Some investors had a scare from last Wednesday’s 88-point fall on the ASX and are now wondering if the ASX is overvalued and poised for a deeper fall. It’s a pertinent question given the forward price-earnings ratio on the ASX 200 has risen from ~10 times earnings to 16 times earnings over the last six years. Sixteen times has been something of a ceiling for the multiple over the last 16 years:

Source: StocksInValue, Thomson Reuters
As always in investing, the right approach to any disappointing macro event or bout of volatility is not to freeze with fear but instead to understand the event/trend and position the portfolio to benefit accordingly. This time the catalyst was a negative offshore lead from Wall Street, which sold off on concern delays to the passage of US President Trump’s healthcare reforms meant the President’s tax cuts could also be delayed. Hope tax cuts would stimulate the US economy and boost corporate earnings was a major theme in the Trump Trade rally since the 8 November election. Our view is a negotiated healthcare package will soon pass Congress but investors should proceed on the basis of no fiscal stimulus from Trump in 2017. Instead investors should extrapolate the pre-Trump improvement in US economic conditions and expect the Federal Reserve will in 2018 offset moderate fiscal stimulus with a higher Fed Funds Rate.
The market is more expensive than it was and is therefore susceptible to disappointments like Wednesday’s lead. The way to manage the risk of a correction is to have a higher cash weighting in the portfolio. Our model portfolio’s cash weighting dipped as low as eight per cent after last year’s Brexit shock, when we aggressively bought equities, and currently stands at 18 per cent. In the absence of further hedges like put options or negatively leveraged ETFs, a portfolio’s cash weighting represents the manager’s overall view on the amount of risk and opportunity in the market.
For us 18 per cent is elevated but it isn’t 30 per cent, 40 per cent or 50 per cent, our benchmark for ‘crash funds’. We think equity markets will be underpinned this year by improving world growth, moderate consumer price reflation, Chinese stimulus and, in Australia, expectations of a pickup in domestic corporate earnings in 2018 as the better world scene eventually translates to higher consumer spending and business investment here.
In a fully priced market investors should prefer quality companies bought at discounts to conservative valuations. Investors also need a rational model for valuing stocks away from the sharemarket, which is afflicted by speculation, emotion, shorting and manipulation by hedge funds. Using this method we continue to find selective opportunities amongst large, medium and small companies. In recent weeks our model portfolio has bought positions in Ramsay Health Care, RCG Corporation, Gateway Lifestyle and Veris. We also hold and see value in APN Outdoor, IPH, CSL, Automotive Holdings Group, Collins Foods, ANZ, National Australia Bank, Crown and Qube. And we have enough cash to buy more of these stocks if the market does correct.
Originally published in The Australian, Tuesday 28 March 2017.