Since September last year, certain equity sectors have experienced something of an asset price bubbl...
Since September last year, certain equity sectors have experienced something of an asset price bubble. Although relatively rare, such phenomena have been a recurring feature throughout economic history.
The technology and telecommunications sectors have risen strongly, a crucially important driver being the performance of Nasdaq. In the beginning, this rally was based on a fundamental reappraisal of relative growth rates, and occurred in markets worldwide. Spurred on by the excitement surrounding the commercial opportunities of the internet, investors rapidly drove up the share prices of companies that were in any way related to the internet.
In the excitement, share prices rapidly lost touch with fundamental justification: valuation judgements became increasingly irrelevant, with momentum and sentiment becoming all powerful. In short, precisely the characteristics of an asset price bubble.
In the UK, this liquidity influence has been dramatically exaggerated by the Vodafone acquisition of Mannesman and the share issue which accompanied this bid has doubled the market weight of Vodafone, which now accounts for around 13% of the FTSE All-Share index.
The rebalancing of both passive index tracking funds, and the many other 'managed' funds that have become effectively closet index trackers, has further distorted the relative performance of shares in the UK equity market. Vodafone purchases have been funded by sales of stocks in all areas of the market outside the TMT sectors, creating a bear market environment for the least favoured sectors. In many cases, leading FTSE 100 and 250 companies have seen share prices halve in a 12-week period.
Valuation judgements are based on an appraisal of a company's expected cash flows and a comparison of these discounted cash flows with the share price. On this basis, it is difficult to identify attractive investment opportunities within the TMT sectors.
However, when this analysis is applied to many other sectors it reveals extreme undervaluations. Indiscriminate selling of these sectors has created unprecedented investment opp-ortunities. It is likely that the coming months will see a succession of cash bids in these areas (such as the recent offer by Royal London for United Assurance).
Momentum buying may continue to sustain these sectors for some time yet but, ultimately, investment fundamentals will reassert themselves. Improved sentiment on interest rates will help the fundamental background for economically sensitive sectors in the UK but the principal influence on TMT sectors remains the performance of NASDAQ. Until this index begins to unwind its performance relative to the rest of Wall Street, it is unlikely that global TMT sectors will crumble.
Neil Woodford is head of income funds at Perpetual
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