SKAGEN are long-term investors and I always urge the same patience among our clients – it will be rewarded – but with market views appearing to be pretty evenly split between the bulls and bears, here are some thoughts on the likely winners and losers as we approach the final straight.
At the risk of repeating what I said in December, I believe that now is the time for value. So far in 2023 markets have been gripped by AI Mania – seven large cap technology companies have incredibly generated 80% of the S&P 500's gains and now make up almost a quarter of the index. JP Morgan recently warned that market concentration in the US is increasing at the steepest rate for six decades and approaching similar levels to those that preceded the 'nifty-fifty' market crash of the 1960s.
We have already started to see some profit-taking by investors with the 'magnificent seven' down 6% since their summer highs, despite each company beating analyst expectations. This is equivalent to losing over $600bn in combined market value, yet the disparity in valuations between growth and value stocks remains huge and suggests there is further to go.
On a price-to-earnings basis, one dollar earned by an average growth company is currently valued at 31.0 dollars, which is 2.4x more than one dollar earned from an average value company (12.8 dollars). The ten-year average premium is 1.8x meaning that growth stocks need to fall 28% or value stocks need to rise 38% for the current premium to revert to mean levels. With the overall market currently valued in line with its 10-year average (18.5x), a combination of the two scenarios looks quite possible.
The risk-reward balance is even more skewed for smaller companies. Small-cap value stocks are currently available at a near 50% discount to ten-year average prices. This provides a good safety net but also huge upside potential, particularly as I believe we will see more smaller companies being acquired by larger ones to boost their own valuations (especially if earnings come under pressure). This could soon start to raise small-cap valuations towards their historic averages.
Into the unknown
I was struck during my summer reading of numerous economist and bank forecasts that opinions are split – even more than usual – on the stock market outlook. The bulls believe that with inflation under control, real wage growth turning positive and consumer spending remaining strong, central banks will start reducing interest rates in 2024. They expect economies to achieve a soft landing and AI to drive huge efficiencies for corporates, which will in turn deliver higher earnings and rising share prices. Goldilocks is back!
The bears meanwhile believe inflation is much stickier and will not return to 2% target levels during 2024, forcing central banks to continue tightening and economies into recession in 2024. Indebted corporates will become cash strapped servicing rising debt burdens while needing to invest heavily in AI. In this scenario, productivity gains and earnings growth are delayed and stock markets undergo a correction within the next six months.
Where do I stand? I was very bullish in January (maybe for the wrong reasons) but more cautious now and lean more towards the 'higher interest rates for longer' camp. I expect a market correction at some point, which will signal an end to the AI frenzy that has driven dispersion in stock performance and market concentration to unhealthy levels this year.
As well as removing some of the current market imbalances, it is important to remember that corrections are welcome. Much like siblings arguing once in a while, it is healthy to let off some steam, talk things through and start afresh!
This doesn't mean that I would advise selling down to avoid a market sell-off. As with family quarrels, it is important to take the rough with the smooth. More money is earned long-term by staying invested; attempts to time the market risk missing the best days that can seriously hurt overall returns.
This year's market rally in the face of strong economic headwinds also highlights why we shouldn't walk away from equities, however gloomy the forecasts may be. SKAGEN celebrates its 30th birthday at the end of the year and we have successfully navigated many economic and market cycles over the lifetime of our funds. The market may be ever-changing but independent thinking and working hard to find the best companies at the best prices will deliver the best outcomes, both for the rest of 2023 and the years ahead.