The Dow fell at the opening bell and stayed there. Confusion reigns supreme. What’s the Fed doing? Is China going to recover? It appears investors are Fed up with uncertainty.
Get used to it.
A sustained contraction in the global economy isn’t in the script. We’ve all been conditioned to believe trees can grow to the sky and beyond. Growth will just happen…on the small proviso we keep borrowing at least 8–10 trillion dollars each year. Just a minor detail.
This morning our new Treasurer is flagging tax cuts. Fantastic. Less revenue at a time when welfare and healthcare costs are growing to the sky.
But wait, former Treasury Secretary Ken Henry says we have to increase the GST. Remember, Ken Henry was the Treasury bureaucrat that oversaw Wayne Swan’s $300 billion spend-a-thon.
Which is it? Tax cuts or tax increases? Maybe we’ll get both? My guess is on the latter…a typical Government magic act. Giveth with one hand and take it back with two hands.
Then again I could be wrong.
Is your view WRONG!!
This was the heading of an email I received recently from a subscriber to The Gowdie Letter.
When I saw the heading ended with WRONG followed by a double exclamation mark (rather than a question mark), I knew there was going to be some emotion behind this email.
The short answer: possibly, maybe, could be, I don’t know. But before I give you a slightly longer answer, here’s the email:
‘It seems that Shane Oliver is not agreeing with you.
‘He has graphs and figures to prove his view which is contrary to yours.
‘……….and I have just sold 50% of my portfolio based on your views and moved a large portion of equities to cash.
‘The view is the market has oversold and China has plenty of cash to prop up China’s economy in the short to medium term.
‘What is your view on this as timing is everything.’
The reason for the double exclamation marks is apparent…RA has a case of seller’s remorse.
Also included in the email was a reply from RA’s financial planner as to whether RA could obtain a guarantee on his investments:
‘As mentioned in a previous email. I am afraid we cannot provide guarantees on any investments. The best “guarantee” we can offer is a Guaranteed investment product/option which is very expensive and does not 100% guarantee until after 10 years.
‘I appreciate your and Vern’s views below. My understanding is that Vern always takes a contrarian view of things. His views have always been on a negative basis. Doubt this will be the last time that we see a similar view. In saying this I have no issue with taking the views of all before providing an opinion. I know through strong debate this is how our investment committee undertake our portfolio construction.
‘As an example I have provided the views of Shane Oliver (see his recent “insights” documents attached). A very trusted economist that a lot of people look up to. I am not saying that he will be correct in all views but as an example of a differing opinion.
‘My views are still the same as previous discussions. With the banks increasing their capital ratios this only provides a stronger platform for the hybrids.
Personally I prefer to see myself as cautious rather than negative. But I respect that my views are open to interpretation and opinion. However, to balance up my perceived negativity, here’s a quote from Shane Oliver’s 2008 outlook, published on 31 December 2007 (with my emphasis):
‘While the Australian share market is likely to be volatile in the first half of the year in response to US worries and Chinese tightening, the trend is likely to remain up. The ASX 200 share index is likely to rise to around 7300 by the end of 2008 thanks to combination of reasonable valuations, okay profit growth and solid fund inflows.’
The ASX 200 finished 2008 at 3700 points — around half the level that was predicted.
At the end of 2007, the ASX 200 was at 6300 points. Therefore, Mr Oliver was predicting a rise of 1000 points in 2008. This equates to a 16% increase…compared to the market’s long term growth of around 6% per annum. If I’m negative, Mr Oliver is positively positive.
The investment industry (as a whole) never and I repeat, never see the market having a bad year.
The reason is simple: the investment industry collect fees from products that they sell. The vast majority of those products have varying degrees of share market exposure (local and/or international). The investment industry’s share market glass is always more than half full.
Imagine it’s June 1929 and an institutional economist goes to his or her institutional paymasters and says; ‘This market has the potential to tank nearly 90% over the next three years, we should warn investors of this possibility so they can reduce their exposure and protect their capital.’
Here’s a multiple choice quiz of the bosses’ likely response:
- A: We are so thankful you’ve identified this possibility. We should send out a newsletter straight away advising our investors to withdraw their funds from our products and put their money into the safety of cash.
- B: Interesting theory. Not sure we should be too alarmist about this old chap, it might not happen. How about you bury that research and come up with something a little bit more positive.
- C: The market’s been going strong for most of the 1920s, we think this performance should be extrapolated into our future outlook. Now run along and give us a report along those lines.
- D: You’re fired. And before you pick up your severance pay, make sure you liquidate your investments.
If you answered B, C or D, you can give yourself a tick…
At the risk of stating the obvious, the industry is called Fund Management. Institutions manage funds. If the funds are withdrawn en masse to the safety of bank accounts, there ain’t no funds to manage, no fees to be extracted, and no fund management business.
Institutional economists have a job to do. And that’s fine. But just remember whose payroll they’re on, and apply that filter to their opinions.
In a low interest rate world, hybrid securities have been the flavour of the month. It’s reflected in the financial planner’s statement; ‘With the banks increasing their capital ratios this only provides a stronger platform for the hybrids.’
That may be true in normal trading conditions, but take a look at what happen during the GFC to the CBA hybrid offering called PERLS III (started trading in April 2006 at a price of $200).
Source: Yahoo Finance
At the GFC low point, the hybrid (paying a 1.05% margin above the bank bill swap rate) was down 35% on its issue price. The price has gradually recovered. But for original investors, was an extra 1.05% worth the ride?
When the next downturn hits, those who bought into hybrids for a little extra return are going to find out the hard way that the stronger platform is not a strong as you thought it would be.
When a market is in panic mode and investors want cash, they SELL EVERYTHING — shares, gold, hybrids, property, golf clubs, kitchen sinks…you name it.
The only guaranteed investment is CASH — provided you are under the Government Deposit Guarantee limit of $250,000, AND the Government honours its guarantee.
What if I’m wrong and am overly negative?
That is a distinct possibility. I am human. Often wrong (just ask my wife). And extremely cautious.
No one knows the short term direction of markets. There are far too many forces at play to even bother trying to divine the direction of markets in the near future. When I undertake a risk versus reward analysis on investments I do so with some simple parameters — based on worse case and best case scenarios to try to determine the upside to downside ratio.
For example when I invested in the US dollar at $1.05 my view was the Aussie dollar may go to $1.20. If this happened my downside would have been approximately 15%. Alternatively based on previous periods of economic upheaval our dollar could possibly fall to 50 cents. If this happened my upside was over 100%. Therefore my upside to downside ratio was better than 6:1.
Strategic investing is about working out probabilities. You’ll never be 100% correct, but hopefully you minimise the prospect of experiencing a serious level of capital loss.
Applying the same approach to the question on whether I’m right or wrong on my outlook for a severe and sustained market downturn, here’s a simple table on the future possibilities:
Statistically there is a 50% chance of my outlook being correct in the short term and 50% chance of being correct in the longer term. Then we apply some qualitative analysis and see what that does to the probability equation.
The US share market has been in a bull market for over six years. This is rarefied territory.
‘According to our work, the US stock market is currently in the longest running cyclical bull market that has ever taken place in a structural bear market. We are currently in the 6th year of the cyclical bull market. No other cyclical bull in a structural bear has ever made it past five years (the prior longest was from October 2002 – October 2007).’
GaveKal Research, July, 2015
- Global debt levels (the driver of past economic growth) are at the highest levels in history. And we know from history that every period of excessive debt ends in a crisis.
- The Shiller PE 10 ratio is currently recording one of its highest multiples in the 140-year history of the US share market.
- US earnings per share have been enhanced by record levels of share buyback activity.
- Global interest rates are historically low to make debt servicing costs cheaper and to force investors out of cash.
- China (the global growth engine) is slowing.
- The Fed openly pursued a stimulus strategy (multiple QEs) to create the ‘wealth effect’ — deliberately pushing up asset prices.
Scenario 1 — completely ignores history and assumes debt levels and market values can continue rising indefinitely with a major setback. I only rate this a 5% probability. Highly unlikely.
Scenario 2 — the Fed may be able to keep the growth and market illusion going for another two or more years. But they’ll take us to a much higher place to fall from. This market is getting tired and the fact the Fed could not even move interest rates 0.25% (after seven years of stimulus) indicates how much debt weight is in the global economic saddlebags. This scenario is a 30% probability…because the Fed could do a version of Abenomics.
Scenario 3 — the market undergoes a severe market downturn but the Fed mobilises some unknown and not previously considered stimulus strategies to reboot markets to once again recreate the ‘wealth effect’. Under this scenario you suffer a big hit to your capital and hope like crazy the Fed can find some other stimulatory rabbits in the hat…negative interest rates, helicopter money, steroidal QE. Call me crazy but that hardly seems like a genuine long lasting recovery. Probability is 10%.
Scenario 4 — the chickens come home to roost. Probability: 55%.
Therefore in my simple risk assessment there is an 85% chance of something really bad happening to capital…a Great Depression-like market collapse.
And there is a 15% chance I am wrong and we can continue living in a world fuelled by perpetual growth of debt and continued market intervention by central bankers. History actually gives this outcome a much harsher reading…0%.
If I’m wrong then so be it. My capital is still intact. But if I’m right, then it was a bullet well worth dodging. In my opinion, staying in this market is like playing Russian roulette with five bullets in the chamber. No thanks.
Editor, The Daily Reckoning