However, the “winners” are now trading at a record historical premium to the market. A non-exhaustive list of stocks include those in the large cap health care sector such as CSL, Cochlear and Resmed, the technology space with REA, Seek, Carsales.com, WiseTech Global, Altium and Afterpay Touch and consumer goods such as Treasury Wine Estates, A2 Milk and even Woolworths and Wesfarmers.
A high valuation by itself is not necessarily a reason to sell a stock, as long as it keeps delivering strong earnings growth, the stock price can rise and if it surprises the market then a reassessment of future growth prospects may see multiples expand. Although the expansion in multiples in the last year has had little to do with fundamentals in many cases.
There are many reasons to explain this move up in valuation levels, but the most obvious one is the extraordinarily loose monetary policy being employed by central banks around the world.
Most major economies, including Australia, have interest rates set at or below the level of inflation and many central banks have been engaging in the large scale purchase of government bonds, broader credit instruments and even direct equities. These policies were put in place to counter the effects of the global financial crisis, but as banking systems have been repaired and employment and growth have recovered they have helped to turbo-charge asset prices.
This liquidity expansion is coming to an end as the US Federal Reserve starts to reduce its balance sheet, the European Central Bank is tapering its quantitative easing (QE) and the Bank of Japan is less aggressive in targeting its own bond yields. At some stage this will put pressure on high valuation multiples, but we are likely to need to see clearer signs of inflation picking up to get central banks winding back accommodative policy.
Nevertheless, the environment that has seen stock prices driven by expanding multiples from excess liquidity pushing down bond yields is coming to an end.
As we move into reporting season, valuations will also be tested by the reality of earnings not just from reported numbers but also from outlook statements. There are already a few areas of risk that are developing. Housing prices have rolled over as credit availability has been tightened within the banking sector and this is likely to directly impact turnover in the property market.
There are also second-order impacts from wealth effects with consumers less likely to purchase big-ticket items and, depending on how this evolves, it may impact the prospects for employment growth. Another change has been the attitude towards immigration by both political parties. Along with some frosty relations with China, student intake growth to the education sector looks less promising. This also feeds into less housing demand.
There will definitely be some winners out of that list of stocks, but the price of disappointment is very high.
Afterpay Touch recently delivered stellar performance in the US which saw the stock move up materially, while Seek has guided to flat profit growth and saw a sharp fall in its share price. On a risk-reward basis this part of the market looks unappealing with the cost of disappointment higher than the gains from success.
Certainly, if you own every stock on that list you may like to think about some portfolio diversification.
By: Sean Fenton
Source: The Australian Financial Review