“Bull markets,” said legendary investor John Templeton, “are born on pessimism, grow on scepticism, mature on optimism and die on euphoria.” The equity bull market started in October 2022 and is well under way, although it is further advanced in the US. Market sages are in denial, having warned of a recession that would dent stocks, but it has failed to appear. Ed Yardeni of Yardeni Research likens them to Vladimir and Estragon, the characters “waiting for Godot” in Samuel Beckett’s play. Godot never turns up.
The sceptics point to the narrow base of the bull market. The “MegaCap-8” of the US market (Apple, Amazon, Alphabet, Microsoft, Meta, Nvidia, Netflix and Tesla) fell by 41% in 2022, but have since rebounded by 64%, so their share of the S&P 500 index has risen from 19% to 27%. The S&P 500 has climbed by 17% this year, but only by 5.5% without the MegaCap-8.
The forward earnings multiple of the MegaCap-8 has risen to 31 times, still short of the 38 reached in 2020, but up from 21 at the start of the year. This has propelled the multiple of the whole US market from 15 at the October low to 19.6. But the multiple for the rest of the S&P 500 has risen only moderately to 16.7. The forward multiple of the mid-cap S&P 400 index is only 14.1. The small-cap S&P 600 is on just 13.7.
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The sceptics say the MegaCap-8’s performance is entirely driven by artificial-intelligence (AI) mania, a bubble waiting to burst. In truth the surge is mostly due to the actions taken in 2022 to reduce costs, streamline their companies and focus on profits. The sceptics may also be dismissing the impact of AI too readily.
Investment guru Ken Fisher shrugs off concerns about poor market breadth. “This is normal as you move to new all-time market highs. It is also normal for the stocks that got hurt the most on the way down, as in 2022, to bounce the most in the subsequent bull market.” Robust earnings growth is bringing multiples down, with both first- and second-quarter US earnings ahead of expectations.
European growth lags behind
The European and UK markets have rallied less and their valuations are lower – but GDP growth is lower and likely to remain so. In addition, GDP growth feeds into profit growth more easily in the US than in the UK or Europe. America’s higher valuation is thus supported by structurally faster growth in earnings.
The UK and Europe might benefit if there was a preference for “value” investing over “growth”. But Ron Tabbouche of RIT Capital argues that “the expansion of earnings multiples, driven by lower interest rates, accounted for most of the 12% annualised return of equities in the last ten years, with rising margins, helped by globalisation, also a significant factor”. Now, growth in revenues is needed “to drive returns”.
Higher interest rates and bond yields than have been seen in the past 15 years have held markets back, but won’t necessarily continue to do so. Equities performed well in the 1980s and 1990s against such a background as the high cost of debt constrained productivity-sapping government spending. Still, markets don’t go up in a straight line, and a setback is always possible. Almost inevitable is a change of gear in which the shares that led the market up initially take a breather and new leaders emerge. This makes now a good time to review a portfolio, taking some profits in the winners, selling the lame ducks and buying into some stocks left behind.
Only 4% of the companies listed account for all of the US equity market’s gains since 1926. Just 90 of 24,000 have made up half. Owning any of these but selling too early would have been a mistake. “Nobody ever went broke taking a profit” goes the saying. The riposte is that they went broke reinvesting in a loser.
So there are no simple rules to follow about when to buy or sell. Purging the losers in a portfolio has merit as investors worry more about losses than profits, but the risk of selling a loser is that it will then bounce back. It’s best to make an active decision: either sell or double up.
When it comes to new investments, it is tempting to buy a share that has fallen a long way as it’s easier to believe that a share price that has halved can double than to believe one that has doubled can double again. The latter is more common. As this year’s huge rebound of the MegaCap-8 demonstrates, if you don’t buy quality growth shares when they are temporarily out of favour, you probably never will. Cheap shares can wait.
Cash and government bonds
Bank deposit rates and the yield on government bonds are the highest for 15 years. But resist the temptation – those yields do not look nearly so attractive when inflation and taxation are taken into account. Besides, the appetite of professional investors for bonds will have been dulled by the savage bear market of the past 18 months, which ended a 40-year bull market.
Polar Capital Technology (LSE: PCT) and Allianz Technology (LSE: ATT) trusts
Those who held on to these in defiance of the consensus that the sector had further to fall have good reason to feel smug. The shares still trade on double-digit discounts to net asset value (NAV), the bears are still in denial and their capitulation lies ahead. Still, it’s hard to believe that the MegaCap-8 will continue to outperform and there are plenty of attractive alternative investment opportunities. This suggests some profit-taking.
Scottish Mortgage Investment Trust (LSE: SMT)
The shares have more than halved from their early 2021 peak and a premium to NAV has turned into a 16% discount. Yet the share price has been rising steadily since May, the NAV is up by 8% this year and good news is emerging on unlisted investments such as SpaceX. This is a trust worth adding to, not cutting.
Ruffer (LSE: RICA), Capital Gearing (LSE: CGT), Personal Assets (LSE: PNL)
These defensive trusts performed well in 2022, but have disappointed this year. Managers remain bearish. Ruffer’s allocation to equities is at a record low of 14%. Capital Gearing has just 27% in risk assets, including alternatives and property. The trusts are structurally averse to equities, so they tend to be poor stockpickers. Bonds are no longer defensive, limiting the scope for diversifying risk. The shares trade on low discounts to NAV, so these are prime candidates for a sale.
RIT Capital Partners (LSE: RIT)
RIT has also been a poor performer this year, yet the shares trade on a 20% discount. Exposure to quoted equities is only 34%, but 40% is in private equity. This was a minor drag on returns in the first half of 2023, but should now be positive. RIT’s managers are “keen not to sacrifice the upside” so they are not structurally bearish. Their stated view that “revenue growth and margins rather than multiple expansion will drive returns from now” implies that they are growth rather than value-orientated. The shares seem at least worth holding onto at the current price.
Infrastructure funds
The shares have heavily derated this year and are now trading at discounts of between 5% (BBGI Global Infrastructure, LSE: BBGI) and 21% (HICL Infrastructure, LSE: HICL). 3i Group’s (LSE: III) shares are only down 3% over one year thanks to some good asset sales, but the others have lost roughly 20%. Investors have taken into account the effect of higher interest rates in pushing up the rate at which future cash-flows are discounted to present values (thereby reducing asset values), but taken no account of the benefit of higher inflation on those cash flows and hence dividends. This leaves the funds very attractively priced relative to inflation-linked gilts with a yield approximately 5% higher, making them a strong hold, especially if held in a Sipp or an Isa.
Renewable energy funds
The same applies to these, although their exposure to market electricity prices has been an additional adverse factor. Over-enthusiasm about investment, especially by the government and opposition, has threatened lower long-term prices, but the discounts of the funds to net asset value is bringing their expansion plans to a halt. Vattenfall’s decision to suspend work on its North Sea site due to rising costs makes excess capacity look less likely, while demand for electricity will grow steadily. This makes the sector attractive longer term, with even the highest quality funds yielding roughly 6%.
UK equities
It’s probably too late to bail out from a market that has reverted to underperformance this year. The market certainly looks cheap, but may deserve to remain so. There is very good value in small- and mid-cap funds and in those, such as Finsbury Growth & Income (LSE: FGT), investing in high-quality global businesses. The best returns are coming from the supposedly high-risk recovery shares most funds avoid: Rolls-Royce has more than doubled. But avoid stocks whose business models are broken, such as banks and general insurers.
In the very long term, shares have delivered an excess annual return over government bonds of nearly 4%, but in the bull market for bonds, the excess return was much lower. It could now be considerably higher for an extensive period, especially as the earnings multiples of most markets have fallen in response to higher bond yields. For equity investors, happy days are here again.
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