With equity markets closing on record highs, investors are questioning whether this is irritational. Romain Boscher, global chief investment officer for equities says this is all taking place within the realms of rationality.
As such, a two-speed, K-shaped recovery in equity markets is beginning to emerge, said Boscher.
He explained: “Given the conditions in the market, a scenario is playing out where market participants are behaving logically to such an extent that it’s forcing unusual divergences in the value of securities.”
Former Federal Reserve chairman Alan Greenspan famously described the markets during the dotcom bubble of the late 1990s as “irrational exuberance” and Boscher explained that the concept is back but with a different twist.
He explained that it is also closely associated with the ‘Fed Put’, a term first coined during the stock market crash of 1987.
Boscher said: “It implied a safety net where the central bank would purchase government bonds at high prices in order to lower the Fed Funds rate.
“Today, major central banks around the world are buying a whole range of assets at an almost unfathomable scale.
“A similar level of amplified spending can be observed on the fiscal side, where growing budget deficits have in some cases have more than offset the impact of Covid-19 related recession.”
Such ‘amplified spending’ can be seen in the levels of personal income among unemployed Americans.
US incomes rise during lockdown
Source: NIPA data, Bureau of Economic Analysis, Fidelity International, August 2020.
Boscher outlined the unprecedented trends that defy conventional economic thinking: zero and negative interest rate policies, growing disposable incomes and rising trade deficits during recession and all-time market highs despite contractions in earnings.
“This bull market coinciding with falling earnings has been made possible by the zero-rate environment that is driving up valuations,” he said.
“Investors are joining the headlong rush to profit from the rising market out of the fear of missing out, and, with bond yields so low, many investors believe there is no alternative to allocating to stocks.”
Boscher said this will lead to two distinct camps emerging in the equity space, those that do well and those that fare badly, hence the ‘K-shaped’ recovery.
In an environment of low economic growth and yield, capital competes for growth and income exposure.
“Those characteristics are becoming increasingly scarce and this is likely to continue,” he said. “This will further drive investors to, quite rationally, seek growth and income-oriented names, sometimes at dizzying valuations.”
Boscher explained that investors are more inclined towards companies pursuing sustainable growth as the pandemic has showed the vulnerabilities of some industries. But, the issue is valuation.
He said: “These sustainable growth companies undoubtedly present strong financial profiles but investors are buying them at almost any price.
“As a K-shaped outcome starts to exert itself – this time in expected returns – I anticipate valuation discrimination to come back into focus.
“In the short-term, abundant liquidity will whipsaw markets, but earnings will be the yardstick to measure performance in the long term.”
Source: Credit Suisse, 2019
Conversely, he explained that the ‘K-shaped’ scenario is also valid for value stocks, with businesses that are trading at low multiples and are currently at historically large discounts to growth names.
“Two groups are emerging within the value bucket: those that will struggle to survive and those that can thrive,” said Boscher.
On the one hand, he sees fossil fuel companies and high street banks in terminal decline but thinks industrial companies and low-cost airlines have the potential to surprise investors with fiscal and monetary inspired recoveries.
“Fiscal support will help repair Covid-19-inflicted damage to the economy while monetary easing will lubricate the market to climb higher,” he said. “It’s 24 years since the term ‘irrational exuberance’ was first coined, but what we are experiencing now is within the bounds of rationality – albeit an exaggerated form of it.”