Why is the share market crazy?

By July 14, 2020 Share investing
share market

You may have read commentary that the share market isn’t reflecting reality at the moment. For example, the share market can rise by 3% on the same day that we receive bad news in respect to the spread of the virus. Spectators are left thinking how can market values rise when global economic expectations are so negative? That is a fair question.

Then there’s stocks like Tesla in the US and Afterpay in Australia.

Electronic car manufacture, Tesla’s share price has risen by 50% over the past couple of weeks. Its market value is now equal to the total value of Australia’s big 4 banks plus BHP combined. The difference is that the banks and BHP make total profit of $12 billion p.a. whereas Tesla loses money (and has never made money)!

These exuberant valuations are happening here too. Towards the end of March, Australian listed FinTech company Afterpay was trading just above $8 per share. Today, it is trading at circa $70 per share and is worth over $20 billion. It also doesn’t make a profit.

So, how do you navigate a market that doesn’t make a lot of sense?

The Robinhood effect

One of the contributors to this irrational exuberance is the influx of amateur investors – often first-time investors. Back in May, Australian regulator ASIC noted there had been a 340% increase in the opening of new share trading accounts. The US has also reported a record number of new account openings this year.

The theory is that people are becoming bored being locked in their homes. Sports betting and casinos are closed. So, people have turned their attention to “gambling” on the share market.

FinTec companies, particularly in the US have jumped onto this trend. US provider, Robinhood is best known for gamifying share trading. It offers free stock to anyone that opens a new account – and additional free stock if you refer friends. The screen turns green if your trade is in profit (and red if its not), sends you confetti when you buy and gives you your money straight away after you sell, so you can trade again (it takes 3 days in Australia). Many brokerages in the US now don’t charge commissions or fees – instead they hide their margin in the quoted share prices. All of these things are aimed at encouraging people to gamble, not invest.

Similarly, ASIC has noted its concern with Australian retail investors trading in pursuit of quick profits. Its data suggests most are unsuccessful and lose money. For example, per ASIC, in the week of 16-22 March 2020, retail clients’ net losses from trading CFDs were $234 million.

Of course, this behaviour is against everything we believe at ProSolution and is more akin to gambling than it is investing. But speculators (gamblers) can have a substantial impact on markets in the short term – Bitcoin is an excellent example of this.  

Everything is popular until it’s not. This will end in tears

Well-respected stock market analyst, Rob Arnott highlighted in this interview that Amazon is currently valued on a price-earnings (PE) ratio of 120 times. Even if you believe that Amazon could grow its sales by 20% p.a. over the next 10 years (which would mean that in 10 years it would be larger than the entire retail marketplace globally – you’d have to be sceptical whether that is possible), it should be priced at a PE of 70, not 120! The only way an investor can generate a positive return after paying 120 times earnings for a stock is if the bubble continues to grow, as long as they sell before it bursts.

As mentioned above, Afterpay is now trading above $70 per share. This implies a valuation of over $20 billion – which is almost as valuable as Coles supermarkets. In the 2019 financial year, Coles made a profit of over $1.6 billion whereas Afterpay lost $24 million (and has never turned a profit in its history).

I have no doubt that valuations like these are indicative of a bubble. And all bubbles burst at some stage. Unfortunately, thousands of amateur investors will end up losing a lot of money.  

Traditional index funds will have to buy overvalued stocks

It is important to note that traditional index funds are forced to participate in these rising stock valuations. That is, now that Afterpay is a top 20 company in Australia, traditional market cap index funds will need to buy more of this stock when they rebalance. Most index funds tend to rebalance one to four times per year – often around the end of the financial year. This is one of the criticisms of traditional market cap indexing i.e. they tend to follow price bubbles.

Are all stocks overvalued?

These irrational valuations (as discussed above) can distort the market as a whole. As such, I have been reading an increasing amount of commentary that suggests “markets” are over-valued i.e. they are not factoring in the potential risks caused by the Covid-19 lockdowns. The charts below provided by JP Morgan (click to enlarge) show the Australian and US market and PE ratios at various times of the past 25 years.

share market valuation

The Australian market (ASX200) is currently valued at a PE of 19.1 times and the US market (S&P 500) at 21.7 times. These valuation levels appear expensive when compared to the average – being 14.3 times for the Australian market and around 17 times for the US market.

But whilst the market overall seems overvalued, it is clear that this is concentrated in certain stocks and sectors.

In the US, the following sectors have the most elevated valuations: Consumer Discretionary (e.g. Amazon), Industrials and Technology. In Australia, it is Technology, Health Care and Industrials.

More importantly, there are sectors in both markets that exhibit below mean valuation metrics.

‘Growth’ is very expensive compared to ‘value’

You can allocate stocks into two main categories being growth and value.

A growth stock is a business that is expected to generate a very high level of growth in the future. As such, its current revenue and profitability level is not representative of what an investor might expect in the future. The thesis is that you are happy to pay more for a growth stock on the assumption that the future increase in profitability will more than compensate you. Tesla, Afterpay and Amazon are all growth stocks.

A value stock is one that is currently undervalued by the market having regard to historical valuation (PE) multiples for that stock and its underlying fundamentals.  

Over the past 5 to 10 years, growth investors have been rewarded and value investors have, as a result, been punished as they have achieved much lower returns.

The chart below (also prepared by JP Morgan) shows how expensive growth has become compared to value. Growth is a bubble ready to pop!

Growth versus value

How to invest in a market that doesn’t make sense

The best way to invest in share markets at the moment in a way that minimises your risk is to adopt value and quality overlays.

A value overlay essentially filters stocks out of a given index that are trading at very high valuations. Various valuation metrics can be used including PE, price-to-book and so forth.

A quality overlay filters out stocks that exhibit low quality characteristics which can include high debt, volatile earnings and low profitability or return on equity.

All of these are rules-based, statistical filters and do not require any subjective assessment. Furthermore, these approaches can and have been back tested.

The idea is that a value approach will protect you from overinflated sectors of the market and a quality approach will protect you (to some degree) from the risk of a prolonged recession, as high-quality, strong companies are likely to better whether economic storms.

It is not an all or nothing decision

Investing in the share market should be a slow process.

In most situations, it is erroneous to decide to invest nothing but is also silly to invest everything.

Instead, you would be well-served by considering two questions:

  1. which approach or methodology helps you avoid the risks whilst capturing the future opportunities (which is what I have discussed above); and
  2. what quantum of investment would you be comfortable making? For most people, the answer ranges between $1 and $1 million i.e. it’s not zero. If markets are making you nervous, invest in smaller, regular tranches.

It’s a bubble and we should be concerned

Some sectors of the market (and individual stocks) are very worrying. Some sectors are bubbles waiting to burst – without a doubt, its “when” not “if”.

But that is not to say that all share market investments carry equal risk. The best thing is to seek independent, professional financial advice to ensure you are adopting the most appropriate approach.