The US S&P 500 index and the German DAX index both stand at all-time highs. Despite comments from Fed governor Lael Brainard last week that the global economy is brighter than it has been for the last few years, investors are nervous.
All three main themes of Australian individual and SMSF share portfolios — higher growth stocks, demographic exposures and dividend yields — are likely to suffer in a global correction, but not equally.
Investors can draw comfort from data this year which shows European expansion, an upswing in the US and stabilising growth in China. The better outlook reduces the potential for a market meltdown.
But there is an argument that current share market levels are reflecting an “as good as it gets” scenario. Among other factors, if the White House can’t deliver its stimulatory measures, if the European economy stalls, if the upswing in growth data doesn’t flow through to wages, there is potential for substantial corrections.
If a global fall of 10-20 per cent is on the cards, how will local stocks fare? The short answer is badly.
More experienced investors can take advantage of the historically low levels of volatility and use derivatives to cover any downside risks. Other investors face selling down stocks to reduce any impact of a market stumble. But what to sell?
Where a stock has a healthy outlook, a higher dividend yield is likely to offer better protection, especially where investors have longer time horizons. An income stream makes holding a stock through a period of weakness more palatable.
An important consideration is the sustainability of the company’s earnings.
Concerns about competitive impacts mean dividend yields for stocks such as Telstra may be under threat. While current cash flows are strong, some analysts are concerned about earnings beyond 2018 and the NBN roll out. This may mean recent share price pressure continues. Similarly, there are worries about the potential for house prices to fall and affect bank income streams.
Nonetheless, shares with higher dividend yields are likely to be lower down on investors’ sell lists, and therefore may perform better under difficult market conditions. This market theme is reinforced in a low interest rate environment.
Local and global investors have latched on to a demographic investment theme. Ageing populations require a different mix of products and services, and healthcare stocks are a major beneficiary.
There are signs this market driver could falter soon.
The accompanying chart maps the value of the Australia 200 healthcare index against its price to earnings ratio. Note how the P/E expanded with the rise in the index. In Q3 last year the sector took a hit. The index fell more than 16 per cent from near 23,000 to just above 19,000. The P/E contracted from 28x to below 24x. Now the index has risen to new highs closer to 24,000, but the P/E has stalled at the previous highs around 28x. This is significantly above the 16x P/E for the Australia 200 index. The combination of these factors points to a sector correction
This could mean healthcare stocks are at an “as good as gets” level and may be hit hard in any market downturn, underperforming the market. Investors with overweight exposures to healthcare stocks may be in particular danger.
In a low growth environment companies that grow profits at levels well above the systemic rate command a premium. Think Domino’s Pizza, Sydney Airports and Bega Cheese. (Naturally a number of healthcare stocks are also in this category).
The reasons vary, but the share price premium is reflected in the P/E. Ratios in the 30x to 45x range are common.
These elevated valuations could be harbingers of underperformance in a market sell-down. Not only are they caught in any downdraft, they may suffer a larger P/E contraction than the broad market, meaning a greater fall in percentage terms. This is how market darlings become fallen angels.
In my view, any stock market correction is more likely a healthy pullback than a crisis.
Regardless a broad market fall of 10-20 per cent could see some stocks and sectors drop further. Reliable income streams could be more highly valued than projected growth rates. Investors may wish to examine portfolios for vulnerabilities before the selling starts.
Michael McCarthy is chief market strategist at CMC Markets