The ASX200 saw it's best February in history. Gaining over 8%, the index has almost reached that psychological 6,000 mark that many are fixated on. So i beg to question whether the market's valuations are stretched and if so, is it detrimental to our capital?
The ASX200 is trading at slightly above 16 times earnings, which is well above it's long-run average of about 14-14.5. While most question the extent of the P/E ratios validity, i believe it is telling us something (whether it's to act or to keep an eye out). As the P/E ratio continues to expand, it's important to take note of what is going on in the economy in order to help us determine if our capital is at serious long-term risk.
Petrol prices halved in February before rebounding slightly, interest rates are at record lows, the $A is also at low levels but the most recent reporting season erred towards the negative side. Given the benefits of the first three points are more likely to impact on the next reporting seasons, (and the ones going forward if they continue to decline) it must still be taken into account. One industry that recently saw a small surge was retail which might be a sign that the benefits are flowing through. However, given the importance of business investment which are at record lows for various reasons such as political ambiguity has resulted in lower confidence for these firms. These mixed factors may or may not justify sky high valuations, but it's hard to tell which is more prevalent. Given that markets can remain elevated for long periods of time, (longer than you can remain solvent to rephrase Kaynes) corrections may come, but may take a while. This also doesn't mean that our capital is at serious long-term risk, if you're investment horizon is, say, 10 years.
As some acclaim, the stock market is a leading indicator of the economy, (I don't totally subscribe to this view) this suggests that the near future should be bright. However, this may not be the case. It's interesting to see that the average hedge fund now has approximately 30% of their money in cash. This is up from the same time last year. More and more of the "smart money" is moving into the safety of cash. As Buffett says, cash is never a good investment, however cash may be used as a "parking vehicle" which is what i believe is happening. Some managers are moving to cash as value is becoming increasingly scarce. When value becomes more transparent, they're likely to buy back in.
The most recent reporting season saw some surprises on both the upside and downside. Some stocks have recently been bid up significantly, such as Domino's Pizza (ASX: DMP) and Sirtex (ASX:SRX). While i won't comment on whether this is justified or not, i will be locking in some of my profits for Sirtex shortly. This is not because I've lost confidence, but because i believe it's prudent to do so. On another note, despite potentially stretched valuations, i believe in the smaller end of town, there's still some there. In light of that, and some recent research I've undertaken on a particular company, i will also be going long on a stock. This company, which i have mentioned in the past, has grown from strength to strength (despite the fundamentals going through a relatively tough time recently) and dominates it's local market. I believe it has a strong competitive advantage and is priced reasonably.
To answer the heading's question, it's imperative to stick to facts and not necessarily follow the crowd. While it's hard to tell what will happen in the future (impossible, in fact) the benefit of hindsight will prove who was right and who was wrong. Whatever happens, always fall back to the fact that price and value may not be in tandem with one another. You need to assess this and act accordingly. Moreover, you must resist the temptation to become emotionally attached despite what others say or do.
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