As we near the anniversary of the fastest market crash in history, things are starting to look pretty dicey again. After a fairly spectacular first two months, my portfolio has been hit by another rather savage rotation from growth to value. This has been prompted by a sell off in long term treasury bonds, which in turn seem to have been driven by rising expectations of rapid economic growth following the reopening of the economies. So is this another short term rotation from value to growth, imminently due to reverse when the Fed steps in again, or the beginning of the long-awaited bursting of the ‘bubble’? I’ve been considering whether it’s time for me to take some evasive action.
After the very strong run last year, a possible upcoming market crash for high quality growth businesses has been on my radar for a few months now. Up to now I’ve been fairly optimistic that the bursting of this bubble was still some way off. Valuations, while high, have not been as spectacularly expensive as a naïve comparison to historical averages would suggest, given the stronger business models and competitive advantages of the businesses they relate to, as well as the low inflation environment. Rising inflation and interest rates have been my main concern and seem inevitable at some point. The question has always been ‘when’.
The situation has marginally worsened on most dimensions since my last quarterly update. We had a rapid run-up in prices in January and most of February – not a huge one but sufficient for me to start trimming some of my holdings with more demanding valuations and reallocating to cheaper ones. Over the last couple of weeks, many growth stocks have taken a bit of a pounding. The net result is that their valuations are more or less back to where they were at the beginning of the year. For most of the businesses I invest in these valuations seem high but not crazy, though there are many more blue-sky growth businesses out there that do look overvalued – Tesla and the like. Compared to the start of the year the ‘technical’ situation has deteriorated (volatility has ramped up and prices are now going in the wrong direction).
I also find it troubling that investor sentiment has become increasingly euphoric with warning signs of increasing retail participation. Growth stocks have become extremely popular over the past year and less regard is being placed on valuations. This is typified by the success of funds like Cathie Wood’s ARK, who have benefited from a self-reinforcing feedback loop of huge inflows coming into their funds and improving share price performance of the stocks it is invested in. I’ve come across quite a bit of speculation that this situation could get ugly once this process goes into reverse, particularly as many of ARKs positions in more speculative investments are very illiquid and could difficult to sell if ARK faces redemptions. This is a situation that will be exploited by other market participants once they smell blood. I’m not how much of a broader risk to the market this poses but I think it is indicative of the instability of the current situation. I think that investor sentiment now seems too complacent about these risks. I’m becoming increasingly concerned that the view that the bubble still probably has some way to go, inflation is still a long way off and all dips should be bought has become consensus.
The prospects for inflation and interest rate rises are also troubling. The US economy seems to be recovering quicker than expected and the ending of lockdown restrictions is now more clearly in sight. Even though the Fed has continued to signal an accommodative stance, the rapid sell-off in long term treasury bonds suggests that inflation expectations are rising. This sort of situation may seem typical of economic recovery anticipated at the beginning of the business cycle. A little inflation from a low base wouldn’t typically be a major concern. But it doesn’t feel like the economic situation at the moment is really very typical. Given the speed of the bond market sell-off and the scale of the expansionary policies we’ve had over the past year, I think there is a danger that inflationary pressures arrive sooner and more strongly than expected as the economy reopens, making the Fed’s current accommodative stance unsustainable. Inflation ultimately becomes harder to control and requires more severe intervention if expectations are not nipped in the bud. I don’t have a very good sense of exactly how this might play out. I still believe it will probably take a fairly long time but there is a significant risk that it is quicker than expected. The concern is that the market may anticipate the paradigm shift some way in advance, sending the dynamic that has driven some of the recent outperformance of growth stocks into reverse.
My perspective has gradually become more bearish. I’m less optimistic about the the possibility of a bubble in growth stocks to develop much further and feel a crash in the next few months seems like a distinct possibility. To be honest my overall view has not changed that much – I still feel very uncertain, but I have decided I would be better off raising some cash to take advantage of opportunities should they arise. I have contemplated changing tack to diversify into value stocks likely to benefit further from economic recovery, but I haven’t yet found any of sufficient appeal to warrant shifting my strategy in this way. Most have already done very well over the past few months and don’t now seem obviously cheap even accounting for an improving near term situation. Instead I have raised about 25% of the portfolio in cash. My sells were focused on more highly-rated holdings and those where the shares are more illiquid and have the potential to get hit harder if the market crashes:
- Tristel for 84% profit
- Atoss Software for 269% profit
- DotDigital for 58% profit
- Keywords Studios for 79% profit
- Fabasoft for 2% profit
- Etsy for 52% profit
- Pinterest for 100% profit
- Adyen for 13% loss
- Pharmagest for 57% profit (this was actually my monthly trade for March made earlier this week. I replaced it with old favourite Mastercard)
The plan from here is to sit on my hands and see how it plays out. If the market crashes then I will reinvest. Otherwise I’ll wait for a month and revisit the situation in April.
I place considerable trust in the old saw “Bull markets climb a wall of worry”. Like you, i wouldn’t be surprised if markets turn down, but I expect this to be a correction (10%) rather than a crash (20%). There will be considerable variation, Tesla and ARK Innovation may well fall by over 20% given how frothy they have become, but generally I expect movements to be less extreme although still stomach churning. While I seem to be able to trim my investment exposure ahead of the major turning points (I cannot find anything of value at these times and my target prices have been hit), I have given up trying to exploit the gyrations of the market as I cannot get the re-entry timing correct. If you have a portfolio of companies that you expect to perform over the long term, sit tight although the ride may not be enjoyable!
Many congratulations on your portfolio performance. It appears that we share very similar views and my watchlist has many of the same names! To date, I have demanded a much lower margin of safety and although I have rated many of these companies highly, I find them too overvalued to buy. One burning question I have is how/whether you go about chasing the overpaid/withheld dividend tax – perhaps a subject for a new post?? I have this issue with European companies in particular, but I do think it is best to diversify outside the UK (although the GBP has appreciated significantly of late!)
Thanks for the comment Adrian
Yes the ratings on many of these growth companies (particularly tech-related) have got to a level where I am becoming less optimistic about returns over the medium term, particularly given the current macroeconomic uncertainty.
Good question. I haven’t bothered with trying to chase the withholding tax for European shares. It didn’t initially seem worth the trouble and to be honest I’d forgotten it existed. Diligence in form-filling is certainly not my strong suit. Though now you mention it I might now be owed enough to justify look into it further. Have you attempted?
No – I haven’t attempted yet. Seems a like a major hassle, but compounding the unclaimed dividends could come to a big number over many years… Perhaps I could just view it as donating to the relevant country’s government and people!