Macro markets

Today’s topics

  • State of play
  • Valuations

State of play

Markets have dropped but a handful of percent, and remain otherwise near all time highs. Yet my feed is alive with words like “carnage” and “capitulation”.

The market drivers are a mix of narratives, namely

  • a hawkish Fed, with tightening or tapering on its mind
  • a COVID resurgence, with daily case rates growing strongly even in countries with a high degree of vaccination
  • fears around market valuations, namely that they are overcooked
  • growth scares, with expectations that the end of fiscal stimulus will leave a hollow log for the economy
  • inflation scares, with fears of too much money chasing too few goods

And you can immediately see that some of those resolve themselves. A COVID resurgence that threatens global growth is not likely to be an environment in which the Fed attempts to re-exit the zero lower bound. They’ve shown before that they are inclined to care about their dancing partners on the global stage, which is everyone else.

It is the same for growth scares. If macro market data like retail sales or housing slow, or the contraction in fiscal policy appears to be too much of a drag on the economy, than the Fed is likely to respond by slowing the pace at which it withdraws support.

Some, however, are a little more sinister. If inflation does force the Fed to tighten more aggressively, then those “overcooked” valuations do become much more problematic. It is also likely that the Fed is not especially concerned about the stock market dropping 20% as discount rates in analyst models normalise.

An appeal to macro market movements doesn’t shed a huge amount of light on the matter, either, as the decline in yields (both nominal and real) are supportive of the “growth scare” thesis, but commodity prices remain buoyant and credit spreads, whilst they’ve moved somewhat, are not signalling much of anything around anticipated default rates.

That could all change, if vaccines suddenly prove less effective, if hospitalisation rates start to climb, or if the Fed’s reaction function changes, or if an entirely new concern arises, for example, the presently bubbly like conditions in global housing markets “froth over”.

Where does any of that leave an asset allocator? Well, portfolios need to generate returns. That means allocating to markets with a non zero expected return, and hopefully, picking up some modest correlation benefits along the way. Sitting in cash is one way to greatly increase the risk of not meeting a given portfolio’s risk and return objectives (unless that objective is to lose money in real terms, post inflation and tax on the nominal component of income). To some degree, this is a variant on the term TINA: “there is no alternative”.

When you’re uncertain, diversify. Across asset classes, sub asset classes, geographies. In addition, you can engage in a modest degree of market timing, which attempts to moderately de-risk the portfolio when valuations are exuberant, tilting away from risky assets, increasing the sources of low or non correlated returns in the portfolio, and to increase market exposures when valuations are more compelling. And that’s exactly what our diversified investment portfolios are designed to do.


Take a simple model that regresses valuation measures (e.g. P/B) against companion variables (e.g ROE), and other fundamentals (e.g. forecast EPS growth) and compare the implied P/Bs to actuals. On this measure we can suggests stocks like Afterpay (APT) and Altium (ALU) are still expensive even after accounting for their attractive underlying fundamentals.

It is the same for many of the secular growth health care names, like Nanosonics (NAN), Clinuvel (CUV) and Cochlear (COH).

Secular growth stocks are very sensitive to the assumed future interest rate, and given our concerns about valuations today we are only more concerned when we think about valuations tomorrow, in a world where the 10 year nominal has moved back towards 2.5%.

As to the price people appear willing to pay for pizza, well, the mind boggles:

There aren’t all that many pockets of the market that do look cheap, and certainly not all that many pockets of the market where we can have a reasonable degree of confidence that they aren’t cheap for a reason, a reason that we just haven’t hitherto stumbled onto.

And that’s where the oil and gas names, like Woodside (WPL), Origin (ORG) and Oil Search (OSH), come in. The “cheap” part is probably uncontroversial. Everyone knows they’ve sold off hard since the onset of the COVID crisis. But the “cheap for a reason” part might surprise you.

The odds of being surprised by an unexpected gremlin associated with these companies is relatively small. It is a sector wide phenomenon, in which the known unknowns (how long COVID will persist, how quickly can vaccines return us to normalcy) are, well, pretty well understood. The investors who shun the stocks on ESG grounds will continue doing so, and as such are not a “fresh” overhang to the share price. And this greatly reduces the downside risk associated with taking a position based predominantly on valuation grounds.

And what we are left with are good quality companies (in WPL’s case the gross margins are north of 70%) with strong free cashflows, even if the price of oil settles down at ~$60/bbl. To press the point, take the current market capitalisation, project it forward at a “market-like” rate of return (say a 7% CAGR for 10 years) and divide that implied future market cap by a range of different potential market multiples (say 20x for the market, or 16x for historical averages). Then compare the resultant trajectory of required earnings growth to the actual.

And you’ll find that WPL, much like ORG and OSH, don’t need to grow to generate a good return. If oil is with us for the next 10 years, which we think it very likely will be, then these companies may well do even better than that already acceptable “market-like” rate of return.

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