For investors, optimism abounds. But previous market corrections prove the value of due diligence
It was John Maynard Keynes who introduced the world to ‘animal spirits’, coining the phrase to describe the range of emotions, human impulses, enthusiasms and misperceptions that drive economies — and sometimes unwind them.
The phrase came to mind when I read in a recent Bank of America report that investors had poured $602 billion into global equity funds in the five months to the end of March 2021, compared with a total of $452 billion during the prior 12 years combined.
At the end of April, global equity markets were up 90 per cent since the initial early Covid lows and average equity allocations were at record highs of 63 per cent. How rational is this gung-ho attitude?
In countries such as the US and the UK, the pandemic is receding, their economies are reopening and growth is surging, with the US leading the charge. If you live in London or New York, you too may be feeling more optimistic as daily life starts to feel more normal.
However, governments around the world continue to warn their citizens that they are not out of the woods yet. As I write, new tragedies are unfolding. At the annual Berkshire Hathaway investor meeting, Warren Buffett sounded a note of caution when he urged investors to note that while the recovery was ‘red hot’ and business ‘really very good’, there were warning signs of ‘very substantial inflation’ and overexuberance.
If, like me, you find yourself weighing up the mix of headwinds and tailwinds, you might reasonably ask if the low-hanging fruit has already been plucked. If so, does a full allocation to equities still makes sense?
It is true that monetary policies are stoking recovery in both the economy and financial markets with ultra-low interest rates and trillions in new spending. The world is awash with cash and does not know where to put it.
The Federal Reserve has announced that US household net wealth just reached a record $130.2 trillion. But are we missing something? After all, we live in a world of contrasts, and Covid-19 has been the great un-equaliser. The World Bank estimates that more than 100 million people fell back into extreme poverty in 2020.
Millions of businesses are either still shut down or running at reduced capacity. The cost of Covid has resulted in record levels of government indebtedness, which will have to be paid for, at least in part, in higher taxes.
The surge in growth is bringing with it higher inflation. And, to cap it all, even more sinister new variants of the virus may yet emerge.
In their book Ten Global Trends Every Smart Person Should Know, Ron Bailey and Marian Tupy point out that for the most part the world is not getting worse, even though polls measuring global public opinion indicate that people tend to believe it is.
The authors argue that the global population will peak at 8–9 billion before the end of this century, as the global fertility rate continues its fall from six children per woman in 1960 to the current rate of 2.4. The global absolute poverty rate has fallen from 42 per cent in 1981 to 8.6 per cent today.
Satellite data show that forest area has been expanding since 1982. Natural resources are becoming ever cheaper and more abundant. Since 1900, average life expectancy has more than doubled. Of course, major concerns are still with us, but many are already being ameliorated.
So, if an investor who is wary of a pandemic hangover can also identify positive global trends, supported by science and reason, can they have their cake and eat it? Is it possible to and play offensive and defensive at the same time?
Richard Urwin, CIO of private investment office Saranac Partners, recently reminded me that for such a strategy to be successful, it is not enough to identify the sectors and themes of the future.
After all, many investors correctly identified a positive secular trend in technology in the late Nineties but failed to identify the stocks with staying power; the ones that went on to become tech titans, such as Apple and Amazon.
What, then, is the key to success? Richard believes it remains as important as ever to look at the health of individual companies, focusing on key metrics such as price-to-sales ratios as well as on the secular themes that are driving their performance. His advice to investors seduced by the animal spirits driving earnings-free stocks in hot sectors is that themes can be dangerous.
I agree with him. And so do Alliance Bernstein analysts who examined unprofitable technology stocks over 50 years with price-to-sales ratios above 15. They conclude that the worst results tend to visit the most richly valued tech stocks; these stocks lost 18 per cent on average over three years and 28 per cent over five years.
When animal spirits are driving markets and confidence is high, investors are prone to cutting corners and not doing sufficient due diligence. But once cracks begin to appear, they can spread quickly – every bit as fast as an infectious disease.