We are in a bubble

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Neil Woodford 4 December 2017 Est. reading: 4 min read

Many of you may have read press coverage in recent days that Neil believes we are in an investment bubble. We have encapsulated those views in the blog post and short video below where Neil explains what it means for investors in his funds.

In summary: what does this mean for investors?

  • Valuation stretch in markets now at extreme levels
  • Unsustainable bubble in some parts of the stock market and other financial assets
  • Woodford portfolios positioned away from the bubble risk – remain capable of delivering positive long term returns

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.

The valuation stretch in the stock market has increasingly concerned me over the last couple of years and the chart below brought home to me just how drastic the situation has become.

What we see here is the stretch away from trend, between the performance of US value stocks and US growth stocks. It tells you all you need to know about current market conditions across the globe.

US equities – value vs growth differential has never been this extreme

Source: Woodford, based on Fama and French data

1930 1940 1950 1960 1970 1980 1990 2000 2010 2020 0 -3 1 -2 2 -1 Standard deviations from trendWall Street CrashNifty-fifty bubbleDotcom bubbleDo you see what we see?

The difference between the performance of value stocks and growth stocks today, is greater than at any stage in stock market history. Let that sink in…

We’ve had our fair share of bubbles in this period, as highlighted on the chart. The Wall Street Crash looks like a tiny blip compared to some of the other periods of market madness that we have seen, when fundamentals become irrelevant and animal spirits take over temporarily as the primary driver of share prices.

Obviously, the late nineties dotcom bubble was a painful period of performance for me – its impact on valuation stretch is all too visibly acute on the chart but, in the context of history, it was a brief dislocation. By focusing resolutely on fundamentals, my funds enjoyed a meaningful period of positive performance when the bubble burst, continuing to rise in value as the market plummeted in 2000 and 2001.

There are echoes of the tech bubble today. More similar, however, to the current predicament, was the nifty-fifty bubble which afflicted stock markets in the late 1960s and early 1970s. A narrow group of so-called “one-decision” stocks with dependable growth characteristics enjoyed a run of popularity with investors that took their valuations to extreme, unsustainable levels. I wrote about this in the FT in 2010, explaining that, “when growth is hard to come by for the wider economy, investors are prepared to pay for companies that can provide growth in shareholder returns no matter what the economy throws at them.”

Mark Twain once famously said, “History doesn’t repeat itself, but it often rhymes”. The market appears to be making the same mistakes again, but this time the bubble has grown even bigger and even more dangerous. In a challenging global economic environment, the few stocks that are perceived to be capable of delivering dependable growth have, like in the early-1970s, become very popular and that popularity has manifested itself in extreme and unsustainable valuations.

I have owned some of the stocks that have benefited from this trend – Reckitt Benckiser, for example, is a very high quality business which I would be delighted to invest in again at the appropriate price. But on the basis of valuation, I have sold it, and others like it, from the portfolios, replacing them with positions which look much more attractively valued.

That is a consistent feature of bubbles – there is always a subset of the market which falls out of favour as investors clamour for the fashionable stocks of the day, providing the fuel to power the bubble on through the final leg of its journey before it bursts.

In the dotcom bubble it was the old economy stocks – today, in the UK stock market, it is domestically-focused stocks which have become profoundly unloved and undervalued. The funds I manage are positioned to exploit this opportunity and I am utterly convinced it will pay-off when the bubble bursts, which I believe it inevitably will.

Timing such an event is not easy but there are certain events on the horizon that could prompt the market to acknowledge that some parts of the global growth outlook are nowhere near as benign as it has complacently believed. More on that in the near future – but in the meantime, investors should take stock of the risks that exist in many parts of the market.

Investors should be careful chasing the zeitgeist. The temptations and excesses are right here, right now. There is always risk when markets become obsessed and extreme but there is also opportunity – an opportunity to capture assets at incredibly depressed valuations, the likes of which I have only seen two or three times during my 30-year career.

Woodford Investment Management Ltd is authorised and regulated by the Financial Conduct Authority (firm reference number 745433). Incorporated in England and Wales, company number 10118169. Registered address: 27 Old Gloucester Street, London, WC1N 3AX.

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