Not the bottom, not the end

"For people still in their prime earning years, this bear market is likely to be as bullish in the long run as it is painful in the short run. For older investors, the decline is potentially devastating."

Jason Zweig in the Wall Street Journal, last weekend.


As the Danish proverb goes, making accurate forecasts is very difficult, in particular about the future. Which is but one reason why I think investors put too much emphasis on forecasts and their accuracy.

A much better strategy is to identify and manage risk. This can be done by shifting allocations away from more vulnerable and volatile parts of the portfolio to defensives and cash, taking on less risk when the overall environment looks to become increasingly challenging.

Thus far in 2022, defensives have not operated as they should have, as suggested by history and the label they carry. 

One explanation is every new bear market differs slightly from the past, generating its own idiosyncratic framework. Another explanation is this year's bear market is only in its infancy; there's a lot more to come.

Six months in, assuming we can all agree the current bear market started in January, and with circa 60% of the ASX200 down by 20% or more, it is but normal for investors to start wondering whether The Bottom is in.

Maybe a macro-dissection, top-down style, from the process thus far can provide us with better-than-guesswork guidance in this all-important manner?

The process thus far

Those who pay attention to the finer details, and who are able to maintain a broad, macro overview, could potentially argue this year's bear market for global equities started in the early months of 2021 - well before the calendar moved into a new year.

It was then that the more speculative parts of US share markets started to falter. Take Cathie Wood's ARK Innovation ETF, for example. 
Its price peaked in February last year, stabilised for a while, and then fell off the cliff from early November onwards. It's still an open debate whether that fall from unbridled adoration has now ran its full trajectory.

In hindsight, ARK's step-by-step demise was simply the first signal inside the post-covid process that today has pulled major US equity indices down by 20% and deeper. 

Once the more speculative market segments had received their first public flagellation, liquidity was subsequently withdrawn from US micro cap stocks, then followed the midcaps with smaller-sized technology stocks attracting most of the attention.

The process, by now, was no longer confined to publicly-listed companies. In the equally exuberant and speculative crypto markets, NFTs were the first to be pulled into the abyss, shortly after followed by other vulnerable assets and faulty crypto-finance constructions, before a general rout took over the whole crypto market.

By then, the world's mega-cap technology stocks were already part of the process, and pretty much every market around the world had joined-in.

The Australian experience

In Australia, where the major index is dominated by banks, energy companies and miners, the global withdrawal of liquidity initially showed up mostly below the surface, leaving many an investor with the false impression that whatever bad was occurring internationally might not be repeated on the ASX.

Such an assumption ignores the fact the 2022 bear market is developing through multiple, distinctive phases. Phase one was all about pricing out the Grand Exuberance that had been running wild when both governments and central banks provided additional support for covid-hit economies and markets.

Phase two kicked in when bond markets started normalising from emergency-driven levels, as inflation forced central bankers to change course and start hiking interest rates. Sharply higher bond yields triggered a violent re-adjustment in every asset trading on historically elevated valuation.

As investors sought refuge in those sectors responsible for the jump in inflation, Australian investors might be excused for thinking they were once again operating from the Luckiest Country in the world.

However, understanding how this process is now moving into the next phase means one can see why Australian banks had to be the next shoe to drop on the ASX, and why oil & gas, iron ore, coal and gold miners will follow next, not necessarily in that order and with exact timing unknown.

The next phase: Corporate profits

The next phase in this year's bear market is all about the R-word; recession.

While it might take a while yet before investors find out which regions exactly will suffer economic contraction as higher interest rates, the rising cost of living and falling asset prices (housing, equities, cryptos and bonds) will exert downward pressure on household budgets and business's spending intentions, one recession that looks most likely to arrive next is a recession in corporate profits.

Zooming in on elevated margins, just about every market strategist worth his salt is today predicting forecasts for corporate profit growth are too high, both in Australia as elsewhere. What we don't know is whether sharply lower share prices are already accounting for the downgrades that haven't been implemented yet.

One extra complication investors are facing is that economic processes tend to be rather slow. Take the Australian housing market, for example. Most economists are now in agreement in that accelerated tightening by the RBA will push property prices down in 2023. Whether this will be down by 5%, 10%, or 15% is by the by.

Given plenty of historical precedents and references, a fall in property prices next year seems but a plausible projection. The problem investors are facing is how do you account for this, and its impact on consumer spending, in 2022?

Meanwhile, the upcoming quarterly reports from US corporates might shine some light on ongoing supply chain disruptions, input costs, inventories and margin pressures.

In Australia, investors will have to wait until August, with the preceding confession season offering the ability to surprise either way. On Monday, shopping mall operator Vicinity Centres (VCX) issued an upgrade to its FY22 guidance, accompanied by an uplift in asset valuations, and its shares rose 6.3% on the day.

The shares are projected to offer a yield well in excess of 5% and had fallen almost 9% over the preceding two weeks.

In contrast, shares in auto-parts manufacturer and distributor GUD Holdings (GUD) fell by some 30% between April and last week, when the company issued a profit warning, causing the shares to fall by another 19%.

The experience with GUD Holdings once again pays tribute to that old Wall Street adage that a profit warning is never fully priced-in, irrespective of share price weakness beforehand.

The problem for investors 

The problem for investors, as I see it, is that it's not always possible in advance to distinguish the next profit upgrade from that painful downgrade. And thus the risk of owning equities at this point in this bear market remains too high for comfort.

This is not to say portfolios should be reduced to zero exposure, but investors should be prepared to suffer at least one disappointment and preferably stick with solid, less risky exposures - or make a conviction call with a long-dated horizon.

As per my standard view, a healthy allocation to cash in portfolios seems appropriate and the best possible defence against left-field, unexpected disappointment. 

A reminder: each of Coles Group (COL) and Woolworths (WOW) delivered an operational disappointment earlier in the year, which led to instant pummeling of the share price. In both cases, investors have been reminded that solid, defensive stalwarts are not immune from the pressures this year.

Anyone who's buying shares ahead of August better account for the risks involved. I recommend you limit your purchases to cautious nibbling, and remain patient overall. This still remains an environment in which heroic behaviour will likely not be rewarded and instead can result in immaculate pain and suffering.

We haven't even found out whether there's an economic recession on the horizon. It matters not whether you believe it can be avoided or not, what matters is that you reduce the risk of maximum pain in case of an alternative scenario than the one you are inclined to side with today.

As I like to remind everyone who strongly believes energy companies and large bulk miners are the new defensives in 2022 no matter what happens: let me check my notes, when was the last time that share prices in cyclicals held up while economies were facing recession..?

Oh, that's right! It has never happened before!

Gold and gold miners are at risk of central bankers achieving what they're aiming at: bringing inflation back inside the 2-3% range.

Rally potential in the short term

May and June have been extremely harsh on Australian equities with the ASX200 losing 11% over the past ten trading days alone. We don't need all kinds of sophisticated technical indicators to assess whether the share market looks over-sold in the short term.

This provides yet another platform for a broad rally upwards. Given the overall macro-context, however, I very much doubt whether this year's bottom is in, or whether it matters much for the months ahead.

On consensus forecasts, the local share market's Price-Earnings (PE) ratio has now fallen to circa 12.5x - a number not seen since the troubled Grexit period of 2010-12. But a crucial input to calculate today's number stems from analysts' forecasts, which are almost by definition too rosy.

On top of all of the individual considerations, while inflation is still high and surprising to the upside, and central bankers are putting their feet on the accelerator, which means bond markets cannot settle anytime soon, I believe an investor's biggest enemy is his own impatience.

From where I am sitting, there is absolutely no hurry to allocate additional funds to equities right here, right now. Unless for trading purposes, or for longer-dated conviction calls.

Incidentally, anyone still holding some low-quality, low-conviction exposures in the portfolio might want to use the next rally to sell and increase the level of cash. This will come in handy no matter what scenario unfolds next.

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