The premium on growth stocks over their value counterparts has now surpassed its 2000 peak, a worrying sign that suggests we could be “an hour closer to midnight” in the current cycle than many people believe.
This is according to Columbia Threadneedle’s Richard Colwell, who says the relationship between growth and value is just one of many parallels that can be drawn between today and the eve of the dotcom bubble.
For example, Colwell, who manages the Threadneedle UK Equity Income fund, also pointed to a graph of higher yielding stocks across Europe and the UK, which has only been cheaper once during the past 30 years – again in 1999 to 2000.
“At the turn of the century the global market’s appetite for growth also saw investors draw a line between stocks which represented the ex-growth, tepid ‘old economy’ and the dynamic, disruptive ‘new economy’ led by stocks predominantly belonging to the TMT [telecommunications, media and technology] sectors,” he said.
“If that chart suggests the ‘old economy’ is once more being neglected, the right-hand graph tells us that the ‘new economy’ has returned to levels of animal spirits also seen two decades ago – for new US IPOs – here a proxy for the ‘new economy’ – it appears a case of the more negative your earnings, the better.”
It is not just the valuation disconnect that reminds Colwell (pictured) of the late 20th century. He said that this year, just as then, a dovish pivot from the Federal Reserve following successive hikes sent a signal to markets that low rates and cheap borrowing could be here to stay.
However, while many investors think the next cut from the Fed will spur on another leg of growth, as seen in its dovish response to the Asian financial crisis in 1998, the manager pointed out they seem to have forgotten what happened next.
“In assessing the present day, we believe we could be an hour closer to midnight than many would like to believe,” he explained.
“An accommodative Fed may have kept the party going in 1999, but sowed the seeds for a painful hangover in 2000.
“And while the music’s still playing, most people take the view that, in the words of former Citigroup chief executive officer Charles ‘Chuck’ Prince, ‘you’ve got to get up and dance’ – that’s even if more than four of every five companies coming to market is loss-making?”
Colwell is not necessarily calling the end of the cycle – he just wants to give some context to his cautious positioning compared with the current consensus.
For example, the manager said any recession – if there is one – could be mild, but that it could well be accompanied by a “violent” rotation out of growth stocks.
“We think the proliferation of passive and exchange-traded fund money in the market these days will only amplify the severity of any such event, given the valve-like quality of passive fund positioning,” he continued.
“In the meantime, some naysayers are folding as the pressure of taking the opposing side intensifies up to the point of reversal – voluntarily or otherwise.
“With the elastic once again becoming very stretched, we think that, just as in the early 2000s, a marked rotation from growth into value is overdue. Our aim is not to predict the timing or the indeed the trigger, but to ensure our portfolios are best prepared to weather the turbulence and seize the opportunities when that moment arrives.”
Growth has become synonymous with tech over the past decade, but Colwell is keen to point out this is not the only sector where valuations look excessive, meaning the UK market would not be immune from any rotation.
For example, the manager pointed out that “quality growth” stocks have enjoyed a major re-rating in the current cycle. Meanwhile, oil and mining stocks have been lumped in with the quality defensives because of their current cash generation, after strong commodity price-rises – which he said seems to be ignoring the risk of future cyclicality.
In contrast, Colwell said the large part of the UK market which is neither domestically exposed nor commodity-driven has been largely left behind, despite counting many proven international franchises among its number.
“The weight of money that has exited the UK market due to the political and economic uncertainty brought about by the Brexit maelstrom has opened up a large price differential between those companies listed in the UK and their peers listed overseas,” he added.
“In fact, valuations of the UK market relative to the MSCI World index show it has not been this cheap versus the rest of the world for 30 years – and has only been cheaper once over the past 40 years – a discount we would say is highly disproportionate to reality.
“This is an important area of value and has created opportunities for active managers – as has the blanket de-rating of ‘old economy’ stocks thought to be doomed to declining growth, or worse, by ‘new economy’ disruptors.
“We acknowledge that some of these companies have big structural issues, but should they really be priced for extinction?
“In our view the answer is not black & white, but in fact grey. Instead, we would ask whether the market has punished a share price without giving due consideration to the resilience of the business or its ability to adapt.”
Data from FE Analytics shows the Threadneedle UK Equity Income fund has made 143.8 per cent since Colwell became manager in September 2010, compared with gains of 105.3 per cent from its IA UK Equity Income sector and 103.56 per cent from its FTSE All Share benchmark.
Performance of fund vs sector and index under manager tenure
Source: FE Analytics
The £4.1bn fund has ongoing charges of 0.83 per cent and is yielding 4.2 per cent.