Rudi’s View: Market Reflects Risk & Opportunities

Rudi's View | Oct 09 2024

In this week's Weekly Insights:

-Market Reflects Risk & Opportunities
-All-Weather Model Portfolio

By Rudi Filapek-Vandyck, Editor

Market Reflects Risk & Opportunities

It is easy, probably too easy, to be deterred by what looks like richly priced asset prices, but if the years past have shown one key message for investors, it is that present 'valuation' is only one aspect of the investment proposition.

It is much more difficult to understand the broader context in the background and why a valuation that looks beyond 'normal' can still be an attractive investment. I think this is one reason as to why the adage of bull markets climbing a wall of worry equally applies today.

Markets are forward looking. All investors understand the basic principle, but not so much when forward-looking translates into above-average valuation multiples in anticipation of better times ahead.

The last time we were all confronted with seemingly eye-watering PE multiples happened after covid temporarily closed down societies.

Those voices warning about an impending market crash based on historically outsized PE multiples have long gone silent as they ignored the one key reason why valuations at that time had to be well-above the long-term average: the subsequent recovery in earnings and cash flows would automatically pull back multiples to more moderate levels, and that's exactly what happened in 2021.

It is true large parts of highly-valued equities experienced a tough time throughout most of 2022, but that was a consequence of bond markets resetting from exceptionally low yields, with follow-on impact on equity multiples, irrespective of where those multiples were at.

The carrot of rate cuts

Since this time last year, equities are at it yet again, rallying hard to push average market multiples well above long-term averages, simply because central banks were preparing for rate cuts. That process has now well and truly begun. The RBA will join-in at some stage, exact timing still unclear.

But equities have not subsided, not even when the historical pattern of seasonal weakness in September would have suggested this might happen. So, is this the mother of all bubbles, as some narky observers have declared it is, or is there a better, more accurate explanation, just as was the case back in 2020 and 2021 (as it equally applied back in 2009 and in 2001)?

The first thing to note is that if/when rising bond yields impose a negative correction on equity valuations generally, then the opposite happening allows for valuations to rise again.

This process becomes even more 'logical' when those benefiting from lower yields are also benefiting from the newest megatrend on the menu, one that most likely will stick around for much longer and plausibly will re-shape the decade ahead for businesses and economies.

That's simply par for the course, or, to put it differently: normal investor behaviour. Shares in Goodman Group ((GMG)) and NextDC ((NXT)) and the likes are now expressing general investor confidence that many billions in investment will be made in new data centres and this should -all else remaining equal- translate into above-average growth for such beneficiaries for multiple years into the future.

There is another, equally important factor in play: lower yields support and stimulate economic activity.

The broadening of the market rally

The larger part of Australian businesses listed on the ASX has had a tough time since 2022, as yet again proven throughout the recent August results season, which ranks among the worst locally post 2013 (that's how far the FNArena data history stretches).

History suggests what usually follows a coordinated global tightening cycle is economic recession, in which case today's market 'exuberance' would look painfully misplaced. But that is clearly not what equity markets are reflecting. Instead, general confidence is rising that central banks, and governments, might be able to pull off that rather rare outcome: a 'soft' landing.

Recent economic data, including Friday's non-farm payroll upside surprise have only further strengthened general confidence in a different outcome this time around.

There are, of course, no guarantees. If/when the economic picture deteriorates to the point where such a favourable outcome becomes less plausible, valuations will have to shrink and today's prices and multiples will be judged as utter fantasy in the months to follow.

The fact authorities in China are now actively stimulating their sluggish domestic activity levels adds further credence to the 'soft' global landing scenario, though, admittedly, still does not guarantee such a favourable outcome.

One of the dangers with the market's forward-looking optimism is there remains plenty of potential for mishaps and disappointment until rate cuts and lower bond yields start positively impacting on economic activity. Witness, for example, the numerous 'punishments' that have occurred in August locally.