Are we headed for a bear market or simply a correction?
The JSE has reached new records for the past two weeks and currently trades around the 55 000 mark. In such an upbeat environment investors should be cautious not to overpay for stocks and guard themselves against future slumps.
The JSE is currently steaming ahead, reaching one record high after another. But financial markets fluctuate by nature, and sooner or later the JSE will begin to lose momentum and these record highs will become nothing but a distant memory.
ENJOY THE RIDE
Financial analysts concur that the JSE is expensive, especially compared to other stock markets around the world. “If we look at the JSE relative to its own history, the market is very expensive,” says Andrew Newell, head of business development at Cannon Asset Managers. “This holds true across a range of metrics, including price-to-earnings (P/E) and price-to-book ratios.
“Having said that, this does not necessarily mean that the JSE will correct anytime soon,” says Newell. “It has been this way for some time, and, as we know, markets can always get more expensive.”
Two important underlying factors that determine the value of any share market are estimated earnings and prevailing interest rates over the short and long term. “A market can be expensive as long as the future outlook supports the evaluation,” says Wayne McCurrie, portfolio manager at Momentum Wealth Management. “The earnings outlook for the South African market is reasonable, especially in rand terms. So there shouldn’t be any threat to our
market from disappointing earnings over the next two years or so.”
Lower interest rates lend great support to equity markets and they’re likely to remain low for the rest of 2015, locally and globally, says McCurrie. In the current low interest rate environment the market is unlikely to collapse.
Moreover, inf lation is under control and there is no sign of an imminent recession. “If anything,” says Graham Bell, strategist at Old Mutual Equities, “the economy is picking up steam. The low interest rate environment is a problem for investors with cash, as they don’t get good returns in the cash or bond markets, so they push down the risk curve, looking for riskier products that will give a better return.”
He says: “Equities are attractive in such an environment, as companies are the most f lexible investment vehicles. People who run companies are also very responsive to market conditions and they can change the business or the management quickly.”
CANARIES IN THE COALMINE
While things are still looking up for stocks, there are a few ‘canaries in the coalmine’ that could indicate the onset of a bear market. “The primary thing that would be cause for concern is if interest rates globally start going up much faster than expected,” says Rhynhardt Roodt, head of the Investec Equity Fund.
“It’s not so much the start of a rate hike, but rather the pace of it that is a warning sign. Rates tend to go up quickly when economies are overheating, and economies overheat when global inf lation is getting out of hand, levels of capital expenditure are elevated and businesses are over-confident. We don’t see that currently.”
There will be some market correction, though, Roodt says. “Returns will be lower and prices will be more volatile, but as long as interest rate hikes are accompanied by a strong, robust growth environment and favourable liquidity it will be okay. Money needs to find a home and there aren’t many alternatives.”
DON’T PAY TOO MUCH
The general consensus is therefore that equities will yield good returns for some time to come. However, fund managers warn that investors should avoid areas of the market that are overpriced.
“We don’t invest in stocks with trade above their intrinsic value and where there is a high risk of capital loss,” says
Patrice Rassou, head of equity at Sanlam Investment Management.
Cannon’s Newell agrees: “By definition, a run in a market implies that shares become too expensive. Make sure you don’t overpay for stocks. Buying equities at the right price will help to protect your portfolio.”
Duane Cable, head of SA Equities at Coronation, reiterates this, saying that the South African equity market is becoming increasingly dislocated. “The market is increasingly prepared to pay any price for good businesses with good prospects and is increasingly indifferent to the low valuations for poorer-quality businesses with weak short-ter m prospects,” he says. “Paying too much, even for a good business, can cripple your future returns. It’s therefore important to remain disciplined in your assessment of longer-term valuations.”
In the event of a market correction, it is best not to be overexposed to equity, says Momentum Wealth’s McCurrie. “Make sure you are diversified. This is the only free lunch in investments. And if you’re fortunate to have some of the big winners of the last few years, sell some. They’ll be hardest hit if we have a bear market.”
Duncan Artus, portfolio manager at Allan Gray, believes that the value of cash is currently understated. “No one likes cash at the moment because of the lower returns, but we have a higher cash portion in our portfolio. While it hurts in the short term as interest rates are low, people don’t take into account that cash can be used to buy cheaper stocks.”
Coronation’s Cable agrees: “Although we contend that the longer-term real returns for cash will be poor [interest rates are l ikely to remain lower for longer], we view it as an underrated source of tail-risk protection that will provide us with the f lexibility to respond in a market correction.”