Investors should take the current pessimism towards markets as a buying signal, according to Russ Mould, investment director at AJ Bell, who points out a strategy of consistently moving against the crowd would have proved extremely lucrative in recent years.
Mould (pictured) said the oft-repeated quote from legendary investor John Templeton – “bull markets are founded on pessimism, grow on scepticism, mature on optimism and die on euphoria” – can help investors spot value and future upside opportunities and – just as importantly – avoid popular areas that are so overvalued they are likely to experience a major correction
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He added that you do not have to look too far into the recent past to see the benefits of such a strategy.
“At the start of 2018, the euphoria surrounding cryptocurrencies was all-pervasive, only for Bitcoin to promptly lose 75 per cent of its value,” he explained.
“By contrast, defensive equity sectors were widely viewed with scepticism 12 months ago, amid widespread optimism regarding what was termed as a synchronised global recovery.
“But, using the S&P Global 1200 as a benchmark, healthcare and utilities turned out to be the best two performing super-sectors – out of 11 – while financials and materials (miners), both cyclical areas that had been forecast to do well, did worst.”
“Few major asset classes beat cash or generated a positive total return in sterling terms in 2018 – German bunds and gold were rare exceptions and that hardly smacks of widespread optimism.”
Mould said that while it takes nerve and patience to go against the crowd, that is often where the best long-term returns are to be had, adding: “So perhaps the best news so far for investors in 2019 is that a lot of the euphoria of early 2018 has faded away to be replaced by nervousness, even gloom.”
However, he said the difficult part is gauging where exactly sentiment has been unfairly washed out, meaning there is value to be had, and where exuberance still prevails and danger may lurk.
One way to do this for stocks is to look at the VIX or ‘fear’ indices, which measure expected future price volatility.
Mould said that times of great confidence (and low VIX readings) and times of great fear (and high VIX readings) tend to provide a contrarian indicator as to when the market waters are safe and when they are not.
“Piling in during times of confidence has tended to prove painful and bravely stepping in when everyone else was panicking has been the better option, over the long term,” he explained.
The VIX has been running in the US since 1990, with an average reading of 19.3, a low of 8.9 (in November 2017 as the current bull market was on the march) and a high of 80.9 (in November 2008 as the financial crisis peaked).
It reached 36.1 on Christmas Eve, which Mould said suggested panic was setting in and US stocks were potentially oversold, but it has since recovered to 21.4 as the S&P 500 bounced.
“This does not smack of a long-term market bottom even if the recent recovery will have been welcomed by many investors,” he added.
Meanwhile in the UK, the VIX has been running since 2000, with a long-term average reading of 19.1, a low of 6.2 in March 2017 (eight years into a bull run) and a high of 75.5 in October 2008, following the collapse of investment bank Lehman Brothers. At the moment, it reads 19.3, slightly above its long-term average.
Performance of FTSE 100 vs FTSE 100 VIX since Jan 2000
Source: AJ Bell, Refinitiv data
Mould said that while looking at the VIX offers a quick overview of sentiment, the best test of all is to analyse valuations on a case-by-case basis.
“Valuation is even more subjective and every bit as much of an art as it is a science,” he added.
“The most suitable techniques will depend upon the nature of the asset class or industry involved, but multiples of earnings, cashflow, book value or dividend yield, as well as long-term analysis via a discounted cashflow model, can all be useful.”
The problem with valuation, however, is that there is no ‘right’ answer: bulls on the US argue that the S&P 500 looks cheap on 14.3x forward earnings for 2019 relative to its history, while bears will argue that this lowly multiple prices in yet another record high in US corporate profits and a 9 per cent increase on 2018’s all-time high, despite worries over a recession and increases in wage bills, interest costs and the dollar.
“Sceptics will therefore assert that it is better to look at US stocks on the basis of a 10-year rolling, historic earnings figure to take out some of the guesswork involved in profit forecasts,” he added.
“This is exactly what professor Robert Shiller’s cyclically-adjusted price earnings [CAPE] ratio does, on an inflation-adjusted basis, and the results here offer less encouragement to bulls.
“Even after the second-half slide of 2018, US stocks still trade on a CAPE multiple of 29x. The S&P 500 has reached a CAPE rating of around 30x on two prior occasions, in 1929 and 1998 to 2000, and both of those episodes ultimately ended very badly.”
Historical CAPE ratio on P/E
Source: AJ Bell, http://www.econ.yale.edu/~shiller/data.htm
So, while euphoria is a lot harder to find than it was a year ago, this still suggests that US stocks – tech stocks and the FAANGs (Facebook, Apple, Amazon, Netflix and Google parent company Alphabet) in particular – remain popular.
By contrast, emerging markets – a consensus favourite in January 2018 – are out in the cold after the summer rout. Financial stocks are unloved after a poor year and high yields and low multiples of book value mean banks may pop up on value screens – even if value remains out of favour.
“But if investors are really looking for an area where pessimism may mean value is available,” Mould added, “look no further than the UK, wracked as it is by the Brexit debate – although admittedly you could have said the same at this time last year, to no great effect.
“It will be interesting to see if the FTSE 100 confounds its doubters in 2019 and beyond whether a deal is struck with the EU or not.”