Investment Insight | Sell in May and go away?
It is human nature to be fearful of missing out. Especially as other people experience short-term financial success. As we discussed in last week1s insight 07 May 2021 | All biases covered, behavioural biases such as confirmation bias and recency bias creep in and can stoke the flames of market exuberance.
While some market participants are pointing the finger at newer asset classes, such as cryptocurrencies, it is within parts of the share market where assets have become irrational and overvalued. This includes high growth technology shares, unprofitable or early-stage technology shares, biotech shares and SPAC IPO shares (Special Purpose Acquisition Vehicles).
The NASDAQ index is comprised of many high growth technology companies and provides a broad indicator for the valuations of these businesses. Currently the NASDAQ is trading at a valuation of 23x next year1s earnings. This compares to an average level of 16x over the past 10 years.
This extended valuation level and excess speculative investing in 2020 has been a significant contributor to the underperformance of the NASDAQ compared to the broader share market in 2021. For example, the NASDAQ is up 1.8% in 2021 versus the broader S&P 500 which is up 9.5%.
The NASDAQ has had a particularly difficult month in May where it is down 6.0%. While market negativity has spread to the wider market, it is concentrated in high-growth technology shares. It is no surprise that the adage of the financial world ‘sell in May and go away1 is appearing in the global financial press.
What is causing the sell off?
Rising inflation expectations has led to higher interest rates. Interest rates become a headwind for high valuation ‘growth1 shares as these businesses are valued using cashflows that may not be earned for 5 or 10+ years into the future. When interest rates rise, the present value of these cashflows earned, say 10 years in the future, become much lower.
This differs to ‘value1 or cyclical businesses where they are typically valued primarily on cashflows earned in the next couple of years. Higher interest rates have less detrimental impact on valuation and hence value and cyclical businesses outperform high growth businesses.
While much of the expected inflation is attributable to factors that are transitory as global economies reopen, we believe markets are underestimating more sustained inflation pressures, predominantly due to the stickiness of wage inflation.
For example, in the United States a record share (44%) of small business owners reported unfilled jobs in April, and firms are offering higher wages to lure workers given the tight labour market. Fast food restaurant chains now offer employees a referral bonus to help recruit new hires and McDonalds are lifting hourly wages and offering sign on bonuses to new employees.
How to manage volatility
MFS Investment Management ('MFS'), who NZ Funds partner with to manage a portion of clients1 global shares, say that it is active management that helps navigate volatile markets.
Active management is like analysing inclement weather forecasts and responsibly anticipating what is to come. MFS focus on fundamental factors that lead to the responsible allocation of capital and the potential of creating long-term value. We agree.
We will continue to see periods of outperformance and underperformance in technology shares throughout 2021 and beyond. That said, we are not giving up on technology. Technology companies are some of the most innovative companies on the planet. Client portfolios continue to own technology businesses which we consider to have exciting long-term prospects.
It is interesting to note that the 2000 'tech bubble pop' was not so much of a 'pop' but in reality, a prolonged 13-month period of underperformance where it ultimately fell 70%. However, in that 13-month period there were segments of outperformance including periods where the NASDAQ gained over 20% on three separate occasions. Markets never move in straight lines and we remain focussed on understanding the broader trends that are in play so we can position clients' capital effectively to benefit from them.
Active management
NZ Funds is an active multi-asset manager. Our approach means we are not limited by asset class. We can seek out growth opportunities, wherever they may be in the financial markets. This includes currencies, commodities, cryptocurrencies, futures contracts and options and is not just limited to shares and bonds.
While some market participants are pointing the finger at newer asset classes, such as cryptocurrencies, it is within parts of the share market where assets have become irrational and overvalued. This includes high growth technology shares, unprofitable or early-stage technology shares, biotech shares and SPAC IPO shares (Special Purpose Acquisition Vehicles).
The NASDAQ index is comprised of many high growth technology companies and provides a broad indicator for the valuations of these businesses. Currently the NASDAQ is trading at a valuation of 23x next year1s earnings. This compares to an average level of 16x over the past 10 years.
This extended valuation level and excess speculative investing in 2020 has been a significant contributor to the underperformance of the NASDAQ compared to the broader share market in 2021. For example, the NASDAQ is up 1.8% in 2021 versus the broader S&P 500 which is up 9.5%.
The NASDAQ has had a particularly difficult month in May where it is down 6.0%. While market negativity has spread to the wider market, it is concentrated in high-growth technology shares. It is no surprise that the adage of the financial world ‘sell in May and go away1 is appearing in the global financial press.
What is causing the sell off?
Rising inflation expectations has led to higher interest rates. Interest rates become a headwind for high valuation ‘growth1 shares as these businesses are valued using cashflows that may not be earned for 5 or 10+ years into the future. When interest rates rise, the present value of these cashflows earned, say 10 years in the future, become much lower.
This differs to ‘value1 or cyclical businesses where they are typically valued primarily on cashflows earned in the next couple of years. Higher interest rates have less detrimental impact on valuation and hence value and cyclical businesses outperform high growth businesses.
While much of the expected inflation is attributable to factors that are transitory as global economies reopen, we believe markets are underestimating more sustained inflation pressures, predominantly due to the stickiness of wage inflation.
For example, in the United States a record share (44%) of small business owners reported unfilled jobs in April, and firms are offering higher wages to lure workers given the tight labour market. Fast food restaurant chains now offer employees a referral bonus to help recruit new hires and McDonalds are lifting hourly wages and offering sign on bonuses to new employees.
How to manage volatility
MFS Investment Management ('MFS'), who NZ Funds partner with to manage a portion of clients1 global shares, say that it is active management that helps navigate volatile markets.
Active management is like analysing inclement weather forecasts and responsibly anticipating what is to come. MFS focus on fundamental factors that lead to the responsible allocation of capital and the potential of creating long-term value. We agree.
We will continue to see periods of outperformance and underperformance in technology shares throughout 2021 and beyond. That said, we are not giving up on technology. Technology companies are some of the most innovative companies on the planet. Client portfolios continue to own technology businesses which we consider to have exciting long-term prospects.
It is interesting to note that the 2000 'tech bubble pop' was not so much of a 'pop' but in reality, a prolonged 13-month period of underperformance where it ultimately fell 70%. However, in that 13-month period there were segments of outperformance including periods where the NASDAQ gained over 20% on three separate occasions. Markets never move in straight lines and we remain focussed on understanding the broader trends that are in play so we can position clients' capital effectively to benefit from them.
Active management
NZ Funds is an active multi-asset manager. Our approach means we are not limited by asset class. We can seek out growth opportunities, wherever they may be in the financial markets. This includes currencies, commodities, cryptocurrencies, futures contracts and options and is not just limited to shares and bonds.
Source: Bloomberg.
For more information please contact NZ Funds.
This document has been provided for information purposes only. The content of this document is not intended as a substitute for specific professional advice on investments, financial planning or any other matter.
While the information provided in this document is stated accurately to the best of our knowledge and belief, New Zealand Funds Management Limited, its directors, employees and related parties accept no liability or responsibility for any loss, damage, claim or expense suffered or incurred by any party as a result of reliance on the information provided and opinions expressed except as required by law.
For more information please contact NZ Funds.
This document has been provided for information purposes only. The content of this document is not intended as a substitute for specific professional advice on investments, financial planning or any other matter.
While the information provided in this document is stated accurately to the best of our knowledge and belief, New Zealand Funds Management Limited, its directors, employees and related parties accept no liability or responsibility for any loss, damage, claim or expense suffered or incurred by any party as a result of reliance on the information provided and opinions expressed except as required by law.
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James Grigor is Chief Investment Officer for New Zealand Funds Management Limited (NZ Funds) and a member of the NZ Funds KiwiSaver Scheme. James' comments are of a general nature, and he is not responsible for any loss that any reader may suffer from following it.
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