High flyers to fall, rotate into mega caps

Chief Investment Officer and founder of Aitken Investment Management
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I’ve had numerous questions from investors about whether I thought the high-flyer valuation correction, that has started on Wall St and spread to Australia/New Zealand, would be the trigger for a broader equity market correction? This is obviously the key question and today I will try to answer it in an Australian context.

No doubt broader equity market corrections can start when the stocks that have previously led the rally, run out of momentum and turn south. The initial reaction is a rotation from high-flyers to laggards, or in the current US example, from high-growth tech stocks to relative value industrial stocks, but the second leg can often be an asset class one, where the entire equity market corrects.

At this very moment, I am not sure whether this is going to be a “stage 1 rotation” or a “stage 2 broader correction”. Either way, it is highly unlikely the broader US equity indices can advance while its highly valued market darlings hit a bit of an air pocket.

The situation on Wall St requires very close daily monitoring. US equity valuations are already very high, thanks to the Fed’s largesse, and any stock rotation is only to relative value, not absolute value. That alone makes the broader US equity market vulnerable to a correction. Similarly, there is no real dividend support in US equities. Hedge funds appear long, not short.

Similarly, on pure technical analysis, there is a growing number of “head and shoulders” patterns that are testing near-term support on Wall St. Again, this technical situation requires close daily monitoring.

Sell in May and go away

But the aspect of all this that makes me extremely vigilant is actually a seasonal one. We are approaching May and every May for the last five years we have seen a trading correction in global equity markets. Sell in May and go away is five for five in the last few years”. The chart below reminds you the five-year bull market in US equities, as measured by the S&P500, had five solid trading corrections that got negative momentum in May over the last five years.

The ASX200 actually amplified those annual trading corrections because we have a financials/global cyclicals heavy benchmark and each “May scare” was either driven by a global growth scare, or financial sector solvency scare, or both.

But this time around we are dealing with a different driver of a potential broader equity market correction. This is a valuation correction of high-flying stocks meeting the increasing consensus view that the next move in global interest rates is a rise. Quantitative easing is also in the process of being turned off, while there’s also a view the Q1 US reporting season will be mixed, due to the very cold weather of January.

In terms of the NASDAQ, you can see below that capital growth really accelerated away from the trend-line in the last 12 months. This chart suggests there is further downside in the NASDAQ composite index.

The local context

So what does all this mean in an Australian equities context?

Below is a chart of the NASDAQ composite index (blue) and the ASX200 (red) over the last five years on a common performance base.

Now let’s compare the NASDAQ Composite Index vs the ASX200 Accumulation Index (XJOAI). This reminds you of the power of accumulating dividends.

Either way you look at it, leading Australian equities have dramatically underperformed high-flying US tech names over the last few years. Fair enough, we offered lower growth but significantly higher yield.

No doubt if the current valuation correction in high-flying US tech names broadened to a US equity asset class correction, then Australian equities wouldn’t be immune to that selling pressure. However, I can see no scenario where Australian equities would perform worse than US equities, and every scenario I believe is conceivable sees Australian equities outperforming US equities relatively and absolutely.

The main reason I come to this conclusion is the weightings of tech and biotech names in benchmark Australian indices is miniscule. The Australian names that went up with the NASDAQ are on a limited list; the list of names that underperformed the NASDAQ is a very extended list.

Valuation rotation

The way this could play out, is the high-flyer valuation correction on Wall St broadens in May, just as Australian banks report record earnings and dividends. Either way, the scenario leads you to avoiding high-flyer Australian stocks with high NASDAQ correlation, parking in leading Australian stocks with clear valuation and yield support, or simply moving to cash/the sidelines for a little while, away from high flying NASDAQ correlated stocks.

I suspect this isn’t a situation to over-complicate. If you take some profits on the Australian high-flyers with high NASDAQ correlation, then I think at this moment in time you have probably done enough. You saw earlier this week how Australian/New Zealand high-flyers went seller no buyer, and this just reminds you how spectacular a momentum change can be in overvalued stocks.

Interestingly, the broader Australian equity market hung in well this week (fresh six-year high) despite the carnage in high-flyers. This was particularly evident in the ASX TOP 20 (XTL).

The simple advice I am giving institutional investors is if the chart of a given stock has basically gone up and only up for 12 months and has a FY14 P/E over 20x, it is vulnerable to this valuation correction. If its correlation to the NASDAQ is high, it is extremely vulnerable to a valuation correction.

Stocks that previously were “momentum” darlings, and trade on large P/E premiums to the market, remain vulnerable to further de-rating. That de-rating can be relative and absolute. That is where I am focusing my attention, while keeping a very close eye on whether this valuation correction in high-flyers spreads and triggers a broader “sell in May” equity market correction. At this stage, I don’t know the answer to that, but as I wrote above I am monitoring it daily.

Time to go

Today I am simply going to reiterate what I have said to institutional investors for the last few weeks. Below is a selection of names in different Australian sectors that are vulnerable to a valuation correction. I have significantly broadened the list of vulnerable stocks and sectors, but they all have one thing in common, they have been the big “momentum” stocks of the last 12 months. As I say, when the “MO goes”, you need to go.

I think this clearly means you need to be careful in any stock that has previously been dragged up by this NASDAQ valuation vortex. It doesn’t matter how good a company they are, if this becomes a global tech and biotech/healthcare/momentum stock valuation correction, which I think it could, then as my old mentor Peter ‘Fish’ Whiting used to say “even the pretty girls get hurt in the bus crash”.

It doesn’t require negative earnings revision or any stock specific issue. It just requires acceptance from investors that they have paid too much for near-term growth and that in itself could see P/E’s drop two to five points in leading Australian technology, biotech/healthcare stocks/momentum stocks.

Without overcomplicating the issue, the Australian stocks that come to mind that are vulnerable to a valuation correction include, but are not limited to…

  •  REA Group (REA)
  • Seek ltd (SEK)
  • Domino Pizza Enterprises (DMP)
  • CarSales.Com (CRZ)
  • Xero Ltd (XRO)
  • Vocus Comms ltd (VOC)
  • TPG Telecom Ltd (TPM)
  • iiNet ltd (IIN)
  • CSL ltd (CSL)
  • ResMed Inc (RMD)
  • Ramsay Healthcare (RHC)
  • Sirtex Medical (SRX)
  • 21ST Century Fox (FOX)
  • Navitas (NVT)
  • G8 Education (GEM)
  • OzFoxex (OFX)
  • Vocation (VET)
  • Donaco (DNA)
  • James Hardie (JHX)
  • Magellan Financial Group (MFG)
  • BT Investment Management (BTT)
  • Platinum Asset Management (PTM)
  • Henderson Group (HGG)
  • Credit Corp Group (CCP)
  • Veda Group (VED)
  • ASX Ltd (ASX)

For tactical traders and hedge funds, shorting the list above via an OTC ETF equally weighted could work very well if I am right and a genuine valuation correction takes hold. For long only investors in these high-flying names, the simple question is should I take some profits and move to the sidelines for a little while? I think the answer to that question is absolutely yes.

Once some profits have been locked in in high flyers, I recommend rotating that money to ASX TOP 20 laggards that have clear valuation and yield support. Obviously I still like the big four banks, SUN, MQG, AMP, IAG, TLS and BHP to name a few mega cap stocks.

Today’s note is a continuation of the “tracks vs trains” view of Telstra from last week. For me, from this point I don’t want to be over-exposed to mid-cap high flying, highly valued momentum stocks, I want to be over-exposed to large caps with clear value and strong yield support.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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