Valuation stretch to normalise

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Throughout financial market history, there have been occasions in which markets have become completely detached from valuation reality. We believe we are in one of these periods right now, with bubble-like characteristics increasingly evident and adding considerable risk to the investment backdrop. The elastic between the valuation of the popular stocks (such as the FAANGs* in the US, or in the UK, anything which offers investors exposure to Asian growth) and the unpopular stocks (anything domestically-focused remains completely out-of-favour) is now at breaking point, in our view.

We have already seen many signals to suggest that this valuation stretch is now starting to reverse: tighter liquidity conditions, pressure on emerging markets, slowing growth in China, vanishing momentum in the eurozone economy, along with the continued resilience of the UK economy – all point to a stock market which cannot remain in denial of fundamentals for much longer.

Timing a market reversal, or pinpointing a specific event that will trigger it, is not possible but neither is it necessary. It is an inevitable consequence of the way that financial markets work and have always worked. Ultimately, fundamentals are like a gravitational force that pull markets back into alignment with reality. That is why bubbles burst. Fundamentals always reassert themselves in the end and that is why they are the only things that matter in the long run.

* FAANGs stands for Facebook, Amazon, Apple, Netflix and Google (now Alphabet).

Neil's View

I thought it might help to draw your attention to today’s trading updates from a number of UK economy exposed businesses to which we have exposure across the funds. The reality is that these companies are broadly doing what they said they would do and in some cases even better. Typically, their share prices are down year to date and most have valuations on the floor. The market continues to behave irrationally whilst the real world of the economy and the businesses in which we are invested operate in a parallel universe.18 January 2018

“Today Deutsche Post issued some convertible preference shares (€500m worth) at.​.​.
.​.​.wait for it.​.​.
.​.​.ZERO coupon!

The ordinary shares yield 2.8%, but even better, with a 40-45% conversion premium. Nut job!”6 December 2017

Ten years on from the global financial crisis, we are witnessing the product of the biggest monetary policy experiment in history. Investors have forgotten about risk and this is playing out in inflated asset prices and inflated valuations. Whether it’s Bitcoin going through $10,000, European junk bonds yielding less than US Treasuries, historic low levels of volatility or smart beta ETFs attracting gigantic inflows – there are so many lights flashing red that I am losing count.1 December 2017

Relative performance of US value stocks now at levels not seen since the dotcom bubble

Source: Bloomberg, Woodford

UK domestic stocks trade on decade low valuations relative to globally-exposed stocks

Source: UBS, Woodford

UK-focused stocks trade on very attractive valuation levels not seen in years. Our funds are positioned to capture this long-term opportunity.