The market is overvalued – except where it isn’t.

Over the course of a career in asset management, it is not unusual to find oneself presenting to a room of fellow investment professionals. Addressing that audience comes with the challenge of saying something new, original and interesting to a group of people who all have the same Bloomberg and newspaper subscriptions.

The task is then to unpack the headlines and dispel some of the myths and cliches that have the potential to lead an industry into damaging groupthink. Consider some of the phrases that have come and gone over the years. Commodities Super Cycle, European Sovereign Debt Crisis, Credit Crunch. Handy heuristics for the environment in which we operate but less helpful for more precise decision making.

 With this in mind, I would often ask my audience to imagine that they could re-live some of the big moments in recent financial history with perfect foresight. The run-up in Japan of the late 80s, the dotcom boom and bust. Who would be first back into equities in March 2009 following the Global Financial Crisis? To let a little daylight on magic, the reason for opening with this fanciful thought experiment was an attempt to put the audience in a frame of mind where they could see themselves making great decisions in times of heightened uncertainty.

A recent column from Bloomberg’s John Authers in his Points of Return column posed a similar question, although his version of the game gives us perfect foresight from January 2020 of economic conditions but not that of the market. Given the conditions of a global pandemic, in which at least a third of the global economy is shut down and governments are paying people to sit at home, what would you guess as the annual return for the market? Let’s be honest. Who would have said up c.10%? For those of you that still have your hand up, be honest again with what you might have said given the opportunity to revise your guess in mid-March 2020. Any takers for up 10%? Long-time followers will be aware that Mayar’s hand would not be up because we do not look to the end of the year. We look 5 years hence. More on that anon.

If nobody’s hand goes up and the market finishes in positive territory, slightly above long-term average returns, shouldn’t the implicit conclusion be that the market is overvalued?  Here, we (finally!) reach the first attempt at getting behind the headlines and cliches.

What do people mean when they say ‘the market’? Do they mean global headline indices? Large Caps? The S&P 500. In truth, it is probably a little of all three. And that is a problem for those trying to make decisions about allocating to global equities and by extension active managers.

Allocations to active global managers by their definition are not allocations to the market but a small section of it. The more different the manager’s portfolio is to the reference benchmark, the more different the outcomes have the potential to be. This means looking past a handful of headline generating names, ignoring benchmark weights of sectors and countries and instead focussing on areas and industries where great companies and great businesses are available a great valuations.

This is one of the key drivers of the evolution of Mayar’s country exposure over the past 18 months. Our bottom-up analysis is finding with increasing frequency that companies in the US with valuation ranges that are unattractive. We either look elsewhere for new idea and those already in the portfolio are sold and replaced with other businesses that have attractive valuations and meet all of our other selection criteria.

Ray Dalio has similar view of the market. Dalio has published his own proprietary checklist of whether U.S. stocks were in a bubble. His bottom line:

“In brief, the aggregate bubble gauge is around the 77th percentile today for the US stock market overall. In the bubble of 2000 and the bubble of 1929 this aggregate gauge had a 100th percentile read.”

Authers again (Emphasis mine):

“So by Dalio’s reckoning, we have a somewhat expensive market, and not a historically great time to buy, but nothing that requires immediate action. That is for the market as a whole. He does look at individual companies, and comes up with a measure for how many are in a bubble: roughly half as many as at the top in 2000. There is something to worry about here, but nothing like as terrifying as 21 years ago.”

There is plenty to debate about the definitions used but broadly, Mayar agrees. Under our own selection criteria more US stocks seem overvalued on a 5 year view compared to 18 months ago. That on its own shouldn’t be a deterrent from allocation to global equities.

So where are these opportunities? Are great global equity returns the sole preserve of flights of imagination at the outset of conference presentations? Have those who were reluctant to allocate in March 2020 missed their chance?

Mayar believe that lots of opportunities remain globally. We have to ask ourselves not what the impact of the pandemic will be today but what will the impact of the pandemic be in 2026 and beyond. Through that long-term prism there are many pockets of opportunity.

For example, the UK. Yes, the impact of the pandemic and Brexit is being felt today. Again, what do we anticipate these impacts being as we approach the 2030s? The below chart from Research Affiliates illustrates the point. On a risk adjusted basis, UK and, to a slightly lesser extent, European equities are the most attractive looking asset classes over long-term horizon. Again, there will be opportunities within these markets that have even greater attractive possibilities. It is the task of an active fund manager, thinking probabilistically to find ideas where they are most likely to be.

Source: Research Affiliates, March 2021

In addition to this, more globally, we have the potential return to favour of value stocks. The discount of value stocks relative to growth are approaching all-time highs.

It’s very rare for us to look at benchmark weights but to illustrate the point, we show Morningstar data which shows Mayar’s geographic positioning relative to the index as well as the peer group.

For global equity managers that like to buy great businesses at great valuations, this is excellent news. Our job then becomes one of differentiation between those companies trading at discounts for perfectly valid reasons and those that have been overlooked.

 To do that, what is required is what has always been required. A long-term outlook, a disciplined investment process that looks at businesses and industries that results in a portfolio that is meaningfully different from the market.

 That’s good news for those wondering if now is the right time to increase allocations. And a crystal ball is not required.