By Michael McCarthy

Global share markets are testing investors’ nerves. The German DAX and the US S&P 500 are at record highs. The Nikkei and the Australia 200 index are at post-GFC highs. Markets have clear positive momentum. Yet, event risks over the remainder of the year are high, and valuations are stretched. Buy, sell or hold?

Investors can draw comfort from data this year which shows European expansion, an upswing in the US and stabilising growth in China. The better outlook reduces the potential for a market meltdown.

However, there is an argument that current share market levels are reflecting an “as good as it gets” scenario. Among other factors, if the White House can’t deliver its stimulatory measures, if the European economy stalls, if the upswing in growth data doesn’t flow through to wages, there is potential for substantial corrections.

If a global fall of 10-20% is on the cards, how will local stocks fare? The short answer is badly. More experienced investors can take advantage of the historically low levels of volatility and use derivatives to cover downside risks. Other investors face selling down stocks to reduce any impact of a market stumble.

Which stocks will suffer most in a downturn?

In a low growth environment, companies that grow profits at levels well above the systemic rate command a premium. Think Domino’s Pizza, Sydney Airport and Bega Cheese. The reasons vary, but the share price premium is reflected in the P/E. Ratios in the 30x to 45x range are common.

Healthcare as a sector falls into this category. Leaders such as CSL, Cochlear and Fisher and Paykel have PEs in the 30x-40x range. Ramsay and Resmed are trading at around 25x earnings. The demographic theme of an aging population requiring increasing health services in a sector where the government pays the bills is an attractive investment proposition. The PE premium attached to the sector reflects investors paying up for assured growth and income.

The problem is the crowding into these exposures. The investment themes are well known, and the PE premiums demonstrate the popularity of these stocks. These elevated valuations could be harbingers of underperformance in a market sell-down. Not only are they caught with most other shares in any downdraft, they may suffer a larger P/E contraction than the broad market, meaning a greater fall in percentage terms. This is how market darlings become fallen angels.

The nature of the pullback

The nature of the pullback is an important consideration. A short sharp sell-off that sees investors bargain hunting fairly quickly would most likely see these premium stocks continue to trade at higher multiples than the broad market. However, a gut-roiling market panic could see investors selling what they can. In this sort of sell down, premiums tend towards defensive earnings (Woolworths, anyone?) and away from growth.

In my view, any stock market correction is more likely a healthy pullback than a crisis. Regardless, a broad market fall of 10-20% could see some stocks and sectors drop further. Reliable income streams could be more highly valued than projected growth rates. Investors may wish to examine portfolios for vulnerabilities before any serious selling starts.

In the past eighteen months, share market rewards went to stock pickers and active investors. Willingness to take advantage of market swings in both directions has been an important value creator. For this reason, investors should welcome a pull back as an opportunity to generate excess returns. As the chart shows, a pullback for the Australian share market may be very close: