Written by Mike Taylor, Founder, CEO and CIO
Portfolio Manager of the Multi-Strategy Fund

Overview

The bull market in everything

Earlier this month, the economist cover page was entitled, The Bull Market in Everything. Later in the piece the economist went on to describe this bull market as being “the bubble without any fizz”. The first point is that they are right (but not everyone has profited from this), and the second point is that often this type of media serves as a good contrarian indicator! 

Low interest rates and nearly a decade of Quantitative Easing (QE) have forced even the most risk averse investors up the risk curve in the hunt for yield or return, causing virtually every asset class to rise. But things are starting to change. For a start, QE is being tapered off (Figure 1) and valuations have risen across the board.

Currently the world is in its first coordinated upswing since the GFC.

Regarding equities, in particular in the US stock market, much has been made of the CAPE Shiller index, which has only been higher on two occasions, 1929 and 2000, and we all know how that ended (Figure 2). Without wanting to sound too clichéd, how is this time different? There are some things worth noting. To start, the rise hasn’t been as rapid as 1929 and the length of expansion hasn’t been as long as the 2000 top. Don’t get me wrong, I certainly see worrying signs starting to appear – it’s hard to find value, the market is complacent, volatility is low, but the market is going up because earnings are going up. As you can see from Figure 3 and 4, the price change in 2017 is not about an increase in the Price per Earnings ratio (PE ratio), it’s about an increase in the earnings.

At this juncture, I’m reminded of Sir John Templeton’s famous quote: 

“Bull markets are born on pessimism, grow on scepticism, mature on optimism and die on euphoria”. 

I believe we are currently in the late stage of optimism and will soon enter the exciting and irrational euphoria phase, where everyone forgets about recessions and believes we have entered a new paradigm.

Of course, bull markets can come to an abrupt end at any time due to a black swan event like North Korea or the 1970’s oil crisis. However, currently the world is in its first coordinated upswing since the GFC. All major economies are growing, and this is being reflected in company earnings. 

However, and this is the big caveat, like Auckland property, the drivers of the bull market are changing. The sands are shifting. QE is coming to an end, interest rates are starting to rise, inflation is coming off the lows and the labour market is tightening. Unfortunately, Central Banks cannot stop the economic cycle. Inevitably this cycle – like all that have gone before - will end. 

There are a number of other indicators I’m watching, which are all very positive. I’m worried because of experience and the duration of the bull market (implication being that we are closer to the end than the beginning), but I’m not concerned by any of the data yet – apart from the fact that valuations are higher today than five years ago.

To sum up, the drum is beating, the music is on, the crowd is getting up to dance, but nobody is yet on the tables and the police are a way off. Still I’m cautious, the odds are changing but I see nothing yet to move the Multi-Strategy Fund into net short nor shift Pie’s other funds to full cash. My base case is that I believe the equity bull market still has another year to go – and a recession won’t occur until 2019 at the earliest. As you would expect, I’m reviewing this constantly and if the facts change, I change my mind. 

I believe the equity bull market still has another year to go – and a recession won’t occur until 2019 at the earliest. 

Investment Ideas

Equities

Long

Don’t fight the tape. The number of companies providing positive guidance in the US has climbed to a six-year high. Those providing positive guidance exceeded those providing negative guidance for a second quarter in a row, with the gap also at a six-year high. We are in a bull market, so therefore I’d suggest thinking longs, not shorts for the main part.

As you would expect with around 70 direct holdings across our existing portfolios we have a few strong ideas. Currently amongst our portfolio EML Payments is my most preferred position for the following reasons:

1. High checklist score
   EML Payments ticks a lot of boxes: strong management and chart, recent earnings upgrades, Founder and CEO alignment, Pie forecast forward EPS growth > 50%;
   
   
2. Market cap and liquidity
   The company has just broken through AU$500 million. Our research shows that, in the past, when ASX companies break AU$500 million for the first time, they go through a 44% jump in valuation on average. This typically means the PE multiple rises by 44%. Why? Because as liquidity rises, more brokers seem to initiate research and the number of fund managers looking at this market cap range increases; and 
   
   
3. Conviction 
   I have followed EML for 4-5 years and know the business well, so my conviction level is high.

Globally, I really like Amazon. I think many people don’t realise that Amazon is the 21st century equivalent of an infrastructure asset; shopping, web services, grocery etc. Amazon recently released its quarter three results which beat expectations. As a result, the stock rallied 13% in a day, which when you consider its market cap is huge – adding US$60 billion+ in valuation just like that. 

There are at least another ten companies both inside our portfolios and outside that I’m looking at for potential inclusion.

We are also using quantitative analysis to screen 6,000 stocks globally for those with the best and worst valuations (relative to their traded history), and the best and worst momentum. We have engaged the assistance of a French firm to provide financial modelling for this screening.

Short

There will come a time when the equity portion of the portfolio is made up predominantly of shorts, but right now I feel that’s dangerous. The bull is rampaging, the global economy is booming again and you can get burned being short, even if ultimately you are right. The market can remain irrational longer than you can remain solvent. Therefore, outside specific opportunities that present, a large short book is too dangerous to manage until the market rolls over. Business disruption is a good hunting ground and the likes of SKY TV, Trade Me and Z Energy are on that list.

Interestingly, having originally looked at Netflix for a long, I came away thinking that it’s possibly a short, but I may be at bit early still, as subscriber growth is still strong. It’s worth noting that Disney is pulling its content to start its own version, Amazon is producing content itself and Netflix expects to spend US$8 billion next year on content! Wow!

Interest rates

I think they are on the rise. That’s probably all I need to say, but worth exploring why because I did think rates were bottoming a few years back, but they went lower. As discussed above, the reason I believe rates have bottomed and are heading higher are central banks rolling back QE, wage inflation and strong global growth.

The interesting thing is that this is still not a consensus trade. The market has been slow to price rate hikes. 

The reason I believe rates have bottomed and are heading higher are central banks rolling back QE, wage inflation and strong global growth.

The investments I have in mind are shorting German Bunds futures, which currently still have a negative yield (you profit as interest rates rise) and shorting high yield (junk debt). 

The spread on high-yield, which is the difference between US treasuries and high yield rates, is at an all-time low (Figure 6). During times of stress in credit markets or in recessions, spreads widen and investors demand a higher return for junk debt. 

In addition, when the equity markets look like rolling over, I’d say a move into US treasuries would also be appropriate (Figure 7). I would potentially look to initiate this trade if the yield curve inverts. Yield inversion is when short-term interest rates are higher than long-term rates.

Property 

The horse has well and truly bolted with NZ property but probably has further momentum in other countries around the world, in particular the US or Germany. But there are no screaming buys here and I’m not inclined to buy a property REIT. Potentially there are some short opportunities here with the decline in mall traffic (due to online) and rising interest rates.

Commodities 

Lithium is the latest thing that has taken off. Some say that Lithium could be the next Iron Ore. There are a few listed Lithium players locally. All have run very strongly in the past three months so it’s a wait and see approach at present. 

Oil is the other surprising one. Perhaps everyone has got ahead of themselves with the EV revolution. The market supply is now quite tight. Oil was a favourite hedge fund short six months ago, but I see some potential for this to get squeezed in the new year. In addition, Oil stocks haven’t recovered in line with the oil price (still too many bears), so I will continue to explore this idea. 

Volatility 

This should probably read ‘lack of volatility’. The markets are complacent, and volatility has died away. A common trade of hedge funds in recent years has been to short volatility. This is dangerous in my view because it’s one of those trades that works until it doesn’t, and the day it doesn’t you just blew your P&L. On the other hand if like me, you believe volatility will increase dramatically at some point there are various ways to trade this theme.

Hedging 

Whilst the number of shorts available is limited (given world growth), it’s prudent to be carrying regular portfolio hedging to provide insurance against a market correction or black swan event. As such, during a bull market the fund will be looking to buy put options on various markets, namely the S&P 500. Note, in my opinion, there is no point buying insurance in a bear market. It’s like buying hurricane insurance during a hurricane. It’s expensive and you might not get the cover you need.

Expect this fund to spend at least 1.5% of net assets on “insurance premiums” during most years.

Infrastructure 

Infrastructure spend is likely to remain a key theme for western governments over the coming five years. Post GFC, there has been under investment, and this is now ramping up again as stronger GDP is giving the flexibility for budgets to enact this. In addition, it’s also key policy for the populist movement we are experiencing. Build that
wall, right?

Currency 

The Kiwi has fallen quite a bit since the election result. As recently as two months ago I was quite bearish on the Kiwi dollar, but markets react swiftly, and I’d want more compelling reasons for a further fall. Despite this, I think the trend is now probably down, as NZ is likely past its peak and the rest of the world is improving. 

Betting or predicting currency moves is a bit of a mug’s game. There are only three factors I consider: 

1. Mean reversion – how far away from the long-term average is the NZD? Are the odds stacked?
2. NZD is always vulnerable during a global recession or shock; and
3. The consensus view is usually wrong.

Cryptocurrencies 

I think it’s a bubble– the herd is all over it. This reminds me of the world of tech stocks in 1999. You could float the Titanic if it had ‘.com’ in the name. Like the tech wreck, there is some method to the madness. Blockchain is a useful technology. Ultimately, some of the currencies will survive and may be in widespread use in 10 years. However, they need to go through their Armageddon moment first. There is so much out-and-out fraud occurring presently, it’s all going to come crashing down one day. I’d say most likely regulation will be the catalyst. Do you really think governments are going to allow this to continue un-regulated?

Clean energy 

As you may know I’m a big fan of clean energy, we already have exposure through the Global Fund to one of the best operators in the US. Next Era Energy Partners (NEP) owns and operates a number of wind and solar project across America. NEP has rallied a lot recently, so I’m cautious to buy it here, however we believe the long-term prospects are sound. I have looked at clean energy ETF’s but would prefer direct exposure where possible. 

Unlisted, private equity and alternatives

Over the life of the fund, ideas will be presented and assessed by myself and the team based on their merits.

Emerging markets 

I have an Indian small cap ETF on my radar. I like what Modi is doing and so do financial markets. If one is looking for a high-octane exposure to emerging markets then you need go no further than Indian small caps!

In addition, at Pie we are strong believers in mean reversion. That means if we see a market has had low returns for a period of years we believe the probability of strong returns increases. Brazilian equities collapsed during their recent recession however, in the last year or so, the BOVESPA has been one of the best performing markets globally. 

We will be using our French software to scan for the cheapest markets, industries and regions to find opportunities.

Issued by Pie Funds Management Limited. To download our Product Disclosure Statements and Statement of Investment Policy and Objectives visit www.piefunds.co.nz or www.companiesoffice.govt.nz/disclose. Past performance is not a guarantee of future returns. 

Past performance is not an indicator for future performance. This is not intended to be financial advice and does not take into account any particular person’s circumstances. Before relying on this information, please speak to an independent financial adviser.