Is your portfolio patrolled?

Brett Gillespie

The Super Investor

There’s always a lot to read at the start of the New Year in markets. Lots of predictions for the year ahead, lots of pontification about the risks, advice to “take money off the table” after such strong returns in 2019, and so on.

So I’m sure you, as an investor, and particularly an equity investor, are ruminating over exactly those questions.

But should you be? Hasn’t the best thing to do, particularly in equities, is to not look? To not think?

Well yes actually, at least more recently. However, the problem with that approach is about once every 10 years you get hit by a bus. And that can be fatal.

So what do you do? It is notoriously difficult to get that one year in 10 right, no? And wrong can be very costly, particularly if you miss a market rally. So the consensus advice from large superannuation funds and financial providers is just stay invested. Don’t think. Over the long run everything is always fine…

Of course, as we all now know, this is the same lazy, self-serving advice that sabotaged investors in 2008.

This is where I at The Super Investor seek to help. My goal is to be your lifeguard. To let you know where and when it is safe to be in the water so to speak. I have been doing this for 30 years as a “macro” investor. Analysing the currents, the rips, the sandbanks. Where the danger is. And identifying when the market is too close to that danger. Indeed, my best return years have been when that danger materialises. I returned plus 21% in 2008.

So how is the water? Is it safe to go in? By the time you finish this note, you will at least feel that if you don’t know the answer, you know what to look out for.

So let’s start with a couple of observations. We all know the equity market can be volatile. That’s why funds and advisors recommend equities as a “long-term” investment. The problem is that even a 10-year horizon can be disastrous, if you pick the wrong year to start. The chart below shows the total return from the ASX200 on a 10-year rolling period, by sector. Note total returns (including dividends) have been similar across sectors over time, with only a few exceptions.

It is pretty clear there were three really bad times in which to take a long-term view on the stock market in the last 100 years. Around 1929, 1970 and 2008 (the chart shows the return over the prior 10 years). That’s pretty obvious in hindsight. 1970 was the inflation/energy crisis. The other two were the 1929 stock market crash presaging the Great Depression, and the 2008 housing crash presaging the Global Financial Crisis. Evenly spread about 40 years apart. Great, that means about 30 years until the next one…Hmm, I’ll come back to that.

Shorter term, does the prior year’s performance tell us anything about the next? It can. Bloomberg has data on the Australian All Ordinaries Index back to 1936.

Australian All Ordinaries Index annual return

We can make a few observations. Two negative return years in a row has not happened since 1982. Paradoxically, that was the birth of inflation targeting central banks, under Paul Volcker at the US Fed. Prior to 1982, it was relatively common. Five times over 50 years, or once a decade roughly. No wonder our grandparents weren’t enamoured with stocks.

So since 1982, a negative year has always been followed by a (good) positive year. Made 2019 an easy call right? And is a strong year always followed by a bad year? Biased that way, but mixed. If we look at years where returns were over 20%, there are 15. In 9 instances (60%) the following year was negative. In 3 instances the following year was up more than 20% as well. But 2019 was just below 20%. And there are plenty of clumps returning 15-20% over a number of years. So it doesn’t look too concerning.

So what do you do? A simple review of 10 year returns and one-year returns might suggest let it roll. Don’t look. Don’t think.

Maybe. But can you afford another GFC? Or even a wild ride? Because I think over the next 3-4 years we are in for a wild ride.

How so? Ok, bear with me, because here we dive deep into the fundamentals.

First of all, the worst thing for the stock market is a recession. The market can ride out a slowdown, but a recession will universally slam earnings. We haven’t had a “proper” recession in Australia since 1990, in which year our market fell 22%. But we have suffered from global slowdowns/recessions since then. You can see that in 2000, 2002, 2010, 11, 14, 15 and 18. Flat to down 10% or so. But one’s eye can’t help being drawn to 2008, the Global Financial Crisis, the GFC. Minus 42%. Disastrous.

So how do you pick it? The time to really worry and be cautious? We need to focus on three catalysts that have the potential to cause a stock market crash;

  1. The central bank. In a “traditional” business cycle the economy grows too fast, generates inflation, and the central bank has to hike interest rates to slow the economy, but overdoes it. Think the recessions post WW2 until the mid 1990’s. And there was a risk of this in 2018.
  2. The potential for a bubble to burst. When an asset bubble bursts, wealth is destroyed, people stop spending and save, and the economy falls into a recession. Think the bust in 2000 and the US real estate bust in 2008.
  3. A major geopolitical event. Think tariffs war or even actual war.

Central banks, and particularly the US Fed, no longer have the appetite to risk a recession. In 2017 and 2018, US Federal Reserve Chair Jerome Powell attempted to follow traditional (if somewhat late) central bank orthodoxy by raising interest rates as the economy strengthened and inflation was forecast to rise. But then markets panicked. And Powell panicked. It scared the life out of him. I explained this in my January 2019 note (where I advised “buy equities”. He is going to move rates very carefully – and slowly - now.

So we needn’t worry about the central banks this year. Perhaps not for several years.

What about a “bubble” bursting. Is one about to burst? Well to answer that, we have to identify one first.

Let’s start with the equity market (we could talk about bubbles in the housing and credit markets as well). I’m going to look at the US stock market because that is the biggest market in the world and what happens in the US reverberates around the world.

And let’s start where most people start, the CAPE – the cyclically adjusted price/earnings ratio. This adjusts earnings for where we are in the business cycle, so as to more easily compare to the past.

Cyclically Adjusted Price/Earnings ratio

Nearly 30x. When the average is closer to high teens. That is punchy. Indeed, as high as it has been since the bubble. But is it about to burst? Probably not burst, because it isn’t trading like a bubble (yet). For a proper bubble burst, we first need the “melt-up”. We need to see the greed and delusion of the mania phase.

A typical “bubble”

Nonetheless, the CAPE still says the market is expensive. Should we not be cautious? Yes, if you believe the CAPE is the best way to look at it. And it used to be. When long term US government bonds typically averaged about 5%4. But the world has changed. Only recently, on January 6th, 2019. The Powell Pivot day. The day the Fed gave up on any notion of normalising rates.

This is massive for how you value equities. Hamish Douglass knows it.

"If you tell me what interest rates are going to prevail in the future, I can tell you whether the market's cheap or expensive."

He explains in the AFR article;

Take a business growing at 4 per cent a year, with a cost of equity of 10 per cent based off a 5 per cent risk-free rate and a 5 per cent market risk premium: you would value that at around 16.6 times free cashflow.

At a 3 per cent risk-free rate, the cost of equity is 8 per cent, and the multiple is 25. Finally at 2 per cent – "which is where the world is at the moment"  – the same business would be worth around 33 times free cashflow.

So do you value that 4 per cent growing business at 16 times or 33 times? That is the biggest question true investors should be thinking about

"It's amazing, people go, 'the markets are overvalued or they're fully valued at the moment', and the multiple is higher than it was over the last 10 years. But they're not asking what the interest rates are.

"If you tell me what interest rates are going to prevail in the future, I can tell you whether the market's cheap or expensive at the moment. But without answering that question, people are just making irrelevant chitter-chatter."

Thank you Hamish. I will now tell you what interest rate is going to prevail. Or more importantly, what interest rate the market will assume. About 2 to 3%. Let’s call it 2.5%.

US 10-year bond yield

Why so low? Because the central banks have decided. They will not try and normalise interest rates. They, and particularly the US Fed, would rather an inflation problem than an equity market crash. And they, and particularly the US Fed, don’t believe they should worry about bubbles. It’s not their “mandate”.

So what is going to happen now? Well bond yields will rise. But only gradually. Without central banks raising the cash rate, and without any expectation of significant increases in the cash rate, there is only so far they can rise. The equity market will be fine with this.

At the same time, the market acceptance of a permanently lower US government bond rate will permeate valuation models. Over the course of the next year we will see increasingly higher valuations being justified by the low discount rate. The market will embrace the notion of permanently lower interest rates, hence a permanently lower discount rate, justifying a permanently higher price/earnings ratio. We are in the first quarter of the mania phase.

In 2020 the stars are aligning for the mania phase to accelerate. Why? Because in 2019 we saw a huge easing in “financial conditions”, globally.

US growth should hit 3% this year.

In October 2019, I wrote my “see-saw” piece, advising investors to be overweight equities. The global central banks were providing massive stimulus. And the risks would fade.

We all were acutely aware of the risks. It was hyped in the media everyday. But it is striking when you list the concerns for 2019, they have all diminished, either in reality or as a market concern. Think about them;

  1. US/China tariffs
  2. HK unrest
  3. Brexit
  4. Iran/US clashes
  5. Trump impeachment
  6. Concerns of a far-left Democratic nominee for the US election.

My October 19 piece was focussed on the growth impetus from the central banks supporting the economy and the markets in 2020. This was laying the backdrop for a “good” year for equities. The seed for the bubble has been percolating for 12 months – permanently lower interest rates. If the “risks” were all to “go away” in 2020, we will have the conditions for an explosive rally – a bubble.

Ok, but surely if that starts to happen the Fed will increase interest rates? And that will stop a bubble?

I don’t think so. Not this year. As I said the central banks are going to be very slow to raise rates. Very slow. Maybe in 2021, more likely 2022. Why even then? Because by then it will be very clear they have inflation. I’m kidding right? Everyone knows we will never see inflation again. Well, no I’m not. Wages are already rising. Pretty much everywhere in the world now…

Eventually this will lead to inflation. But it will take time. The analogue is the late 60’s – the last time the US Fed believed inflation would never rise and kept interest rates too low for too long. It took 3 years before they realised their mistake…

In the meantime, it is more likely there is a bubble. If the uncertainty dissipates.

But what about that nasty scare at the end of 2018? Can’t that happen again? No. Because that was driven by the Fed8.

But we can always get a geopolitical event that drives a large correction in the markets? Yes. And that is the main risk to be alert to this year.

So this is how you play it. You stay long equities. You have too. They could explode higher. And you stay alert to two key risks

  1. Geopolitical
  2. Sharply higher rates.

As I have outlined, I don’t think we have to worry about 2, at least not this year. But as always, we have to stay very alert to 1, and this is where I will aim to help you. “Things” can happen at any time. I will provide updates to our subscribers on how “things” are evolving, and how worried we need to be. Can I do this any better than anyone else? Well yes. That is what a macro trader constantly assesses. I do this in three ways;

  1. I subscribe to the best consultants in the US, China and Europe who are experts in this space.
  2. I talk to large hedge funds and institutional investors who are intensely focussed on this area
  3. I have algorithms monitoring every corner of the globe for market signals that concern is building.

And then I overlay that with a healthy dose of experience.

For the risk algorithm I will provide a risk score each week, so you can see for yourself whether it’s safe to go in the water. Like a surf report!

And what about the big one – the risk of a repeat of the GFC? The one that sees you lose 40% of your wealth. It’s coming. It is almost pre-ordained. The global central banks have locked themselves into a cycle of asset bubbles for the last 25 years. And they are pushing harder than ever now for the next one. But it isn’t here yet. We need to have the big “up” first, before you have the big “down”. An explosive rally, an exponential move as we say. The mania phase.

One last point. Is there a way out? Some way this can all be avoided? Well there is actually. I wrote about this in November.9

The salvation would be for policy makers to pivot away from monetary policy to fiscal policy. Aggressively. Call it modern monetary theory, direct fiscal financing, helicopter money, what you will. But the only way to reduce overbearing government debt is to either default or inflate. Using fiscal policy supports the economy rather than asset prices. It would also gradually push bond yields higher, nixing the main driver of a potential equity bubble. And the fiscal expansion can be paid for by literally printing currency to hand out. History is littered with examples. If you are interested you can read my November note for a deeper discussion.

Will it happen? I’m afraid not. Yes we are seeing the economic consensus and policy makers inch in this direction, all the more so as monetary policy runs out of road. But it is incremental. Indeed, at the current rate it will actually aid a bubble, because it will boost growth this year, but not enough to have a meaningful impact on inflation. Unfortunately, it takes a crisis to create change. This move will more likely happen after the next recession…

So get your board! There are going to be some big waves out there. But also, in all likelihood, some submerged rocks and some big rips. As always, there is the potential for conditions to change and if they do, I will keep you appraised. 

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Brett Gillespie
Brett Gillespie
Chief Investment Officer
The Super Investor

The Super Investor is an online membership providing information for investors to grow and protect their wealth. My goal is to educate clients about the global macro trends influencing all financial markets, so that they can make informed decisions.

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