Investing in a Frothy Market

Navigating the investment universe and finding value in share prices when everything seems expensive or ‘frothy’, can be difficult for individual investors. Share markets globally, including Australia’s primary index the S&P/ASX200 Index, have been repeatedly hitting all-time highs recently.

Many investors seek value in share prices, which is to basically look for high quality companies at reasonable prices. In the current environment, it can be seen easy to assume value opportunities are scarce. A fantastic company does not always translate to a fantastic investment, as these companies can often be overhyped, overbought, and expensive which translates to lower future returns for investors.

During these times of frothy valuations, it can be challenging to find such value. What we mean by a ‘frothy’ market, is characterized by overconfident investors that ignore market fundamentals and bid up an asset's price beyond the asset's quantitative worth.

Historical Overvalued Markets

Markets tend to be described as ‘overvalued’ when certain historic indicators and/or metrics point towards the share prices of companies getting too far ahead of the underlying earnings of those companies. These overvalued markets can often be termed as bubbles, characterised by unrealistic future expectations, irrational exuberance, unsustainable practices, etc.

In the 1920s, or otherwise known as the Roaring 20’s, was a decade of great optimism and hedonism. Abundant with a new US economy and built upon improved business methods such as motor cars, aircrafts, and radios. These extraordinary technological advancements led to a feeling that there were no limits on economic growth and the subsequent prosperity.

Investors loaded up on easy credit to capitalise on rising share prices, borrowing money to invest in companies. The Dow Jones Industrial Average, an index of American companies, rose by 75% in little over a year between July 1928 and August 1929, as you can see depicted in the chart below.

Inevitably, the growth in stock prices came to a halt and crashed in October 1929. Further weakness took the index back below 200 in around a month. At the depths of the Depression in 1932, the Dow Jones traded near 40, representing a fall of 90% over 3 years. The US stock market and its trading conditions in 1929 are quintessential examples of an overvalued market and the dire consequences.

A similar event occurred through the 1990s, where markets again began to believe that the benefits associated with new technologies, this time computing, and the internet, were limitless. Any association with the internet led to a mania and the simple addition of ‘dot com’ to a company’s name warranted it to become a proxy for irrational speculation, with many of these without any revenue whatsoever.

A quality example of this, was Amazon.com which was valued at 10 times the combined value of their traditional ‘bricks and mortar’ competitors at US$26 billion. The US technology-centric NASDAQ 100 stock index demonstrates this irrational exuberance clearly. The NASDAQ index grew by 70% from November 1999 to the middle of March 2000, as depicted in the chart below.

In 1929, there was no obvious trigger for the collapse of the tech index, which shredded off 70% in just a couple years. Through the analysis of the historical stock market bubbles such as 1929 and 2000, it becomes clear that bubbles only occur when the initial reason for investing becomes consumed by a widespread demand for assets, whose prices have risen in the past, regardless of the initial reason for the rise. Speculation overrides fundamentals due to the fear of missing out on share price climbs. This fear pervades institutional investors as much as retail investors.

Current Investment Landscape

Currently, there is a massive amount of media coverage and discussion claiming that contemporary global stock markets are overvalued and are in potential bubble territory. This is primarily because in March 2020, the stock markets plunged into a bear market at the quickest pace seen in history due to the Covid-19 pandemic. The market proceeded to ascend back into a bull market, exceeding pre-Covid levels also at historic pace. This sort of activity was unprecedented, and it was apparent to most investors that the company fundamentals did not justify the rapid rebound in share prices.

Fuelling this unprecedented rebound and with the worldwide government policy, particularly in monetary policy efforts. In Australia, the Reserve Bank of Australia, reduced the official interest rate to a historic low of 0.10%. The official interest rate won’t be increased until approximately 2024. The reasoning behind this unparalleled amount of liquidity to the private sector and quantitative easing (printing money to buy government bonds) on a scale never witnessed before. This response was replicated throughout central banks globally and this gave investors something that they didn’t have at the beginning of the pandemic - a sense of certainty. Investors felt as though central banks were there to instil financial stability regardless of the economic situation. As interest rates fell to historic lows globally, share price valuations rose and this has not stopped since. This behaviour can be observed in the below chart, observing the S&P/ASX200 index over a four-year period, which is just off the all-time highs endured in June 2021.

However, it is important to note that irrational and unmatched conditions like this have been observed in abundance throughout history. Through the ebbs and flows of share price movements, the best companies listed on share market exchanges continue to remain resilient and march forward over time.

The best example of this can be observed through analysing the world’s largest stock market index, North America’s S&P 500 Index, totalling a value of approximately $55 trillion and comprising 500 of America’s largest companies. Through the copious number of economic recessions, stock market bubbles, unprecedented scenarios, ridiculous valuations, the value of the index has marched forward in record fashion, rewarding long term investors immensely. The chart below depicts North America’s S&P 500 Index from 1954 till now.

Back in June, when the S&P/ASX 200 was only slightly below where it is today, we discussed in depth whether we thought the market was in bubble territory. Our conclusion was that “while the market itself might not be in bubble territory, and I don’t believe that it is, however, there are pockets of the market that almost certainly are”.  

The most important lesson to deduce when analysing historical share market performance is that the biggest risk to long-term wealth creation is not participating in investing at all, staying on the side lines, and missing out on share price advancements which compound over time. We don’t try and predict share market crashes, and nor should you. Remaining invested in a portfolio of quality companies is the best defence against any impending crash.

Finding Value in Frothy Markets

The fact of the matter is that no one can tell what companies and share prices will do in the future. The biggest risk when it comes to investing is to not invest at all.

The average interest rate on Australian savings accounts between 2004 and 2021 was 3.27%. The Australian average annual inflation rate has been 2.3% over the same period. This means that if you were to put your hard-earned cash into a savings account, you would have only been making a real return of 0.97% per annum.

Compared to 7.64% real annual return of the ASX 200 Accumulation Index over the same period. Plainly this means that if were to invest $1,000 into a basket of high-quality Australian companies and simply hold onto them over a sustained period of 17 years, you would have turned the initial $1,000 into $5,008, or $3,496 real dollars (after taking inflation into consideration). In contrast, you would only amount to $1,728 or $1,178 real dollars (after inflation), if you were to leave your $1,000 sit in a savings account over the same period.

Summing Up

It’s very transparent that one of the most effective methods of creating lasting wealth is through holding a diversified portfolio of shares in high quality, established companies over long periods of time. Although in the short-term the share market can appear risky, high-quality companies will always be able to persist through enduring times.

As Warren Buffet’s mentor Benjamin Graham once wrote “in the short-run, the market is a voting machine – reflecting a voter-registration test that requires only money, not intelligence or emotional stability – but in the long-run, the market is a weighing machine.”

During these volatile times, is when the most value can be found. Think of a stock market crash as if your favourite clothing store is having a 40% discount sale where you can buy your favourite items at ridiculously low prices. This occurs when investors discount stock prices in excess that doesn’t reflect reality as they are overly pessimistic.

As the Oracle Advisory Group of Omaha Warren Buffet, once stated “it is wise for investors to be fearful when others are greedy, and greedy when others are fearful.”

Get in touch with us today for complimentary consultation to discuss your financial position and we can provide you advice tailored to your unique situation.

Important information - Oracle Advisory Group makes no representation or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. The information in this document is general information only and is not based on the objectives, financial situation or needs of any particular investor. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek their own professional advice. Past performance is not a reliable indicator of future performance. The information provided in the document is current as the time of publication.

Sources

https://www.rba.gov.au/publications/confs/2003/pdf/simon.pdf

https://www.bis.org/publ/work934.pdf