Ignore the confusion in global markets to find outstanding opportunities


One could be excused for feeling that recent global equity market activity is overly confusing. The bipolar combination of market euphoria today, and despair tomorrow, repeats itself over and over. Whilst a source of frustration to investors, these wild fluctuations are quite understandable when their underlying drivers are assessed and therefore should not influence investors into avoiding global equities entirely.  Doing so would result in them missing out on some strong opportunities in global markets.

What we are seeing at the moment are two very strong trends that are having opposing impacts on markets.  Low interest rates, low valuations and a lack of alternatives (as neither bonds nor property are seen as prospective) are key supports for equities and are helping to fuel brief periods of exuberance. However, the persistence of weak economic growth, fiscal deficits and high unemployment, are all contributing to subsequent despair and apathy which saps any market rally.

The result of such opposing forces is some unexpected outcomes.  Uniquely in a volatile market with a decidedly uncertain and negative bias, a number of small speculative companies are performing very strongly. Many small caps are at 52-week highs while quality blue chips languish at multi-year low valuations. Speculation in small caps is symptomatic of a low interest rate environment whilst at the same time investor disillusionment is keeping investors away from the big end of town. This market behaviour provides very little predictive value.

In addition to macro-economic uncertainty there have recently been attention-grabbing statements and sound bites from market commentators that seek to add insight but rather disclose a weakness of analysis.  Such statements only add to the confusion level for investors.  For example, following a 10 year period of flat equity markets, it is now often said that “buy and hold” is dead.

Bold, game-changing statements such as these are common after periods of above or below trend outcomes. Recall the tech boom of 1999-2000 and how investors scoffed at valuations and earnings. “Earnings don’t matter” they cried as they rushed to embrace the dotcom economy at all costs. That strength of conviction is back in force but this time in reverse. These days it’s “P/Es don’t matter” as the marginal buyer seems not to care about the long term given so much uncertainty.

Adopting this assumption fails to grasp the components of investment returns or, more specifically, that a share price is a function of valuation and earnings. Suggesting that stock prices will not rise over time is an explicit statement that earnings will stagnate or valuations will drift lower. But historical evidence is firmly against this assumption.

Over the past 10 years the average earnings growth of S&P 500 constituents was 3% per annum despite two severe recessions. It is prudent to assume that at least a similar rate of growth can be maintained over the next 10 years. With the addition of dividends, returns of 6-7% per annum are achievable in the medium term with no change in valuation.

On the valuation side, company earnings are currently valued very cheaply at around 12 times earnings. The reason share prices went nowhere over the past 10 years was exclusively due to valuations contracting from about 25 times earnings to close to 12 times today. The long term valuation range is between 10-25 times earnings with only brief periods above and below this range. Given corporate balance sheets are in great shape and investor sentiment is so poor, the risk to valuation is arguably to the upside. In this environment, rising valuations can easily lead to double digit returns even assuming weak earnings growth.

For these reasons, at Wingate we believe the bull case for equities has significant fundamental underpinnings. The negativity bubble engulfing investors has delivered this opportunity but investors need to get away from the immediate noise in the market and maintain their focus on fundamentals.

In addition, the strength of the Australian dollar, which for many reasons will likely revert lower over time, provides local investors an exceptionally strong currency. Using the strong currency to purchase international equities provides an additional investment benefit that is unavailable on domestic stocks.

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