Numerous asset bubbles will start to deflate in 2021, as money is siphoned away from financial markets towards the “real” economy.
This is according to Gary Potter (pictured), co-head of the multi-manager team at BMO Global Asset Management.
Last year saw numerous assets rocket in value, despite little change in their fundamentals; for example, Bitcoin rose by 164 per cent and Tesla was up 750 per cent. Potter warned there seems to be a belief in markets that “trees grow to the sky forever”.
“Well, they don’t,” he said. “Sometimes they exceed what you think they will do, but I’ve been around for nearly 40 years and eventually things fall.
“This is the biggest issue that all of us face in the marketplace: the belief that trends that have been established in the last two or three years are going to carry on.
“Speculation is bubbling away quite meaningfully and we think that is on the change.”
Anthony Willis, an investment manager in BMO’s multi-manager team, noted that Tesla’s current market cap of $805bn implies a value of $1.6m for every one of the 500,000 cars it sold last year. If a similar valuation metric was applied to Volkswagen, which sold 11 million cars last year, that stock would be worth $17.7trn.
As a growth stock, the case for investing in Tesla rests on the potential for future sales and although it only sold 500,000 cars in 2020, chief executive Elon Musk expects this to rise to 20 million by 2030.
Although Potter does not want to take a view on whether Tesla can fulfil its potential, he said its P/E (price-to-earnings multiple) of 1,300 is an example of the excessive valuations that can be seen in markets.
“Quite frankly, I want to be around to get my money back when I buy a stock or a fund and we’re much more comfortable buying funds or stocks on P/E multiples of 10 or 12,” he continued.
“If you examine a P/E multiple of 10, what it is basically saying is the price that you paid, if you call it a pound and if the company is earning 10 pence in a particular year, you have to wait 10 years to effectively get your money back in terms of the share price that you’ve paid.
“Whenever I talk about P/Es of 10 to 12, that means that I might actually have a chance of seeing my money back in the price I paid for the company’s earnings. There is another 1,000 or 900 years before I am ever going to see my money back in the earnings profile of Tesla, so there’s an awful lot of expectation built into some stocks which we think could actually falter.”
Value managers such as Potter have been calling growth stocks expensive for many years, yet the outperformance of these assets has continued to accelerate over the rest of the market.
However, he believes the fallout from the coronavirus crisis helped push many growth assets into speculative territory – and a normalisation of conditions could be all it takes to burst the bubble.
“Quite simply put, the more the real economy grows, the more that liquidity gets syphoned away from alternative homes, so it gets syphoned away from financial assets, and vice versa,” he said.
“When Covid struck and the economy hit a brick wall, the money that was destined for the economy went into financial assets and particularly things like Tesla and Bitcoin.
“As investors turned to financial assets, they chased momentum, they bought low-cost index funds and that became a self-fulfilling prophecy. Tesla went into the index and more people bought Tesla because they were being given money by the government.”
Kelly Prior, another fund manager on BMO’s multi-manager team, noted that the average gain of the largest 50 stocks between the announcement of their inclusion on the S&P 500 and their actual entrance into the index is 3 per cent. Facebook, the previous record holder, went up by 14 per cent. But Tesla rose by 70 per cent.
“They punted on the stock market because the economy was on its knees,” Potter continued. “That is most likely to change as we go through 2021. And it is quite possible that as the economic traction gets firmer post-vaccine, post-Easter, we start to see financial asset performance become a bit more of a challenge because the money might start to be diverted towards the real economy recovery.”
And the manager said that you do not need to look too far into the past for an example of where a similar scenario unfolded.
“If you think back, the US economy strengthened meaningfully in 2018, spurred by supply-side tax cuts passed at the end of 2017,” he added.
“Then what happened was the average equity market performance in mainstream terms fell about 10 per cent, because money was diverted away from financial assets into the real economy. And then of course, the Fed then tightened.
“The whole process was reversed in 2019 as the Fed eased long-term interest rates. In 2019, after a very difficult 2018, the market did very well; in fact, far better than it should have done, because liquidity went from the real economy into financial assets.
“Then in 2020, Covid struck.”
However, this does not mean Potter is pessimistic on the outlook for markets this year. In a previous article on Trustnet, he said the “starting pistol” in a value rally may have already been fired.
Performance of manager vs peers over 10yrs
Source: FE Analytics
Data from FE Analytics shows Potter has made 65.01 per cent for investors over the past decade, compared with 72.55 per cent from his peer group composite.