Analysis: Prepare for a meltdown, not a continuing bull run

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Bullsandbears

REUTERS

A bull and a bear styrofoam figurine.

Last year was an excellent one for equity investors globally, with equity markets posting an eye-popping 23 percent return in dollars. Around the world stock markets posted new record levels.

The JSE joined the party, with the Swix, a shareholder weighted index, up 21 percent in rands. But in dollar terms, most of the return was wiped out by currency depreciation – a trend seen in most emerging markets.

Even the zombie economy of Japan seems to have rejoined the land of the living with an astonishing 51 percent return in dollars last year.

But what is a worry is how the prevailing enthusiasm for stocks is leading to expectations of further strong gains this year, with the so-called Vix fear index at low levels – a sign of optimism.

Globally, the bull run in equities has now galloped on for approximately five years boosted by a cocktail of quantitative easing from the developed market central banks and record low interest rates.

However, bull markets tend to last five years, on average, and the beginning of Federal Reserve tapering will mean the doses of steroids being injected into the largest financial market will be curtailed.

So there is a contradiction in terms. Many commentators see more upside than downside even as they question the sustainability of the bull run.

Jeremy Siegel, a Wharton professor, recently forecast the Dow Jones industrial average would overshoot to 24 000 this year from a current level of 16 500. Others are even more bullish.

While I believe some areas of our own market are expensive – especially the industrial sector, which was up 28 percent a year over the past five years – I would not say that the whole JSE is in bubble territory. This is despite its trading on a hefty historic price-earnings multiple of 15 times.

There are some specific areas of the domestic industrial universe that trade at stretched valuations and have a high level of foreign ownership. (Offshore owners are often weak holders of equities.)

A good indication of extended valuation is when companies come to market. This has been the case mainly in the listed property sector, where new listings and capital raisings last year were equivalent to close to 10 percent of the sector’s market capitalisation.

There have, however, been a few sectors where one could start to be concerned that bubbles may be developing:

l US technology firm listings.

Facebook, which listed at $38 (R405) in 2012, finished the year close to $55 and was up almost 90 percent last year alone. Rival social media outfit Twitter has more than doubled since it listed at $26 a share in November last year to close the year at $67 a share with a whopping market cap of $39 billion.

Some of these sharp price movements for companies that are not even making profits are reminiscent of the market action during the Nasdaq euphoria in the late 1990s.

l Bitcoin.

This online currency was gripped by speculative fever, with its value surging from under $100 to peak at $1 200 – worth more than an ounce of gold – before ending the year closer to the $900 mark.

While Bitcoin may well survive to facilitate online transactions, the volatility in its price puts question marks on its role as a store of value (an issue that itself has had an impact on the gold price, which suffered its worst annual drop in 30 years last year).

l Unsecured lending.

Analysis by our economist at Sanlam Investment Management shows that in South Africa unsecured lending has surged since the global financial crisis from 22 percent to 26 percent of personal disposable income.

This proportion is now much higher than in the US and UK, where there has been a sharp pullback in the use of such debt when measured against personal disposable income. We expect a sharp pullback will have a dampening effect on consumer demand and retail sales, bearing in mind that household consumption accounts for 67 percent of gross domestic product (GDP) in South Africa.

Emerging markets are now trading at a discount to developed markets for the first time since 2005. But South Africa has been punished alongside many other emerging markets for the following reasons:

l A deteriorating current account deficit at 6 percent of GDP, as in the case of Thailand and Malaysia, with only Turkey’s deficit worse;

l A budget deficit of 4.9 percent of GDP. It is one of the highest among emerging markets, alongside India;

l A weak currency. The rand has been one of the weaker emerging market currencies over the past three years, with Brazil, India and Indonesia not far behind; and

l Weak demand for commodities, which has also been the case for Brazil and Chile.

South Africa has been lumped into a group of emerging economies facing some structural economic challenges – the so-called fragile five. The others are Brazil, Turkey, India and Indonesia.

While many may see further upside this year in equities, I believe that investors should focus instead on ensuring that they don’t suffer capital losses.

This only way to do so is to avoid areas of the market that are truly in bubble territory and by remaining invested in assets that still offer value.

The JSE trades at a hefty premium to the historical norm with some industrial stocks trading on price-earning multiples of 20 plus. Rather than hoping for a melt-up, I would prepare for a meltdown.

Patrice Rassou is the head of equities at Sanlam Investment Management


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