The first two months of 2016 have been characterised by a tremendous level of angst – or panic, if you will – about equity valuations. Set against a backdrop of low liquidity in markets, shares have tumbled as a result of too few bids to balance large sales orders.
The falls have taken another 6 per cent off the S&P 500 year-to-date, adding to losses seen at the very end of 2015, to leave shares almost 10 per cent lower on a one-year view.
Is something fundamental at fault in the US? We do not believe so. Instead what we have seen is a deterioration of liquidity over a long period, caused by increased regulation, which means stocks can now experience sharp declines in relatively short periods of time as there are fewer players able to take the other side of the trade.
The loss of the market maker means these sharp falls – typically followed by sharp recoveries – can continue for some time. And there could be more to come as we move into election season proper.
Companies can see their stock prices fluctuate and become divorced from fundamentals very rapidly during an election period, with political rhetoric over the issue of drug pricing a recent case in point. We expect there to be a lot more commentary around this particular issue over the next few months as we approach the November election.
But while there may be further volatility for the biotech and pharmaceuticals names specifically, it is important to remember it will not change the underlying value of the businesses. Indeed, for investors with longer investment horizons, this is a chance to add to holdings at attractive valuations.
What the recent price action in the market and tightening of financial conditions does mean is that further rate rises by the Federal Reserve have almost definitely been pushed back. The change in direction for markets will encourage the Fed to be extremely cautious in its approach and we believe monetary policy will remain accommodative and therefore supportive for equities. Indeed, longer term we believe the sell off – painful as it has been – will reinvigorate the bull market, injecting fresh impetus into stocks.
However, some areas must still be treated with caution, even after taking price falls into account. For example, while we recognise the big banks are clearly trading at attractive valuations, it is hard to make the case that they will be able to generate any significant growth in light of increased regulation. The fact capital allocation is, in effect, dictated by the regulator also makes us uneasy about owning them.
But while we think big banks should be avoided, energy represents one of the best opportunities this year.
Right now the market continues to be concerned with elevated oil inventories but there is actually very little spare capacity, and supply is exiting the industry at an accelerated pace, particularly as prices have fallen below cash costs in many cases.
The decline in the oilrig count is one illustration of the vigour of the supply response. This sows the seeds for a sharp recovery in the price of the commodity, although it is impossible to time precisely.
The scale of the recovery can be as rapid as the decline when it comes to energy. Historically in this type of environment, the reduction in excess capacity has, over the corresponding 12 to 18 months, sent commodity prices spiking by between 2.5 and 4 times (a move which, if it materialised, would see oil trading between US$75 and US$120 a barrel based on its current price).
While the outlook for the price of oil is hard to predict, what is clear in this environment is that it remains important to focus on energy companies that have a valuable portfolio of assets or value-added technology. We favour these over the very big companies that operate across the entire value chain, which will struggle to generate growth, even in a normalised environment.
Indeed, we believe investors must use that approach across the various sectors of the US market for now. Liquidity and balance sheet strength is essential, as is avoiding companies lumbered with large near-term debt obligations. Companies that can fund their own growth and invest in their businesses will eventually see that additional value monetised, be it through share price appreciation or through takeovers.
Evan Bauman is manager of the Legg Mason ClearBridge US Aggressive Growth fund