The answer of course is yes, until it isn’t!
For some years investors have ridden the wave of success as certain sectors have driven the market.
A number of factors have been at play. One is record low interest rates. Money is cheap and low-cost loans have delivered inflated results to growth-oriented assets. Increased leverage, or debt, has been a powerful contributor to investor returns in recent years. Those who borrowed to invest have been able to keep their costs to repay loans the same, or lower, while assets have risen in value, which has enhanced returns.
Many investors have relentlessly pursued yield, or income, at almost any cost. This has resulted in share prices being bid up for historically more defensive companies, providing their yield was high. Infrastructure, real estate, and banks have all performed well.
What does the future hold?
In aggregate, the market now looks expensive. There is, however, a significant disparity between those shares that are very expensive and those that are very cheap. An interesting thing to look at is momentum in the market, which is shown in the chart.
Trending has been Extreme
Source: Allan Gray, 31 January 2017
This chart shows the relationship between the rankings of shares from one year to the next. It uses the performance ranking in each year for the largest 300 shares in the Australian market. The best performing share in a year is ranked first and the worst is ranked 300. Whilst it is academically possible for shares to maintain their ranking every year (which would lead to perfect correlation of 100% from one year to the next), the reality is that last year’s winner is typically next year’s laggard. In recent years, however, this has not happened and many of the winners have kept on winning.
When there is a lot of momentum behind certain shares the correlation rises to around 20%. Amazingly, the level of trending today is higher than it was during the tech boom of the late nineties… the shares and sectors driving it are just different this time around.
As the chart line heads south the concept of mean reversion, or normalisation, occurs. The winners and most popular stocks begin to unwind and perform poorly relative to those that were previously out of favour.
As you can see the chart line has rolled over recently, but it is impossible to know if the chart line will fall to zero (or indeed below) or how long it might take to get there during the next part of the trending cycle.
Popular isn’t always better
What we do know from history is that buying and owning the most popular companies in any market cycle can end in disappointment.
Domino’s Pizza is a good recent example. Domino’s has been very popular with investors in recent years and the share price has risen strongly. Yet despite announcing strong profits in the recent reporting season the company’s share price has fallen around 17% over the last three weeks since results were issued. This is because popular companies are often accompanied by high expectations, which are then reflected in the share price. Expectations for Domino’s must have been higher.
As contrarians, we prefer to resist trends and uncover opportunities where nobody else is looking. It is here we find value and the opportunity to outperform. I wish populist investing strategies luck as the tide turns. For me, the opportunities to take a contrarian approach have rarely been more attractive.
Chris Inifer holds a Bachelor of Business Economics and Finance (RMIT University) and a Postgraduate Diploma (with Distinction) in Financial Planning.