Quality and momentum sectors have really been on a tear for the last 6-7 months, particularly global cyclicals and technology stocks. This has been fantastic for performance of the Fidelity Future Leaders Fund however it’s important to stay valuation sensitive.
High valuations, bullish sentiment, rising expectations and cyclically high earnings which can be beneficial on the way up, can endure a painful adjustment phase on the way down. Some high quality growth stocks have risen over 100% in the last 12 months and some moderation of enthusiasm is warranted.
I have been trimming some of these very high performing stocks given valuations are becoming stretched in a number of cases. History has shown that a 10% earnings miss which drives a shift in sentiment from ‘love’ to ‘unsure’ in a high quality or momentum name usually results in a 50% price fall over the next few months. Some examples of fallen angels and fading momentum stocks over the last few years include TPG Telecom; Navitas, Mayne Pharma and, iSentia.
A strong signal to be more valuation conscious is that quality stocks and momentum stocks are currently exhibiting high correlation. Structural and cyclical themes can be very powerful as sentiment drivers and ‘Mr Market’ tends to buy the basket, and not distinguish too much between stocks fundamentals and idiosyncratic risk in this environment. As one of Fidelity’s greatest investors once told me “Sentiment can be more powerful than fundamentals” - Anthony Bolton. One always needs to consider if earnings and fundamentals are driving their valuations at the moment, or if they’re being lifted by unsustainable low interest rates, momentum or extreme sentiment.
Transition stocks and value stocks in sectors such as utilities, infrastructure and telecommunications have not kept up with the strong market and become under-owned consensus sells. Investors need to be vigilant after a 9 year bull market as the price of risk is low, the cost of debt is low, liquidity is high, valuations are high and complacency is rising.
As a reminder to be cautious, I look at the ‘Toddler index’ below which signifies the proportion of each index where companies have been listed less than 3 years. Once again the index is at its highest levels (around 50% in micro cap and small cap) which is similar to other periods of high valuations, liquid debt and high liquidity such as 2000, 2007 and 2016. These young companies have not yet been tested through an entire business cycle and may be enjoying some sector valuation momentum. They also lack management and business maturity and can be temperamental as any parent who has lived through those toddler years well knows!
The toddler index
Source: Macquarie Research, Fidelity International
From a style perspective, the pattern of divergence between growth and value is rapidly repeating itself. Value stocks dramatically underperformed growth stocks in 2015, which was followed in 2016 by an aggressive value market for the unloved sectors of materials and resources. 2017 has been a reversal of this trend with growth, momentum and quality dominating performance tables.
The list of anecdotal absurdities continues to grow prompting many market commentators to speculate ‘somethings gotta give’. Record stock markets continue to run. A depiction of Christ by Renaissance master Leonardo da Vinci recently sold for US$450 million (AUD$591 million) smashing the previous record of US$179 million for the sale of a painting. Paul Newman’s Rolex Daytona was picked up for a cool US$17.8 million - the highest price ever paid for a watch at auction. And let’s not even mention property prices… If something does give in 2018, it will be that the price of risk rises and liquidity falls.
Finally, I’d like to thank you all for your support over the last 12 months and wish you a very happy Christmas and a wonderful New Year!
This document is issued by FIL Responsible Entity (Australia) Limited ABN 33 148 059 009, AFSL No. 409340 (“Fidelity Australia”). Fidelity Australia is a member of the FIL Limited group of companies commonly known as Fidelity International.
Investments in overseas markets can be affected by currency exchange and this may affect the value of your investment. Investments in small and emerging markets can be more volatile than investments in developed markets.
This document is intended for use by advisers and wholesale investors. Retail investors should not rely on any information in this document without first seeking advice from their financial adviser. This document has been prepared without taking into account your objectives, financial situation or needs. You should consider these matters before acting on the information. You should also consider the relevant Product Disclosure Statements (“PDS”) for any Fidelity Australia product mentioned in this document before making any decision about whether to acquire the product. The PDS can be obtained by contacting Fidelity Australia on 1800 119 270 or by downloading it from our website at www.fidelity.com.au. This document may include general commentary on market activity, sector trends or other broad-based economic or political conditions that should not be taken as investment advice. Information stated herein about specific securities is subject to change. Any reference to specific securities should not be taken as a recommendation to buy, sell or hold these securities. While the information contained in this document has been prepared with reasonable care, no responsibility or liability is accepted for any errors or omissions or misstatements however caused. This document is intended as general information only. The document may not be reproduced or transmitted without prior written permission of Fidelity Australia. The issuer of Fidelity’s managed investment schemes is FIL Responsible Entity (Australia) Limited ABN 33 148 059 009. Reference to ($) are in Australian dollars unless stated otherwise.
© 2018 FIL Responsible Entity (Australia) Limited. Fidelity, Fidelity International and the Fidelity International logo and F symbol are trademarks of FIL Limited.