Bubble Territory or not? Everything has changed – should my investments change too?

It is hard to imagine that only a year ago, markets hit rock bottom and investors were worried about how the rest of 2020 would pan out. Across the globe, investors were faced with questions such as – will valuations decline even further? How and when will markets recover? Is it perhaps time to deploy cash into the market? Should we disinvest and wait for better days? Should we sit on our hands and do nothing?

Today we are facing a different dilemma. Markets are at an all-time high. In a short space of time, everything has changed. The rollout of Covid-19 vaccines and associated hopes for imminent economic recovery, along with unprecedented fiscal and monetary support from governments and central banks around the world, has driven equity markets beyond or close to record highs of late. With stock market valuations at historically high levels speculation about a market bubble has been rekindled.

 

The Price-to-Earnings (P/E) ratio as a measure of valuation

Investors often look at a valuation in its most traditional form, also known as the P/E multiple. A P/E multiple (price to earnings ratio) gives investors an indication of what the market is willing to pay for every R1 of earnings generated. Setting aside the impact of short-term changes to profit, a high P/E ratio typically indicates the expectation and/or perception that a company could/would have good growth prospects, or less risk to profits, than the average company. Thus, a company with a proven long-term track record of growing profits would normally trade at a high P/E ratio and a company with low growth, or a patchy profit history, would trade at a lower P/E ratio.

While P/E is an incredibly good starting point to assess the valuation of a company or a market, many investors fail to look deeper.

 

Delving deeper into markets

The P/E ratio of the S&P 500 is trading at near-record highs. One could argue that it is, perhaps, a very blunt way to look at the world. It is important to unpack what drove the performance of the S&P 500 to these levels.

When analyzing the data depicted in the below two graphs, it is clear that most of the performance of the S&P 500 came from large FAANG stocks. [FAANG is an acronym referring to the stocks of the five most popular and best-performing American technology companies: Facebook, Amazon, Apple, Netflix and Alphabet (formerly known as Google)].

Exhibit 1 depicts the cyclically adjusted P/E ratio for the US market.

There is no doubt that most of the large tech giants are good companies, with robust business models and incredible management teams. However, one must keep in mind the two tailwinds that existed – the first being record low interest rates for a prolonged period of time and the second being that most of these FAANG stocks were direct beneficiaries of lockdowns worldwide. Therefore, caution should be applied when assessing if they will continue to generate such exceptional performance indefinitely.

Looking at the opposite side of the coin – what about the other sectors that have not enjoyed such lucrative returns over the last number of years? Could the grass be greener on the other side but investors are not seeing it?

 

Is local still lekker?

On the local front, investors have enjoyed good returns from the JSE All Share index over the last few months. The question remains – will this continue or are we due for a correction? The truth is that nobody knows how long a rally can and/or will continue.

What we do know is that emerging markets have been severely out of favour for the last decade or so. Within the emerging markets group, South Africa has been out of favour for such an extended period that both local and foreign investors seem to have lost hope.

The recent rally could be the market playing catch up coupled with a positive global backdrop for South African equities. The domestic economy may well continue to face structural headwinds going forward but could also recover from depressed levels gradually as activity normalises and accommodative interest rates stimulate incremental demand.

While we contemplate whether this partial recovery will be enough to generate satisfactory returns from domestic shares (from current price levels), there is the possibility for a more pronounced and sustained recovery in activity and sentiment as the global economy reflates and South Africa receives a natural slice of emerging market flows.

At Morningstar, we believe some areas in the domestic market still offer a very good opportunity and has lagged in the recent recovery. Financials are a good example of such an area.

 

What is the alternative?

A few years ago, South African investors could generate a real return (a return over and above inflation) of about 3%, by simply remaining in cash. It was an easy choice for those that did not want to expose themselves to equity market risk. Today, this picture is quite different. Cash rates are at historic lows with returns from money market funds sitting at about 4% and there is not much yield either if you look at developed markets.

Long dated South African Government bonds on the other hand still offer very attractive yields and continue to make up an overweight percentage within the Morningstar Portfolios. As far as equity risk is concerned, we continue to assess all individual opportunities through a valuation lens as well as the fundamental risk associated with each asset class. We continue to find value in areas of the market like UK Equities, European Equities, S.A. Financials, Energy etc.

 

Getting back to the question, are markets in a bubble at the moment?

At Morningstar, we believe a blunt expression like this one is probably foolish. The truth is there is always a bubble somewhere, whether it is Tesla, Bitcoin or the FAANGs. The best you can do is to continue to assess opportunities as they arise and patiently allocate money to the areas that will best serve your investment goals.

Although the obvious opportunity set has declined in equity markets over the last couple of months, there is still ample opportunity for investors who are willing to look a little deeper.

Debra Slabber, CFA®

Portfolio Specialist

Morningstar Investment Management South Africa

Risk Warnings

This commentary does not constitute investment, legal, tax or other advice and is supplied for information purposes only. Past performance is not a guide to future returns. The value of investments may go down as well as up and an investor may not get back the amount invested. Reference to any specific security is not a recommendation to buy or sell that security. The information, data, analyses, and opinions presented herein are provided as of the date written and are subject to change without notice. Every effort has been made to ensure the accuracy of the information provided, but Morningstar Investment Management South Africa (Pty) Ltd makes no warranty, express or implied regarding such information. The information presented herein will be deemed to be superseded by any subsequent versions of this commentary. Except as otherwise required by law, Morningstar Investment Management South Africa (Pty) Ltd shall not be responsible for any trading decisions, damages or losses resulting from, or related to, the information, data, analyses or opinions or their use.

This document may contain certain forward-looking statements. We use words such as “expects”, “anticipates”, “believes”, “estimates”, “forecasts”, and similar expressions to identify forward-looking statements. Such forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause the actual results to differ materially and/or substantially from any future results, performance or achievements expressed or implied by those projected in the forward-looking statements for any reason.

 

Morningstar Investment Management South Africa Disclosure

The Morningstar Investment Management group comprises Morningstar Inc.’s registered entities worldwide, including South Africa. Morningstar Investment Management South Africa (Pty) Ltd is an authorised financial services provider (FSP 45679) regulated by the Financial Sector Conduct Authority and is the entity providing the advisory/discretionary management services.

Does Your Portfolio Need Bitcoin? Maybe, but keep it to minimum.

*This piece was originally distributed via Morningstar Inc in the United States. We believe it has interesting perspectives for S.A. advisers.

Bitcoin investors have been on a wild ride lately. After dropping about 74% in 2018, the digital currency nearly doubled in price in 2019, and then nearly quadrupled during 2020. Trading volumes have also skyrocketed as individual investors have embraced cryptocurrencies through commission-free trading platforms such as Robinhood.

Originally conceived as a digital, encrypted alternative to traditional currencies controlled by central banks, bitcoin has also been attracting more interest from mainstream investors. For example, BlackRock recently added prospectus language giving three of its mutual funds the flexibility to invest in bitcoin futures. In late 2020, insurance provider MassMutual purchased $100 million in bitcoin in late 2020 for its investment portfolio. And in recent months, several high-profile institutional investors – including Miller Value Partners’ Bill Miller, BlackRock’s Rick Rieder, and Tudor Investment’s Paul Tudor Jones – have touted bitcoin as long-term investment with significant upside potential, even after its previous surge.

There are some arguments in favour of bitcoin as an investment, but there are also reasons to be sceptical. Overall, it has enough negatives that I would hesitate to carve out more than a small fraction of a portfolio for bitcoin.

 

The Case for Bitcoin

Bitcoin has been hailed as a transformative technology that promises to revolutionize the entire landscape of money and payments. In fact, the enthusiasm surrounding bitcoin is so intense that it borders on religious fervour. Bitcoin itself has even been compared with a religion, with its own set of doctrines, sacred texts, acolytes, and rituals.

Bitcoin proponents often argue that because only 21 million bitcoins can ever be mined, a permanently limited supply should support its value. It’s often viewed as an alternative to gold, which also has a limited supply but has a more definable intrinsic worth because it’s used for jewellery, industrial applications, and as a tangible store of value. Cryptocurrencies like bitcoin could potentially benefit from increased demand for secure international transactions, low-cost banking, and anonymous micropayments or general-purpose payments. The network effect also comes into play with bitcoin, as growth in usage should (theoretically) increase its value at an exponential rate.

Bitcoin’s limited supply also makes it a potential hedge against long-term inflationary pressures. With the Federal Reserve printing money at an unprecedented rate, the market is currently pricing in a five-year breakeven inflation rate of 2.18%, which would be higher than the unusually benign inflation we’ve seen in recent years. Bitcoin has often (though not always) historically had a negative correlation with the U.S. dollar, which started losing ground in March 2020 after a generally strong upward trend over the previous decade. Bitcoin’s future value partly depends on widespread acceptance and usage as an alternative currency. Unlike traditional currencies, it’s not controlled by central governments. In that sense, it’s the ultimate insurance policy against weakness in the U.S. dollar or a collapse in mainstream financial systems.

 

The Case Against Bitcoin

But there are reasons to be sceptical. As a virtual asset that doesn’t generate cash flows, bitcoin has no intrinsic value. Its value depends largely on what people are willing to pay. When Guggenheim’s Scott Minerd was quoted in December 2020 claiming bitcoin could be worth as much as $400,000, bitcoin prices quickly escalated. But without a strong foundation to support an underlying value, asset prices can rapidly drop.

That’s exactly what happened in 2018, when the CMBI Bitcoin TR index dropped 74%. More recently, bitcoin’s price shed nearly 30% from its peak on Jan. 8 until briefly dropping below $30,000 on Jan. 27, 2021. Even intra-day pricing tends toward the extreme, with prices often swinging by double-digit percentages within the same trading day. These sharp price moves mean bitcoin owners must be prepared to “HODL” – hold on for dear life.

Bitcoin is often described as digital gold, but it hasn’t held up particularly well during periods of market crisis. In the fourth quarter of 2018, for example, bitcoin lost about 44% of its value, compared with about 14% for the broader market. When the novel coronavirus roiled the market from Feb. 19 through March 23, 2020, bitcoin lost about 38%, compared with 34.5% for Morningstar’s U.S. Market index. During weeks when the overall equity market posted negative total returns (over the period from August 2010 through the end of 2020), bitcoin notched positive results only about half of the time.

As mentioned above, bitcoin proponents often argue that limited supply should create a floor for bitcoin’s value. But while the supply of bitcoin itself is limited, there’s nothing preventing competing cryptocurrencies from emerging. There are already numerous bitcoin alternatives available, including Ethereum, Litecoin, Cardano, Bitcoin Cash, and Lumens, to name a few.

Fees and transaction costs are another negative. Coinbase, one of the most popular platforms for buying bitcoin, charges a spread of 0.5% plus a fixed or variable fee (whichever is greater) based on the investor’s location and method of payment. For U.S.-based investors, Coinbase charges fees of at least 1.49% (for purchases made through a bank account or Coinbase wallet) or 3.99% (for purchases made through a debit card). Fees for small-dollar purchases can be considerably higher. However, Coinbase doesn’t charge additional fees for the hosting and storage required to keep bitcoin assets protected from digital theft or other losses.

Accredited investors can also buy bitcoin through Grayscale Bitcoin Trust, an exchange-traded fund structured as a grantor trust. The fund, which has been operating since 2014, charges a 2% annual fee, which also covers storage costs. It has limitations on redemptions, making it impractical for investors who may need to make withdrawals. The fund also typically sells at a premium to bitcoin prices and doesn’t track the currency perfectly. Over the past five years, for example, the trust has posted an annualized market return of 115.3%, compared with 135.3% for the underlying index.

A competing firm recently started operating Osprey Bitcoin Trust, which is currently available as a private placement for accredited investors with a lower management fee of about 0.5%. However, investors are subject to a 12-month lockup period, compared with six months for the Grayscale offering.

 

Role in Portfolio

Bitcoin can play a role in diversifying a portfolio, but the impact of adding various weightings varies depending on the time period. To quantify this, I looked at the impact of adding different percentages of bitcoin to an all-equity portfolio.

Over the trailing three-year period ended in 2020, bitcoin’s meteoric rise could lead to a simple conclusion: The more, the better. Bitcoin showed more than four times as much volatility (as measured by standard deviation) as equity market indexes over the period. But because of its low correlation with the equity market, adding bitcoin didn’t increase volatility all that much. Even a 10% bitcoin weighting would have increased the portfolio’s standard deviation by a fairly moderate amount, as shown in the table below. From a portfolio perspective, higher returns more than offset the added volatility; Sharpe ratios increased in tandem with higher weightings in bitcoin.

The picture looks less favourable over the trailing 10-year period, though. Bitcoin’s standard deviation was more than 15 times that of the equity market, making it among the most-volatile assets in Morningstar’s database of 35,000-plus market indexes. As a result, both risk and returns increased with larger bitcoin weightings. Even a 1% weighting would have led to a sharp increase in standard deviation compared with an all-equity portfolio, as well as significantly worse drawdowns. Monthly rebalancing would have led to better risk-adjusted returns, but that approach might be impractical for many investors in light of bitcoin’s transaction costs.

Given the divergence in results over different time periods, deciding on an appropriate bitcoin weighting partly depends on whether you think the future will look more like the recent past, or more like the trailing 10-year period. Much of bitcoin’s eye-popping 10-year record owes to an off-the-charts runup from 2011 through 2013, when the CMBI Bitcoin TR index posted annualized returns of more than 1,000% per year, including a gain of more than 5,300% in 2013 alone. These gains may not be repeatable, partly because trading volumes in bitcoin have increased nearly 3,000-fold since 2014. On the positive side, volatility has significantly decreased, although bitcoin’s standard deviation remains more than four times higher than that of the broader equity market.

It’s also worth noting that as bitcoin moves to the mainstream, it’s becoming less valuable as a portfolio diversifier. As shown in the chart below, bitcoin has had fairly low correlations with most major asset classes over the past three years. Correlations have been trending up, though. In 2020, for example, bitcoin had a correlation coefficient of 0.68 versus the S&P 500, compared with 0.32 for the trailing three-year period. However, its negative correlation with the U.S. dollar has grown even more pronounced, making it a potentially valuable hedge against continued softness in the greenback.

Conclusion

Overall, I’m sceptical about the case for bitcoin as an investment asset. Its popularity with momentum investors and speculative buyers makes it prone to pricing bubbles that will eventually burst. It’s also nearly impossible to pin down what its underlying value should be. As mainstream investors increasingly embrace bitcoin, its value as a diversification tool is diminishing; as a result, there’s no guarantee that adding bitcoin will improve a portfolio’s risk-adjusted returns, especially to the same extent it did in the past. However, there are some compelling arguments in favor of bitcoin as an alternative currency and as a commodity that can help support new technologies, such as smart contracts and more-efficient financial transactions with built-in encryption. For that reason, bitcoin is probably best used in (very) small doses as a hedge against weakness in the dollar and major disruptions in the global financial system.

Note: This article has been updated to remove a reference to Guggenheim Macro Opportunities (GIOIX) seeking SEC approval to invest up to 10% of its assets in Grayscale Bitcoin Trust (GBTC). After the article went to press, we were informed that this is no longer the case. We also revised the article to clarify that Osprey Bitcoin Trust is currently available as a private placement.

Since its original publication, this piece may have been edited to reflect the regulatory requirements of regions outside of the country it was originally published in.

Amy C.Arnott, CFP

Portfolio Strategist

Morningstar Inc.

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Tackling the frequently asked question – How are financial markets faring well when economies are shrinking?

The seeming disconnect between the performance of financial markets versus that of economies across the globe has left many investors scratching their heads. We often get asked how is it possible for financial markets to increase in value, but the economy is shrinking?

It goes without saying that we live in extraordinary times. The South African economy had never faced such an abrupt cease in trade and/or economic activity as with the commencement of the nationwide lockdown on 27 March 2020. The same can be said for other economies around the globe. As economies started to reopen, many investors have been left scratching their heads – the recoil in financial markets painted a very different picture from the economic outlook.

It is not surprising that markets experienced some of the sharpest falls in asset prices during the first quarter of 2020. The JSE All Share Index lost more than 30% from the start of 2020 until 23 March 2020. What was surprising to see was the speed of the recovery hereafter – since 23 March 2020 (the bottom of the sell-off), the market is up more than 70% (as at February 2021) making COVID-19 seem like a mere short-term disruption.

The economy, however, tells a very different story, with one of the largest contractions in GDP ever recorded, coupled with sky-high unemployment numbers.

How are financial markets flourishing when economies are falling apart? Let’s have a look at financial markets in more detail, more specifically the equity market.

 

Equity market

The equity market is forward-looking and prices of stocks/shares/bonds (any listed liquid instrument’s) are determined by the supply and demand of investors. Investors that are buying these instruments are expecting positive outcomes looking forward. Sellers, on the other hand, expect the price of the stocks/shares/bonds to decrease in value.

So how do you know if you should be buying or selling? Ultimately, you need to consider the value of the company. The intrinsic value of a company can be estimated by taking its future expected earnings and discounting the future cash flow with an appropriate discount rate to ascertain what the value of those future earnings are worth now (or at the time one buys the listed equity).

The factor that has changed most notably in the above equation is the significant drop in interest rates – not only in South Africa but globally as well. With interest rates decreasing with 3% since the start of 2020, the discount rate being used to calculate the worth of future earnings is now significantly lower. This will result in future earnings being worth more today than before the interest rate cuts.

When the economy is slowing, the South African Reserve Bank (SARB) cuts interest rates to stimulate financial activity. This benefits businesses in that they enjoy the ability to finance operations, acquisitions, and expansions at a cheaper rate, thereby increasing their future earnings potential, which, in turn, also leads to higher share prices1. The reduced financing cost also increases future earnings figures.

Companies also have control over aspects that contribute to the current value of the company. Companies can use times of uncertainty as justification to cut their cost base and in doing so increase their bottom line/earnings. In other words, the leaner operational costs will result in higher expected future earnings.

In short, market crashes reset valuations of listed companies and provide investors with the chance to invest into opportunities that might not have been available, or an even an option previously due to prices being too high. This ‘opportunity’ buying cycle subsequently drives up market prices.

The last factor that can’t be ignored, and one that is especially important in the South African landscape, is that listed companies that sell products offshore are not reliant on how the South African economy performs. These shares are more broadly known as Rand Hedges (with the weaker Rand also working in their favour).

If one looks at every company listed on the South African stock exchange (the Johannesburg Stock Exchange or JSE), the majority of companies are not reliant on the South African economy to generate earnings. These are companies with business interests that are either predominantly outside of South Africa or entirely outside of South Africa.

In fact, 69% of the revenue generated by the top 40 companies listed on the JSE was generated from outside of South Africa for the 2019 calendar year2. In essence, when you are investing in the South African equity market (as represented by the Top 40), only 31% of company revenues are reliant on the South African economy3.

This is possible due to the fact that some of the largest companies on our stock exchange are dual-listed companies. In other words, these companies are listed on more than one country’s stock exchange. For example – the BHP Group is listed on the London Stock Exchange as well as the Johannesburg Stock Exchange. While the BHP Group used to have operations in South Africa, currently the company does not generate any earnings in South Africa.

There are many similar examples on our stock market and most of these companies carry larger weightings in the index. We call these rand hedge shares. In short, if the rand weakens, it is a benefit to own these shares as they generate earnings in offshore currencies. So, as an investor, you are hedging your currency exposure even though you are investing in a South African listed equity.

 

Local government and economy

In contrast with forward-looking equity markets, Government GDP numbers are backwards-looking. GDP is the value of goods and services produced/rendered in a country during a certain period. It provides a snapshot of a country’s economy, and it is used to estimate the size of an economy and its growth rate.

Due to stringent lockdown rules in South Africa, several sectors came to a complete standstill and, therefore, did not contribute to growing our GDP rate. As an example, in South Africa, GDP numbers are highly dependent on mining, agriculture, manufacturing and construction (to name but a few) – most of which had to halt operations for quite some time. In addition, many of the companies that contribute to our GDP numbers are not listed entities but rather privately held and/or small business.

Unemployment is another number that has a different effect on economies when compared to listed companies. When a company retrenches employees it immediately lowers the expenses of the business and can potentially grow earnings (if income is unchanged) but the opposite is true for an economy. When someone is retrenched and they can’t find an alternative job, they move from being paid by a company to being paid by the economy and thus increasing the expenses of the government.

In closing

Investors too often redirect their attention away from the destination to the journey when faced with a lot of outside noise. Much like in other walks of life, we can lose focus, making us susceptible to capitulation or giving up at the moments when fortitude and resolve pay off most.

Patiently allocating to assets that will help you achieve your financial goals should remain key. So, if you catch yourself getting down about the state of our economy, or speculation around government policies or trying to predict what is next, always remember why you are investing in the first place.

There’s no doubt that the current market conditions are unsettling. It is at these moments that we would discourage investors from making changes that could harm their ability to reach their financial goals. It is often during these difficult times that we have the greatest opportunity to add value for our clients, acting rationally when others struggle to do so.

1 Source: https://www.investopedia.com/investing/how-interest-rates-affect-stock-market/
2 Source: Ninety One Asset Management as at 31 May 2020
3 Source: Ninety One Asset Management as at 31 May 2020

Victoria Reuvers

Managing Director

Morningstar Investment Management South Africa

Risk Warnings

This commentary does not constitute investment, legal, tax or other advice and is supplied for information purposes only. Past performance is not a guide to future returns. The value of investments may go down as well as up and an investor may not get back the amount invested. Reference to any specific security is not a recommendation to buy or sell that security. The information, data, analyses, and opinions presented herein are provided as of the date written and are subject to change without notice. Every effort has been made to ensure the accuracy of the information provided, but Morningstar Investment Management South Africa (Pty) Ltd makes no warranty, express or implied regarding such information. The information presented herein will be deemed to be superseded by any subsequent versions of this commentary. Except as otherwise required by law, Morningstar Investment Management South Africa (Pty) Ltd shall not be responsible for any trading decisions, damages or losses resulting from, or related to, the information, data, analyses or opinions or their use.

This document may contain certain forward-looking statements. We use words such as “expects”, “anticipates”, “believes”, “estimates”, “forecasts”, and similar expressions to identify forward-looking statements. Such forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause the actual results to differ materially and/or substantially from any future results, performance or achievements expressed or implied by those projected in the forward-looking statements for any reason.

 

Morningstar Investment Management South Africa Disclosure

The Morningstar Investment Management group comprises Morningstar Inc.’s registered entities worldwide, including South Africa. Morningstar Investment Management South Africa (Pty) Ltd is an authorised financial services provider (FSP 45679) regulated by the Financial Sector Conduct Authority and is the entity providing the advisory/discretionary management services.