So the S&P/ASX 200 Index (ASX: XJO) is just hitting record highs after record highs this month.
When the market is this inflated, there are many corners of the market that are just one catalyst away from a correction.
Yarra Capital Management head of Australian equities Dion Hershan therefore warned that there are traps everywhere to avoid.
“With the market at ~7,600 – up a stunning 67% (excluding dividends) from the nadir in March 2020 – it’s pretty clear that complacency is creeping in,” he said on the company blog.
“Complacency is observable in so many ways… We are in a glass half full (arguably of Red Bull) environment where everything is perceived as ‘good news’. Inflation is viewed one day as a sign of a strengthening economy, and the following day the lack of inflation is seen as a catalyst for more QE [quantitative easing].”
Hershan is especially finding the lack of volatility “unnerving” — almost like the calm before a massive storm.
“With the economy and the consumer in good shape, it’s difficult to make the case for a collapse or even a major correction,” he said.
“Clearly, though, there are headwinds emerging for markets. These include inflation, interest rates, stretched valuations and fading levels of government support.”
Emphasising that his team is “selective” rather than “bearish“, he pointed out 7 traps to avoid getting severely burnt when the market’s optimism bursts.
Buying mining ASX shares just for dividends
Sounds too good to be true?
“With iron ore prices roughly three-times the 10-year average, mining companies are like ATMs at present,” said Hershan.
“But as iron ore goes from US$200/tonne (vs <US$45 to produce, including freight and royalties, etc) to a long-term average around US$65, dividends could fall by 33% from current levels.”
Valuing ASX shares based on today’s interest rates
Hershan reckons valuations seem to be forgotten these days, citing how the ASX 200 top quartile has gone from a price-to-earnings ratio of 28 times to 44 times forward earnings.
“With momentum feeding upon itself, this period may well prove to be the exception to a long-standing norm. If/when the wind changes, that top quartile of the market is likely the most vulnerable.”
And don’t forget that interest rates are at all-time lows. It’s likely to move in only one direction from here.
“Additionally, while almost everything looks cheap when interest rates are close to zero and investors are using 2-3% discount rates, it clearly won’t always be this way,” he said.
“Valuations for a range of companies simply won’t stack up when rates begin to move higher.”
Generalising what happened in 2020
Because it only just happened and is fresh in everyone’s minds, investors could forget one important fact.
Last year was not normal, and is very unlikely to repeat.
“For so many reasons, 2020 wasn’t a year that was in any way representative,” said Hershan.
“Toll road traffic declines of up to 80% and supermarkets growing sales at >10% shouldn’t be extrapolated.”
Ignore China at your peril
Yes, you’re investing in ASX shares. But the way the world’s second largest economy behaves will have a bearing.
“There were clear signs of overheating in China in 1H21, with recent directives to cut steel production, curtail property price growth, tighten credit, curtail speculation in commodities and cut emissions,” said Hershan.
“These factors are an ominous lead indicator for commodity prices, which are largely being ignored.”
The latest hyped ASX IPOs
Beware of “shiny and new” initial public offerings, warned Hershan.
“IPO candidates are invariably spruced up and over-hyped, with investors forced to make quick decisions based on limited information and rationed access to management,” he said.
“While IPOs can represent compelling opportunities, they are one of the most asymmetric aspects of public markets.”
While not naming any names, Hershan reminded investors that there were more than a few “high-profile IPO duds” in recent times.
Speculative buy hoping for an acquisition
Don’t do it, warned Hershan.
“That’s like long-range weather forecasting: you might get one right but it’s probably more luck than genius,” he said.
“You need to buy businesses on fundamentals. It’s dangerous to assume there is a ‘greater fool’ who will buy out a weak business at a large premium.”
Unyielding loyalty to benchmarks
No matter how far you think Australia’s economy has come, the ASX 200 remains a homogeneous group.
“The ASX 200 is narrow — at this point 4 banks and the 3 iron ore miners are 61% of aggregate earnings,” said Hershan.
“Both groups rely very heavily on unsustainable factors, with iron ore prices 3-times normal and bad debts at their lowest levels on record.”
He emphasised how imperative it is to go past these behemoths that dominate the index.
“It’s critical to look beyond the majors and be able to tactically shift where required.”