Resources – So high it calls for an oxygen mask!
By Adrian Clayton
Regular readers of the Alphen Angle will know that we have written many times before on pockets of market mania, our observations go back as far as 1999 and have included IT bubbles, developed market bubbles, emerging market bubbles, undervalued rand scenarios being driven by a mania for offshore investments, small cap bubbles, preference share obsessions and now, for the latest, the commodity feeding frenzy – possibly not yet a bubble!
Many of these historic euphoric episodes, that in some cases evolved into bubbles, were identified by various market watchers. The most likely reason why they were noticed is that they all contained common characteristics and today we will reflect on some of these. What can usually be observed is:
Very powerful and accelerating price trends for “in-vogue” companies, sectors or asset classes.
Share or asset valuations that increasingly diverge from current reality and begin to rely more and more on future optimistic outcomes which are completely uncertain.
To understand this point, think back to the newly listed IT companies in the late 1990’s. These were companies with super confident yuppies boasting futuristic ideas and riddled with untested management teams that felt the world was their oyster. New age teachers tried to convince the market that technology would be the ultimate driver of economic activity in the future. For those buying such stocks at the high prices at the time, it demanded a blind faith in this “secular” thesis.
As it turned out, resource companies, the very part of the market that was shunned by asset managers and investors in the late 1990’s and regarded as “old world”, became the most important investment theme for portfolio managers as we entered the “new world” of emerging industrialization and hip “new age” IT stocks have been completely commoditized and were proven to be bum investments.
Managers that are not index huggers but utilize a fundamental investment research approach are made to look like idiots by trending markets.
At present we are seeing an enlarging group of dissident managers that refuse to partake in the latest commodity mania and, as was the case with Allan Gray and IT in the 1990’s, these managers are currently being marginalized. Time will surely tell if they will be right.
The concept of “risk” and the way it is defined in the industry is distorted during periods of market mania.
Unfortunately, this normal and logical understanding of risk no longer applies when markets trend, and instead risk is perceived as underperforming competitors that are willing to “go with the flow”, willing to take on huge risk irrespective of the consequences. One needs only look at which managers presently hold large resource exposures to see where the hot money is flowing. Asking such a manager to justify fundamentally why commodity exposure is held is most likely to be met with a response that little “bottom-up” justification can be offered, it is solely a top-down macro call. This is no different to a simple trend prediction!
Asset managers stop making calls based on research as they struggle to deal with waves of criticism that besiege their everyday activities.
New theories are birthed
A trending or euphoric market generally continues for much longer than expected, captures more capital than ever expected and bursts or implodes in a much more ferocious and damaging fashion than any of the trending-supporters could have predicted
Asset managers who capitulate are the ultimate losers.
This point rests on the fact that trends change as sentimentality shifts, but fundamental research usually leads to sound investment decisions.
In conclusion, the resource surge might or might not be a bubble. This we usually only establish after the event, and quite unpleasantly if it bursts. What is clear is that many market participants are ignoring most of the JSE and focusing their attention (and investment monies) into a handful of resource companies. This is an untenable situation and holistically such a microscopic interest at the expense of everything else usually ends in tears.
Source: Adrian Clayton, Alphen Asset Management, March 5, 2008.
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