/data, Vertium


Despite the high likelihood of low long-term returns, valuations are overlooked because the only game in town right now is growth and momentum. However, over the long-term valuations cannot be ignored because growth is cyclical. When growth slows, share prices fall when there is no valuation support.


And recently the other warning flag is fluttering. Global growth has peaked and is expected to decelerate further. Signs of a slowdown have been evident since the beginning of 2018. For example, the OECD composite leading indicator (CLI), which precedes global growth peaked in December 2017 and has been contracting since then. Over the last decade every global slowdown has been marked by a crisis.


2008 was the Global Financial Crisis.


2012 was the Euro crisis.


2015 was the China/emerging markets slowdown.


If the OECD CLI continues its slide then another crisis is looming on the horizon.


Chart 2. OECD composite leading indicator is guiding to slower global growth

Source: OECD Vertium


Even before tariffs dominated news headlines, global trade as proxied by South Korean exports hit negative year on year growth from the beginning of 2018.


Chart 3. South Korean exports is the canary in the coal mine and is gasping for air

Source: CEIC, Factset, Vertium


Given the precarious state of global trade, a tariff war could create a Wiley Coyote moment where global growth could fall off a cliff.


Moreover, global growth is not expected to improve in the near term because global liquidity is evaporating. Cash, as represented by real M1 money supply, is being withdrawn from the global banking system.


Chart 4. Shrinking money supply precedes global growth slowdown

Source: Absolute Strategy, Allianz Global Investors


And more liquidity is expected to be drained from the markets as the US Federal Reserve is accelerating its balance sheet reduction (quantitative tightening). Last quarter, the Fed reduced their balance sheet by $30 million a month, this quarter it’s $40 million a month, and in Q4 it will increase to $50 million a month.


While there are strong signs of slowing global growth, there is little doubt inflationary pressures are building in the United States.


Chart 5. US inflation is expected to rise over the coming quarters

Source: FRED, Vertium


Naturally, rising inflation expectations may make investors think about rising interest rates. However, the prospect of slowing economic activity is disinflationary, which offsets inflation concerns. As a result, US bond yields have fallen in recent months.


With a benign US 10-year bond yield, the yield curve is fast approaching zero highlighting that the end of the economic cycle is nearer. When market valuations are high and growth disappoints the natural consequence is increased volatility: share prices fall when high expectations are revised down.


Chart 6. Flattening yield curve points to greater volatility ahead

Source: FRED


So, what does slower global growth mean for Australian stocks? Most Australian companies are linked to the global industrial cycle in varying degrees. Resource stocks are highly leveraged to the global cycle while defensive stocks such as real estate investment trusts and utilities have the least correlation.


While resource stocks are not trading on excessive valuation multiples their earnings are at risk when the global industrial cycle turns down. Copper, the global economic bellwether, has already confirmed the weakness in global growth.


Chart 7. Dr Copper looks sick

Source: OECD, Iress


You may think it is safer to invest in high growth industrial companies that can grow through economic uncertainty. Think again – many high growth stocks are priced for perfection.


For example, the healthcare sector, led by growth kings such as Cochlear, Resmed, and CSL has historically delivered robust earnings growth and will no doubt continue to deliver consistent earnings going forward. However, their valuations are at decade-highs yet forecast growth rates are lower than they were a decade ago.


Chart 8. The average PE multiple of Cochlear, ResMed and CSL are in nosebleed territory

Source: Factset


Another area of the market where investors seek out growth is from small companies. Like the healthcare stocks, the sector is trading at extreme valuations.


Chart 9. Small Ords PE multiple is at extreme levels

Source: Morgan Stanley


High valuation multiples mean one thing – expectations are very high. Any disappointment from lofty heights would result in stock prices falling. Investors in recent fallen angels such as Ramsay Healthcare or A2 Milk (profit expectations have been revised down twice in the last 2 months!) are surely reassessing whether they are paying too much for their underlying growth.


In summary, the warning flags of overvaluation and slowing growth are clearly waving. Ignoring them will be like swimming against the tide in choppy waters. In the current environment, where the potential for disappointments are high capital preservation should be paramount in investors’ minds.


 
 
 

Comments


DISCLAIMER 

This website and its contents are general in nature and do not constitute or convey personal financial advice. It has been prepared without consideration of anyone’s financial situation, needs, or financial objectives. Before acting on the areas discussed and contained herein, you should consider whether it is appropriate for you and whether you need to seek professional advice. Investment in securities and other financial products involves risk. An investment in a financial product may have the potential for capital growth and income but may also carry the risk that the total return on the investment may be less than the amount contributed directly by the investor. Investors risk losing some or all of their capital invested. Past performance is not a reliable indicator of future performance. The material contained in this website is for information purposes only and is not an offer, solicitation or recommendation with respect to the subscription for, purchase or sale of securities or financial products and neither or anything in it shall form the basis of any contract or commitment. The Company, its related parties and its respective officers may have an interest in the securities or derivatives of any entities referred to in this website. The analyst(s) hereby certify that all the views expressed in this report accurately reflect their personal views about the subject investment theme and/or company securities. Except for any liability which cannot be excluded, the authors of this website accept no liability for any loss or damage suffered by any person as a result of that person, or any other person, placing any reliance on the contents of this website.

Vertium Asset Management Pty Ltd (ABN 25 615 639 659), is a Corporate Authorised Representative (Corporate Authorised Representative Number 001258758) of Clime Asset Management Pty Ltd (ABN 72 098 420 770), AFSL 221146.

The rating issued October 2021 APIR OPS1827AU is published by Lonsec Research Pty Ltd ABN 11 151 658 561 AFSL 421 445 (Lonsec). Ratings are general advice only, and have been prepared without taking account of your objectives, financial situation or needs. Consider your personal circumstances, read the product disclosure statement and seek independent financial advice before investing. The rating is not a recommendation to purchase, sell or hold any product. Past performance information is not indicative of future performance. Ratings are subject to change without notice and Lonsec assumes no obligation to update. Lonsec uses objective criteria and receives a fee from the Fund Manager. Visit lonsec.com.au for ratings information and to access the full report. © 2022 Lonsec. All rights reserved.

The Zenith Investment Partners (ABN 27 103 132 672, AFS Licence 226872) (“Zenith”) rating (assigned APIR OPS1827AU May 2024) referred to in this piece is limited to “General Advice” (s766B Corporations Act 2001) for Wholesale clients only. This advice has been prepared without taking into account the objectives, financial situation or needs of any individual, including target markets of financial products, where applicable, and is subject to change at any time without prior notice. It is not a specific recommendation to purchase, sell or hold the relevant product(s). Investors should seek independent financial advice before making an investment decision and should consider the appropriateness of this advice in light of their own objectives, financial situation and needs. Investors should obtain a copy of, and consider the PDS or offer document before making any decision and refer to the full Zenith Product Assessment available on the Zenith website. Past performance is not an indication of future performance. Zenith usually charges the product issuer, fund manager or related party to conduct Product Assessments. Full details regarding Zenith’s methodology, ratings definitions and regulatory compliance are available on our Product Assessments and at http://www.zenithpartners.com.au/RegulatoryGuidelines

bottom of page