It’s always easy to spot bubbles in asset prices after they have burst. Doing so beforehand is more challenging. However, global stock markets could be severely mispriced at the moment and there may be the potential for a bursting bubble in the medium term.
The main reason for this is a lack of concrete data to back-up the optimistic viewpoints of bullish investors. While the US, China and EU economies are performing relatively well, they are not yet offering significantly higher growth rates or substantially better outlooks than they were a few months ago. Rather, the share price gains seen in recent months have been due at least partly to increased optimism regarding the ECB’s QE policy, Trump’s spending plan and a soft Brexit.
Therefore, buying stocks with a low positive correlation to the wider economy could be a shrewd move. Better still, companies which offer a mix of defensive characteristics, strong growth prospects and low valuations could record relatively high total returns even if there is a bursting of the stock market bubble.
Higher optimism
This month, the VIX index reached its lowest level in five years. The VIX index measures volatility and is sometimes referred to as the ‘fear index’, since a higher level is associated with uncertainty regarding the future for the economy and/or share prices. The VIX index is a key method of assessing near-term expectations for the stock market and, while it is not fool-proof, it can be a useful means of interpreting the current mood of investors.
With the VIX index at a five-year low, the near-term outlook for shares may be viewed as positive. While this may be the case on the one hand, on the other hand investors may be overly optimistic regarding the potential for improving economic growth.
Misplaced optimism
Much of their optimism is centred on the prospects for an improving US economy under Donald Trump. At the time of writing, he is in the midst of cutting a deal regarding his spending and taxation plans. Although higher spending on infrastructure and defence coupled with low taxes may stimulate economic growth, there is no certainty he will be able to put in place all of the policies he campaigned on. They may be watered-down by Democrats and the impact of Trumponomics may be more limited than investors are currently pricing in.
As well as optimism in Donald Trump’s policies potentially being misplaced, investors seem to be overly bullish on Brexit. While a Conservative majority is the most likely outcome in the upcoming general election, it is not guaranteed. Even if Theresa May has a larger majority, she may not have a sufficient majority to push through a soft Brexit. Those on the right of the Conservative party may demand nothing less than a hard Brexit, which could lead to infighting and instability within government.
Hikma is investing heavily in improving its manufacturing facilities and its research capabilities.
Similarly, the ECB’s loose monetary policy may be aiding the European economy, but there is no guarantee this will continue. Problems associated with Brexit will not only be harmful for the UK, but also for the EU since it accounts for 53% of the UK’s imports. Expectations of a soft Brexit which sees the UK and EU economies move from strength-to-strength may be misplaced. Therefore, share prices could experience a correction over the medium term.
The right stocks
Even if the current value of stock markets across the globe proves to be a bubble, not all shares will be severely affected. Companies which have a low positive correlation to the wider economy could even see demand for their shares increase if the outlook for the UK, European, US and global economies deteriorates. They may be seen as a safer option for investors who snub cash and bonds due to higher inflation.
One company which could have investment appeal is Hikma Pharmaceuticals (LON:HIK). Its share price performance is likely to be far less sensitive to the ups and downs of the economic cycle than most FTSE 100 companies. Although it is focused on the development and production of generic treatments, demand for such products is likely to remain relatively robust even in challenging periods for the wider economy.
The right strategy
Hikma is investing heavily in improving its manufacturing facilities and its research capabilities. This is to help it achieve greater efficiency, which could boost margins and profitability. Its investment in research capabilities may allow it to achieve greater innovation, while a wider geographic reach may mean greater exposure to the rising demand for affordable medicines across the globe.
In fact, with the world’s population forecast to rise by 34% between now and 2050 and the proportion of people over the age of 65 expected to double over the same timeframe, the long-term outlook for generic healthcare companies such as Hikma may be very bright.
Since Hikma is forecast to increase EPS by 12% this year and 28% next year, it has a PEG ratio of 0.5. In my view, this indicates good value for money and does not suggest it is overvalued at a time when a number of share prices seem relatively overpriced.
Outlook
Global stock markets have enjoyed a prosperous recent past. The S&P 500, FTSE 100, CAC and other indices have reached record highs lately. While this in itself is not a cause for concern, the foundation of their rise has been optimism, rather than improving economic data. Evidence of this can be seen in the ‘fear index’ (or VIX) reaching its lowest level in five years.
Although stock markets are always influenced by investor sentiment, I believe the market is anticipating positive news which may not materialise. Trump’s pro-growth policies may be diluted so as to give a low-calorie version of Trumponomics, a larger Conservative majority may not improve the prospects for a soft Brexit due to infighting in the Conservative party, while a loose monetary policy may be insufficient to deliver growth if Brexit causes turbulence for the EU economy.
In such a scenario, a stock such as Hikma makes sense. It offers high growth potential at a relatively low price. It should benefit from a tailwind in the long run, produced from a rising and ageing global population. Its investment in R&D and efficiencies should create improving profitability which is less dependent upon the wider macro outlook than is the case for most of its index peers. Therefore, whether the bubble bursts or not, Hikma could be a relatively strong performer.