During the past century, financial markets have tended to be dominated by one or two major economic themes every ten years or so. Not only have these themes changed from one decade to the next, they have often come as total surprises.
Therefore, it is never easy to pick the next winning theme but for those investors lucky or skilled enough to do so, the financial rewards can be huge. For example, the Nifty-Fifty stocks were the stars of the ‘economic go-go years’ of the 1960s. In the 70s, it was commodities and gold on rising inflation and a falling dollar. Japanese equities dominated the 80s to be followed by NASDAQ stocks in the ‘internet revolution’ 90s. With China entering the global economy in a major way from 1980 onwards, globalisation really took off and commodities and oil boomed as a result. FAANG stocks were the big winners of the last ten years. What could be next?
Are we heading for a bubble?
Thinking about themes also makes me reflect on bubbles and many commentators and investors are wondering whether large cap growth stocks, and the FAANGS in particular, are approaching bubble territory.
In early 2000, a book called Dow 36,000: the New Strategy for Profiting from the Coming Rise in the Stock Market made The New York Times’ bestsellers list. It argued that ‘stocks are in an once-in-a-lifetime upward adjustment’ and that the Dow would hit 36,000 in the not-too-distant future. Basically the authors reasoned that equities are no riskier than bonds and, therefore, the equity risk premium (excess yield that investors demand for investing in equities compared to bonds) should fall to zero. In their view, stocks should sell at the same valuations as government bonds.
I’m not sure what happened to the joint authors and the Dow is still materially below 36,000 but this book is a reminder of the crazy times of the tech mania of the late 1990s.
The current environment is very different to then, a time when there were thousands of dot.com companies with huge valuations but no profits. Investors were brainwashed into believing that ‘the world is different’ and equity prices could go up forever.
Today’s technology companies have rich valuations in most instances but are also delivering very attractive revenue and earnings growth in a low growth world. They are also operating in an industry enjoying structural tailwinds as governments, companies and individuals all look to increase spending and investment in technological disruption and advancement in order to boost productivity and long-term growth, as well as keep up with changing lifestyle trends.
Economies are digitalising at an even faster pace as more people work from home and travel less. In addition, the evolution to 5G is another powerful growth theme, enabling the combination of speed, responsiveness and reach to unlock full capabilities in areas such as self-driving cars, drones, virtual reality and the Internet of Things. Consequently, we believe that many technology stocks will continue to deliver superior earnings and sales for many years to come.
However, there is always a danger that a price bubble develops when rates are extremely low for a long time and when liquidity is also plentiful.
The late Professor Charles Kindleberger lays out three preconditions for a financial mania or asset bubble in his book Manias, Panics and Crashes:
Easy monetary policy.
An exciting growth story that ‘captures’ investors’ imagination.
Objects of speculation allowing mass participation by speculators.
All of these seem to be falling into place very nicely at the moment. Monetary policy is the most accommodative it has arguably ever been with zero or negative cash and bond yields and plentiful liquidity. There is no shortage of exciting growth stories driving valuations higher. Amazon has a PE close to 150 and is viewed as a long-term winner, whatever the economic climate. Tesla’s market value is bigger than the three major automakers combined, even though its sales are tiny in comparison.
Finally, these large-cap growth stocks are deep and liquid enough to enable mass speculation and participation in the rally. The number of Robin Hood private investors holding Tesla and Amazon stocks has skyrocketed in recent months along with share prices.
If there is a bubble in these stocks then it is unlikely to burst anytime soon and could go on for much longer than we imagine. Historically, similar asset bubbles have been pricked by rising interest rates, most notably Japanese equities in the early 1990s and the dot.com stocks in the early 2000s.
With the US and global economies struggling to recover from the biggest economic shock in a generation, the Fed and other central banks are unlikely to raise rates for years to come. Hence, ample liquidity, negative real (and in some instances nominal) rates and a recovering world economy will continue to fuel the equity rally and speculation. It could also drive equity valuations to ‘nosebleed’ levels, making it very uncomfortable for both speculators and bears alike.
In addition to technology, there are a number of other potential candidates for the mania playbook. The healthcare sector could emerge as a new winner and pharmaceutical, biotech and life science companies in particular.
Covid-19 is changing government thinking for every country and huge amounts of money are pouring into this industry. Healthcare is another winner in a low-growth, low-interest rate environment and offers strong free cash flow, low leverage, superior returns, relatively low volatility and stable dividend growth in a world which faces a scarcity of attractive yield opportunities.
Other structural headwinds include an ageing population, rising prevalence of chronic diseases, innovation and growing demand from emerging markets as the healthcare system expands to meet the needs of a fast-growing middle class.
Gold also offers the potential to be a major winning theme over the next few years. In previous pieces, I have made a strong case for why we believe that gold is in a long-term bull market. The long list of supportive factors include negative real bond and cash yields, a weakening dollar, surplus dollar liquidity, competitive currency devaluations as all major countries ‘go for growth’, the risk of currency debasements as central banks fund increasing government deficits and the threat of a new cycle of rising inflation.
Gold is always regarded as a safe-haven asset and tends to thrive on economic turbulence, policy uncertainty and rising economic and political volatility, which aptly describes the current environment. Gold-mining companies would also be expected to perform very strongly in this scenario and, indeed, have been enjoying strong gains over recent weeks.
Given that the successful theme for each decade often comes as a total surprise for investors, it is useful to briefly consider some potential candidates. Given the collapse in crude prices to negative territory, oil could be a candidate but it faces a number of structural challenges including the increasing popularity of electric cars. It is less far-fetched to think that other industrial commodities could boom under the following scenario; an unexpected post Covid-19 economic boom; a long period of supply cutbacks and under-investment in the mining sector; a surge in copper demand as electric cars really take off; a weaker dollar.
Finally, I expect emerging markets to perform strongly over the next few years and covered this in my last article.
Focusing on long-term themes
If this decade follows the historical pattern, then an emerging and dominant theme will make investors a lot of money. Given the likely macro backdrop, as outlined above, the chances of a full-blown mania or bubble are high.
It is wise to remember, however, that manias never end well, usually after prices have overshot to the upside further than many expect and with violent corrections along the way. We would certainly never advocate this style of investing and prefer to focus on our long-term themes, backed up by very sound fundamentals and thorough research and analysis.
However, it is notable that healthcare, technology, emerging markets and gold have all featured in our preferred list of investments and themes for some considerable time.
It’s true that valuations are looking stretched in some sectors and markets, most notably the mega cap growth stocks. However, it’s also interesting that valuations look much more reasonable across a range of markets, sectors and certainly the stocks that we own. Also, it would be sensible to apply some flexibility around relying too heavily on valuations as a guide at this point given that most companies have little clarity as to what current or future earnings might be. What we do know is that the current environment of plentiful global liquidity, extremely accommodative monetary and fiscal policies and the likely powerful economic recovery that lies ahead should propel equities higher over the coming years.
Therefore, we continue to focus on investing in the right companies and funds that satisfy our thematic approach and ensuring that we have sensible hedges in place to protect against the numerous threats facing the global economy and financial markets.