By Nick Stanhope, senior portfolio manager at Morningstar Wealth
The sharp selloff in markets at the beginning of August, which was triggered by investor concern that central bankers have maintained interest rates at too high a level, came following a softening of US labour market data.
This was further compounded in Japan by a recent hike in interest rates as the Bank of Japan, in contrast to most other developed countries, tried to exit from years of low rates in its attempt to generate growth and inflation.
Highly rated growth stocks fell almost 14% from their July peak, whilst information technology fell close to 20%, with the Japanese equity market falling over 27% in local currency terms. Defensive sectors – which were trading at relatively low valuations – made gains over the same period whilst remaining attractively valued versus their own history and that of the wider market.
The selloff served as a sharp reminder that those areas of the market that have gone up the most and trade at rich valuations are most vulnerable to a correction. Shifts in market sentiment and a change of leadership in stock markets are often only identified with a healthy dose of hindsight and remind us why portfolio construction is so important.
Getting the balance right between those assets that will drive returns in portfolios versus those diversifying assets that will help to smooth returns during periods of market turbulence is key.
How much you should allocate to each will depend on a number of factors including the price paid for an asset. It is worth examining an asset’s price versus its own valuation history and versus other assets you could buy.
See also: Morningstar: Active managed portfolios now make up less than half of offerings
Disappointing earnings can have a disproportionate impact on stocks that trade at expensive valuations, according to contrarian investor David Dreman. He found that negative earnings surprises can have a much more detrimental impact on stocks trading at high valuations than those trading on low valuations.
The longer the duration of a market theme, the greater price momentum has typically built up in stock valuations, and the greater markets are vulnerable to such reversals.
To help counter market exuberance, it is also worth considering investor sentiment and positioning before establishing investment conviction. Unloved and under owned stocks that are cheap versus their own history and the market are worthy of a higher conviction, provided the tenets of the business remain intact.
Contrarily, widely owned stocks trading at high valuations versus their own history and that of the market could be ascribed a lower conviction to, even if the business is sound. Although paying a premium for a business may be justifiable based on fundamentals, there is still such a thing as overpaying.
Being mindful that our own ability to predict the future is limited, Morningstar’s investment approach is to invest in both return drivers and diversifiers. We flex the amount of capital allocated to each based on our own assessment of valuations and investor sentiment, with the aim of maximising returns and smoothing out the journey.
Consequently, we maintain higher weighting to sectors such as consumer staples, utilities and healthcare than we might ordinarily own as defensive diversifying stocks. We find return drivers in UK equities, financials and select areas within the emerging markets.
Specifically, we are overweight in technology and ecommerce names in China, whilst being underweight in the IT sector globally, despite the strong business fundamentals in the sector.
