10 years ago The Daily Reckoning launched in Australia. We had one mission: to give you an alternative analysis of the finance news and to give you alternative strategies to profit and protect your wealth.
The underlying philosophy of The Daily Reckoning has been and always will be this: ideas matter.
Recently, I sat down with DR Managing Editor Dan Denning to discuss on very important idea for Australian investors: that the economy is in deep trouble.
Callum Newman: You finished yesterday suggesting Australians will face structurally higher unemployment. That sounds grim for the economy. But what about the share market and the Aussie dollar and the government’s budget position?
Dan Denning: The dollar is easy. It ought to fall. I say that on the basis of what would be good for manufacturing companies. Their products would get cheaper overseas. But it would mean imports are more expensive.
That’s bad for consumers and by extension bad for retailers. Based on the fundamentals that were supporting the dollar in the last ten years, you’d think it would be a lot lower than it is. But it’s been supported by a lot of money coming into the country to speculate in the real estate market.
It’s important to point out, though, that the biggest factor on the dollar now is capital flows. It isn’t interest rates. It isn’t GDP growth. And it isn’t the government’s deficit or surplus (if we ever run one of those again). That’s the big wild card.
Anecdotally, I live in St Kilda and take the tram to work closer to the CBD, in Albert Park. A lot of the long-term stay hotels seem to be filled with Chinese tourists. And a lot of the new apartment buildings going up in the capital cities seem to have owners from overseas.
There is not a lot of exact statistical measurement of just how much money is coming in to Australia’s inner capital city real estate market. I think that’s by design, by the way.
I’m not sure the state governments, who love the stamp duty from rising house prices, want Australian citizens to know just how much money is coming up and driving up prices. But as I said, it’s hard to quantify what influence China’s middle class is going to have on Australia’s property market or on the tourism industry.
In basic economic ways, it could be a huge long-term benefit. But in social ways, like younger Australians not being able to get on the property ladder, it’s going to be more challenging. Either way, that’s the big wildcard for the dollar.
CN: And the government?
DD: As for the government, that’s a whole other story. But the short version is that spending will go up and revenues will go down. Expect bigger deficits forever from now on. That may put pressure on interest rates and the credit rating in the future. In turn that would affect how much banks pay to borrow money overseas. So you might see a slowdown in housing lending as interest rates rise.
CN: And the share market?
DD: Well, I can’t say I’m feeling great about the miners and the banks. Those are not growth businesses any more. But they’re priced that way. A lot depends on China. It could keep the price of commodities high for a while.
That would keep the valuations on mining shares high too. But my worry is that Australian investors—the ones who are in a default so-called ‘balanced’ super fund have way too much exposure to the miners and banks. In fact, they have way too much exposure to the Aussie market in general. It’s a huge risk. And they’re missing some big opportunities as well.
CN: Well let’s talk about the risks first. If there were one thing you would tell investors to watch out for, some kind of indicator that there was trouble ahead, what would it be?
DD: That one’s easy: the spot iron ore price per tonne. If it stays below $100 it will be trouble for the junior and mid-tier miners. They generally have higher- cost and/or lower-grade ore bodies. They need a high iron ore price to stay in business. BHP Billiton and Rio Tinto will be fine even at much lower prices. But the smaller companies, especially ones with a lot of debt, will have real trouble.
CN: That’s just one small sector though. Why would the iron ore price be a relevant indicator for the whole Australian economy?
DD: Yeah that’s a fair question. It IS just one price. But it’s also a proxy for what’s going on in China’s ‘Shadow Banking System.’ That’s the part of China’s economy where businesses get credit in unconventional ways because they can’t get it in traditional ways, from the banks. There are a lot of ways this works.
But one of the more popular ways is to use a stockpile of raw commodities as collateral for a loan. Copper is one of the more popular commodities to obtain financing in the ‘Shadow Banking System.’ But so is iron ore. The trouble is, the central government in Beijing is trying to crack down on the ‘shadow banking system.’
The government believes it’s causing a lot of extra risk taking and creating a bubble in the real estate market. You watch the iron ore price to see how serious the government is about reigning in credit growth.
If it’s serious, not only will the iron ore price fall, but it may also mean that China’s economy is going to grow more slowly. And that’s the thing that will have implications for the whole Aussie share market. And it will also have implications for capital flows into Australia, which obviously has an effect on the Aussie dollar.
CN: Okay. Well it sounds like there’s a lot more we could talk about. But let’s get to the part that I’m sure investors are most interested in. What should investors do? What are you telling your readers to do? You’ve painted a pretty grim picture. But people need practical advice. And in plain English. What are you recommending?
DD: Well I can’t tell you specifically what I’m recommending to my readers right now. But I can tell you that I AM regularly recommending new investment ideas each month in my newsletter. I think it’s also safe to give an overview of the strategy. It comes down to three steps: the big picture, exceptional trends, and speculation. Everything I recommend—and I think right now I have around 20 recommendations—falls into one of those three categories.
CN: Can you explain what they are and how they’re supposed to help Aussie investors?
DD: Of course. The first one is really the most important. I say ‘big picture.’ But what I mean, in financial terms, is asset allocation. And if I had to put that in simple terms: when it’s a bull market in stocks, you buy stocks.
When it’s a bear market in stocks, you don’t buy stocks. And if you choose to do so, you buy very few and very carefully. I base this on research that shows individual stock selection has almost nothing to do with your total investment returns. The biggest single factor to making money as an investor is buying the right asset class.
By asset class I mean big, broad categories like shares, property, bonds, or precious metals. If you’re in the right asset class while it’s in a bull market, you’re chance of making money are vastly improved. But you could be the world’s best investor and you’d still probably lose money if you were buying stock in a bear market.
CN: So which are we in, a bear market or a bull market?
DD: Me and a few of the colleagues I work with believe the US entered a secular bear market in 2000. Australia’s secular bear market—and by secular I mean a long-term bear market over many years—began a bit later, in 2007.
China helped us ride things out when the subprime mortgage bubble blew up in the US. But the downside of that now is that it could be many years before Aussie stocks—as measured by the ASX/200 make new highs. Even now, seven years after the GFC, stocks are still down 20% from their all- time high.
CN: But you yourself mentioned that the Dow Jones Industrials and the S&P 500 are making new all- time highs in the US. How can that be consistent with a bearish forecast?
DD: The US market is heavily influenced by the quantitative easing (QE) program of the US Federal Reserve. And in any case, I’d say what happens in China has a much greater impact on Aussie stock prices than what happens in the US.
It’s no coincidence that China’s benchmark stock index, is still down almost 65% from its 2008 high and Aussie stocks haven’t made a new high either. If China breaks out, our market may follow. But my main point is that you don’t tend to make a lot of money buying stocks when it’s a bear market. The various QE programs in the US, or similar policies in Japan and Europe have made things a lot better for investors for the last five years.
But in my view they’ve masked the real problem that, except for some of the emerging markets, there’s not a lot of real economic growth in the world and there’s still a lot of debt in Europe and America. So my whole investment strategy begins with the observation that it’s a bear market and you should not have all or even most of your wealth at risk in stocks. It’s just too dangerous. Let’s not forget that Aussie stocks fell over 50% in the GFC.
That was over five years ago. A lot of people are five years closer to retirement now and can’t afford taking a big blow like that to their retirement funds. The big picture tells me not to risk a lot of money in stocks because it’s the wrong asset class to be in right now.
CN: But obviously you do recommend stocks. So there must be a part of your portfolio where you think the risk justifies investing in the market?
DD: Well, I get paid to give my best investment ideas. That’s what I do. And it’s important to remember that none of us can predict the future. Modesty is one of the most under-appreciated qualities in investing.
You have to remember that you could be wrong. That means you have to manage the risk of being wrong. And that means you have to hedge against being wrong by having some positions or recommendations that could profit if you are wrong. On that basis, the second thing I look for is what I call an ‘exceptional trend.’
It’s something going in on the real world or the economy that’s creating real earnings for real businesses, no matter what’s going on in the stock market. That’s why it’s an ‘exception.’
For me, the main one right now is ‘energy.’ I have at least six oil, gas, and energy stock recommendations. Some are based here in Australia. Some are global companies with world-class technologies that make them very hard to compete with in oil services, especially off-shore. This is just a basic observation.
No matter what the rate of global growth is, the world needs energy to run on. There is a lot of excitement about green energy. But for industrial economies and big cities, it’s still oil and gas and will be for many years to come.
That’s why I think these stocks can succeed even if the general market goes into a period of deflation with low credit growth. And three of them are listed on the ASX. They’re chasing the same of kind of ‘shale gas’ that’s been a big breakthrough in the States. If they can make that breakthrough, then the gains from just one of those shares could justify the whole risk to begin with.
CN: Two things. How big are the possible gains and isn’t shale gas terrible?
DD: On the first question, we’re already up triple digits on two of the recommendations. What these companies are doing is proving that the same technology that worked in the States can work here. They’re not aiming to become producers. It’s more like ‘proof of concept.’
If they can prove it, then one possible exit strategy is a buy out or takeover. That doesn’t have to be the only exit though. These small companies are also finding and producing a lot more oil than they expected. They can sell the oil for cash and use the cash to fund further exploration. And that’s exploration for shale gas and oil.
CN: And the second question?
DD: Is shale gas terrible?
CN: That’s the one.
DD: Is energy independence terrible? Is not having to buy oil and refined fuels and import them terrible? That’s one thing you should watch for, by the way, now that Australia’s closing more of its oil refineries. Importing more refined fuels is going to affect the trade deficit. But with respect to whether shale gas is terrible, the answer is ‘of course not.’
I don’t have anything against people who are against fossil fuels because they want more renewable energy. But there’s a small portion of the community here in Australia that’s mounted a massive disinformation campaign about shale gas, as if it were going to destroy the water table, ruin farmland, and poison communities.
That is all just complete and utter junk and nonsense from people who want the world to go back to a 19th century energy lifestyle. They really do want to put all oil and gas companies out of business, and coal too. Hundreds of thousands of oil and gas wells have been drilled using the methods over in the US. It’s not new.
And like any extraction process, doing it safely is a matter of doing it correctly. If Australians don’t want shale gas, that’s fine of course. But the campaign against it is really a bunch of hype by activists who oppose it on ideological grounds, not environmental grounds, in my view.
CN: Let’s leave it at that. You mentioned that some of your recommendations fall in a third category, speculation. What’s that about?
DD: The first two categories are designed to protect you from the bear market and align you with powerful, long-term trends. But really, every investor should know that if you’re going to be in this market—with all the intervention and unpredictability—you’re more of a speculator.
And that’s fine, as long as you know that what you’re doing is making bets on the direction of share prices (instead of valuing securities). But what I try to do with the third category of recommendations is attach a specific recommendation to a big picture idea. You take a look at the world, observe something specific going on, and then see if you can find a way to profit from it.
CN: Can you give an example?
DD: Sure. We talked earlier about household debt, the trade deficit, and a falling dollar. As an investor, all of those things have consequences. If interest rates go up and the dollar goes down, then imports are going to be really expensive for Australians.
Of course, that may not happen. But what you want to try and do—if you’re coming at markets from a macro-economic point of view—is figure out what businesses are either negatively or positively affected by a given scenario.
In this case, a weaker dollar and higher interest rates would be a real blow for most retail stocks. But not all! There are certain businesses that sell things on what economists call a ‘non-discretionary’ basis.
These are things you buy—like toothpaste, groceries, and cleaning supplies—no matter what the economy is doing. In other words, there are certain types of businesses who will be less affected by high household debt levels and higher import prices. I picked a specific investment which is a basket of just those types of businesses. It’s an exchange-traded-fund (ETF) that you can buy like a single stock. If I’m right about the economic trend, the ETF should go up over time.
CN: How much?
DD: Well I don’t know that. But obviously I wouldn’t have picked it if I didn’t think it could do much better than the market over the course of the year. So, if the market averages 7-8% per year, I’d want a stock like that to at least double the market to be worth your time.
CN: Do you have another example?
DD: I have many! But I’ll give you two more. Remember, it’s the same process behind each recommendation. You observe the world. You question everything. You consult your knowledge of history. You look at data. You try to be as sceptical and realistic as you can. And then you find an idea and see if there’s a single investment that goes with it. For example take the fact that Australia just committed to spending around $20 billion on new military purchases this year.
The government will spend at least $4 billion for new long-range unmanned drones to patrol the coast. It’s spending another $8 billion on patrol planes to hunt submarines. And it’s spending at least $12 billion on the Joint Strike Fighter (JSF), which is supposed to be a 5th generation fighter plane, which basically means it’s a stealth computer with lots of long-range weapons. I looked at all that and noticed that there is a huge military build-up in South East Asia.
Mind you, the United States spends more on its military than the next ten nations combined, and that includes China—which is now spending more on defence as a percentage of its GDP than any other country in the region. You basically have countries like Japan, Australia, and Singapore—which are all US allies—worried about China’s growing economic and military power.
I looked at that and noticed all the planes, ships, and tanks, were being built by mostly US companies. There’s another ETF that’s made up of those companies. You can buy the biggest defence companies in the world in one stock. And since 2000, that ETF has outperformed the S&P 500. I recommended it to my readers.
CN: But does that mean it’s hard for Australians to buy, if it’s in the US?
DD: It’s harder to buy, probably. But not hard. Most big brokers in Australia should allow you to buy US or foreign-listed stocks. You may pay more in commissions. But I encourage every investor to at least check the cost out. The truth is that if you’re only invested in Australian stocks you have what’s called ‘home country’ bias.
You’re at risk to the things which affect your country and your economy. That’s especially true in Australia because the banks and the miners make up over 60% of the ASX/200. When you buy an index fund here, you’re getting two big industries and a lot of smaller ones. The way to deal with that risk is to diversify your portfolio a bit and own some foreign stocks. You also have risks with those stocks, of course, especially currency risk. But for me, if the opportunity is compelling enough, you find a way to make it happen.
CN: And the last example of a speculation?
DD: Right. For as bearish as I am, I’m also prepared for the possibility that I’m wrong. Maybe this market could go much higher for many years. Many of my colleagues believe just that. If I’m wrong, I want at least one or two recommendations that will go up instead of down.
I actually have two at the moment, if I recall. One is just an Aussie market index ETF that tracks the ASX/200. The other, though, is an Emerging Markets ETF. And that’s really a bet that China may scrape by its big credit troubles and keep on booming. There is more to it than that. But I think my main point with speculations is that nearly any idea you find interesting can be attached to an investment speculation.
That doesn’t mean you speculate on any old idea you have. But if you research the idea, find the underlying trend—even if it seems crazy to other people—then you can go for it. In fact, I’d say the more crazy an idea seems to other people, the more closely I’ll look at it.
DD: The craziest ideas are usually the most mispriced. That means you can buy really good assets at a cheap price, because no one else wants them. And I don’t mean crazy, really. I mean you have to be willing to embrace investment scenarios that other people consider unlikely or impossible. It’s because other people won’t touch them that you can usually buy these things cheaply.
But more importantly, the conventional wisdom is often wrong in investment markets. People think in herds. Individual investors buy high and sell low. People do this because they’re embarrassed to take a position that nobody else holds. It’s lonely. You risk looking like a fool to your family and friends. And you could be wrong.
But my experience has shown me that if your research and thinking leads you to a conclusion, you should embrace that conclusion regardless of whether anyone shares your view. More often than not, history will break your way and those people will come around to your point of view. But by then, it will be too late for them to avoided the risks you saw or take advantage of the opportunities you’ve identified.
CN: Interesting. You’ll have to tell us more about that next time.
DD: With pleasure!
for The Daily Reckoning Australia