Are we heading for a market melt-up?

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It’s been a good year for markets, following an exceptionally strong start calendar year to date.

As we look towards the second half of the year, there is a natural tendency to think a pull-back is on the horizon, particularly following a period of strong returns.

However, with dramatic shifts in policy and positioning – not least the unexpected result of the federal election in Australia – a more pertinent question might be: are the ingredients in place for a market melt-up?

A melt-up is generally associated with the late-cycle, or final “optimism”, phase of the market before the next correction.

Given this has already been a very long bull market by historical standards, and with the current price and valuations high, it’s certainly something to be aware of. But are we there yet?

Melt-up warning signs

Some of the signs for a late-cycle surge to look out for include:

1. Price acceleration

Market experts often cite price acceleration as the strongest indicator of late-cycle behaviour. Looking at the ASX300 over the last few months, price momentum has clearly accelerated with the ASX300 Accumulation Index up 15.6 percent the last five months.

2. Increasing concentration

During the last phase of a cycle, investors often focus on buying “winners” rather than looking for long-term value.  This results in money concentrating in a smaller number of stocks while the broader market does not perform as well.  We are arguably seeing this in the flight to the ASX 300 IT “WAAAX” stocks (Wisetech, Altium, Afterpay, Appen and Xero) which are up an average of 65 percent since the start of the year, and up an average of 104 percent in the last 12 months.

3. Quality and low beta outperformance

Another sign is the outperformance of quality and low beta stocks in a rapidly rising market. We also call it the FOMO (fear of missing out) effect, where the market keeps going up and investors feel compelled to keep participating for fear of missing out on returns. There are some stocks trading at all-time highs that would definitely fit this bill.

4. Other asset classes looking “bubbly”

Despite the recent correction, residential property values continue to remain elevated and arguably “bubbly” versus history. In addition, it’s possible that the election result and any further easing in financial conditions could encourage investors back in to the market, adding to bubbly conditions.

5. Extreme expensiveness

Overall, the valuation of the ASX 200 doesn’t look too stretched on a historical basis, but dispersion has increased and some areas are screening extremely expensive. Small caps and quality stock remain most stretched.

However, while overvaluation plays a role in bubbles popping, it isn’t a precondition and doesn’t help in predicting the timing, or size, of an impending downturn.

6. “Touchy feely” measures

They may be harder to call, but often the real indicators of market excess that are the hallmarks of a melt-up are touchy feely measures.

There are a few potential warning signs here, including the media focus on hero and WAAAX stocks – their raising capital because they can rather than for any specific purpose, the wide-open IPO window, and the increased vindictiveness to the bears for costing investors’ money.

Time for concern?

While many of these indicators appear to be in place, we continue to believe that there are not enough signs of euphoria present to call the end of the current bull market just yet.

We also believe that the reassertion of dovish monetary policy at the US Federal Reserve, and without interest rates tightening much, risks of a cyclical slowdown and imminent recession are lower.

It is vital to remember that this has been anything but a conventional cycle and the typical phasing has been distorted by extreme monetary policy.

It has been a long cycle characterised by low growth, below-trend inflation, low interest rates (and risk premium) and high valuations. This adds weight to our view that overpricing and valuation are unlikely to be lead indicators this cycle. Rather the “touchy feely” measures will potentially be better triggers – and we are not there yet.

Furthermore, trying to time the market top and exiting too early will see investors miss participating in this up phase of the market. History has shown that it is more useful to recognise the start of a bear market than it is to identify the peak of a bull market.

There is certainly danger in being late, as market declines are typically faster than advances, but historically, being late has not been materially different in time and pain than being too early.

Hamish Tadgell is a portfolio manager with SG Hiscock & Company.

The original article was published in InvestorDaily Analysis: