Like the ghost in Charles Dickens’s “A Christmas Carol,” recent price action in Japanese equity markets has been an unwelcome echo of the past. Outperformance of stocks with more stable earnings streams has resembled the market dynamics that provided a headwind to value investors in the decade after the financial crisis. However, investors should not allow past experience to dictate their behaviour. Instead, it is important to ensure that past experience does not overshadow consideration of the facts as they stand today.
The journey from 2016 to 2017
For keen observers of price, 2016 in Japan was an emotive journey with something for everyone; negative interest rates, the subsequent episodic decline in financials, large gyrations in the yen, and the election of Donald Trump – to name but a few.
Compared to those levels of price volatility, the experience of 2017 to date has been far less eventful. Apart from a brief period of weakness around the possible impeachment of the US president, the environment has been stable.
However, beneath the surface of relative calm there have been rapid and significant shifts in risk preference in favour of apparently ‘safe’ earnings streams (typically found within consumer staples and utilities, as well as within a select universe of growth names), away from economically sensitive earnings streams (typically found in consumer discretionary, financial, real estate and materials sectors).
The following chart is indicative of how safety has generally outperformed, while more cyclical areas have lagged until very recently.
At the individual stock level, since the financial crisis, any sign that a company’s reported earnings may deviate from analysts’ expectations, either on the up or downside, has resulted in significant price volatility – a shoot-first-ask-questions-later approach to risk.
In the current environment, investors’ time horizons contract and extend depending on the emotional pain or pleasure experienced from company news flows. Markets have rewarded certainty and reacted violently to any sign of short-term surprise. Ultimately, investors are showing that they are still uncomfortable with owning equity-type risk.
Divergence in relative valuations
The resultant irrational price behaviour presents us with significant opportunities as valuations across sectors become stretched.
The following chart provides an illustration of the extent of this today. The x-axis represents the extent to which a stock’s current relative valuation has departed from its historic (20-year) average. So stocks on the left hand side (i.e with a negative figure) are cheaper relative to the market than they have been over the last 20 years, while those on the right are more expensive.
The universe of ‘safe’ consumer staples are now all trading at over 1.25 standard deviations expensive relative to the broad market. Stocks in the financials sector on the other hand all lie 1 standard deviation or greater toward the cheap side.
Recent divergence in context: The importance of market beliefs
The recent price dynamics observed within the Topix are reminiscent of previous phases in which the beliefs in secular stagnation of growth drove price. It is worth thinking why the market remains attached to this belief.
Investing is always a trade-off between earning high positive long-term returns and avoiding a permanent loss of capital in the short-term. In the aftermath of the global financial crises, a desire to avoid short-term loss gained the upper hand. During the ensuing years this shift in risk preferences was expressed in a desire for portfolios exhibiting low volatility. These portfolios showed a preference for assets paying stable yields underpinned by stable cash flows such as government bonds and equity holdings with ‘safe’ earnings streams.
Contrary to financial theory, the shift towards loss-aversion has not been expensive, nor has it been emotionally challenging. Indeed, the emotional experience of the ensuing price trajectory of these assets, bonds and ‘safe’ equity, has been extremely pleasant. The chart below shows the returns over the last ten years from the ‘safest’ of ‘safe haven’ assets, Japanese government bonds. This is not a return profile typically associated with loss-aversion strategies!
A succession of shocks since the crisis has provided emotional reinforcement for the relative success of this strategy: the Eurozone crisis, Fukashima, low/zero/negative interest rates, and Brexit are a few worth mentioning. By examining the market’s emotional journey with these assets we can appreciate why the supremacy of low volatility portfolio strategies have become a widely held, and cherished, belief.
However, whilst the fundamental facts regarding these ‘stable earners’ have not materially changed, the starting point today has. That is, prices are elevated relative to fundamentals, as shown below:
From this starting point, a repeat stellar performance is a low probability outcome. Whilst offering investors relatively low expected future returns, their prices are vulnerable to any reminder that equity-type risk is still embedded within their earnings streams. Learning this lesson is likely to offer investors a less-than-pleasant experience.
In contrast, the prospective return from owning economically sensitive names has two important anchors: they are cheap relative to trend earnings and have seen substantial improvement in profits and shareholder returns. This during a time when economic activity remains comparatively muted.
Unlike with Dickens’s tale, recent visitations from unwelcome acquaintances will not induce this manager to change his ways. Rather, they are a reminder that our most cherished beliefs can take an uncomfortably long time to adjust to the change of facts at hand.