A few months ago, I made my case in a video interview with Livewire as to 'Why the bulls are wrong'. Last week, Livewire reached out to me last week as part of a special series, to expand on my view of what is wrong about the bull case. You may have seen some of my summarised responses in the wire Why you should fear the big bad bear by Patrick Poke.
In this new wire, I've provided my responses in full, including the real reason equities are tracking higher despite the weakening economy, what the credit markets are telling us, why we need to think beyond whether the bull market is right or not, what alternative options are available for investors, and, finally, the nine big risks the market forgot to price in...
The key thing for investors is to avoid heavy reliance on one factor
The bull case may or may not be right in the short-term but is highly challenged long-term. It really has one main factor supporting it – easy money and supportive central bank and government policies. The bull case may be overly optimistic in the long-term because these policies probably can’t and won’t be sustained ad-infinitum without massive second-order effects. The current dislocation between many markets and economic reality and underlying profits is massive, and will probably have to close with time.
Cash and bonds provide woeful yields and are priced to deliver exceptionally low long-term returns – we think there are much better options than this. Many property markets have woeful prospects and are massively overvalued. Equity markets are much riskier than they have been, but could still rise or fall dramatically from here. Carefully selected equities can still be better assets to own than most, albeit it appears prudent to own less equities overall from an asset allocation point of view given the risks if you consider all the alternatives and don’t fall for the bogus “there is no alternative” argument.
But for me, whether the bull case for markets is right or wrong, while important, is not the main issue for investors. Regardless of whether you think the bull case is right or not, good investment management is about avoiding such heavy reliance on one factor dominating your portfolio returns.
A case in point is the last financial year, which may be a more typical year going forward than investors are generally expecting. Last year, a really attractive multi-strategy approach – that is one which diversified its return streams properly and prudently and actively managed its risks in real-time – achieved good positive results with little in the way of drawdowns, despite the dramatic and scary market moves. Compare this to your average super fund which lost money or achieved no return despite taking large risks. The latter is commonly only pretending to be diversified when in essence it is really only a bet on whether equities (and their surrogates) go up.
It is brazen under current circumstances for investors to not genuinely diversify their portfolios, yet this is what most are doing. I get it – it is much harder to implement well – but isn’t that what professionals are for? Most investment offerings are like going to the dentist and saying I need a filling, and the dentist brushing your teeth and charging you for doing something you could do yourself. Investors shouldn’t fall for that. It seems to me that most large institutions simply aren’t able to implement what clients really need, or simply don’t care because it isn’t convenient for their business model. Good investing is harder work than that.
Afterpay continues to confound the bears...
Equity prices have been driven higher by the repeated massive central bank and government fiscal stimulus and intervention and a belief in the same continuing.
The degree of new stimulus is unsustainable in the long-term but is very impactful in the short-term. Investors are recognising that cash rates are now punitive to savers and are being driven by a fear of missing out on rising equity prices. Substantial speculative capital has entered stock markets for short term trades, in many cases bidding up the price of insolvent and obviously near worthless companies. Furthermore, shorters have been forced to risk manage their positions which has also driven stocks higher.
Equities look to most like a better relative bet than bonds, even if both appear expensive and offer an inadequate return for risk over the long-term. Equities also look more attractive than property generally, given much of the latter appears challenged by excessive valuations and poor prospects.
Wisetech (ASX:WTC) and Technology One (ASX:TEN) are potential examples of overhyped stocks in the technology space. With Afterpay (ASX:APT) trading on a PE of well over 200 times on 2022 forecasts, it looks ludicrously priced - yet keeps delivering and confounding the bears!
All is well and good until reality bites and the bubble is pricked once again, however. Most of the financial services industry is built around the notion of selling people on the idea that simply buying the stock market and property will always be rewarded and that they’re missing out, which is simply untrue (but is very convenient for business profitability). Most people haven’t thought creatively enough and considered the other options available to them to invest more in line with their goals (including avoiding the risk of large capital losses), rather than believing mainstream dogma.
Even bonds are a speculative asset now
Like equities, credit markets have generally also reacted very favourably to central bank support and perceptions of further support, so their story is a little impure. The lowest rated credits, however, have underperformed the more liquid and higher quality end of the market. This appears broadly consistent with relative performance within equity markets, albeit the equity market appears more willing for now to gamble on speculative stocks than credit markets are.
Government bond markets are far less sanguine than both equity and credit markets and are suggesting that a sustainable V-shaped economic recovery is a fanciful idea.
Yields across high-quality credit and bond markets broadly appear very low and un-enticing on a longer-term view to absolute return orientated investors seeking highly positive returns. Passive money of course will buy any asset regardless of its yield and hold it regardless whether it represents value or not.
Even bonds are a speculative asset now. If things turn south, there should still be some short term return out of bonds, but that would probably be the last hurrah of the secular bull market in bonds.
The 9 big risks markets forgot to price in
The massive volatility, both down and up, that markets experienced in the first half of the year was a stern reminder of the nature of risk. Unfortunately, many more identifiable risks still lie ahead of us, and here are nine that you should consider:
1: A Biden win will see US taxes rise
A democratic victory in the US election will likely see rising corporate taxes and a less corporate-friendly regime. Given how important this has been to markets, and how challenged profits already are even without higher taxes, this poses a major under-recognised risk.
2: More QE will drive further inequality and populism
Increasing further wealth disparity doesn’t make for a stable system and is being driven by current monetary policies. Rising populism and the real world may begin to impact more on markets over time and pose increasing challenges to investors.
3: Rising geopolitical risks
Geopolitical risk is high. Rising tensions with China and China’s increasing forcefulness pose serious and increasing risks to the global status quo.
4: Further asset price deflation
Deflation of many assets in “real terms” is likely to continue. Stocks are already underperforming gold, and property is massively underperforming gold.
The world needs inflation to overcome its debt burdens (in the absence of better economic management) but inflation itself would pose a massive challenge to the pricing of many assets (which are highly dependent on low inflation and low interest rates to support high valuations).
Investors really are in a pickle and no wonder many of them have given up and resorted to gambling; they simply don’t recognise there are other options outside the mainstream that can provide sufficient return prospects and manage current market risks.
5: Markets not pricing in existing risks
Markets do not care and are not pricing in risks in general. This comes with the territory of being in a massive bubble.
6: COVID-19 is still not well understood.
There is an obvious risk given that the health risks, and government and community responses to the same, have and obviously still do pose further substantive challenges to markets, although this is now somewhat understood by markets. There could be a truly horrible outcome if we do not produce and distribute an effective vaccine quickly enough and then get further iterations or mutations of the virus washing through a society that doesn’t or can’t establish herd immunity. Beyond the obvious issues of mortality, there are also the morbidity risks that are not fully appreciated. Much is still not known and the likelihood of other future pandemics – and biological warfare in the future - has increased and is higher than what most people realise.
7: Unsustainable practices
In general, we’re not operating in a sustainable fashion. What can’t be sustained... eventually won’t be.
8: Beware the punters
Speculative behaviour is high. Many market participants today are only focussed on the short-term and think they can get out before the next crisis hits. We know that can’t be true of most. Anyone can make money in a bull market but very few can keep this wealth largely intact when times get tough. It is far better to make less money in a bull market but have better compounded long term returns, but this is not how most operate, because funds tend to chase the best performer of the last year, rather than the most “likely to succeed” over time approach.
9: We are living in a poorly-run Ponzi economy
Many think that easy monetary and fiscal policy can and will support markets ad infinitum, regardless of economic and earnings realities. This has created one of the biggest dispersions between the fundamentals and market pricing of all time.
Passive money in bonds, equities, and property is betting heavily on continuing policy interventions in markets to avoid another nasty run-in with reality. I suspect the latter is far more likely than is generally appreciated because we still haven’t established favorable underpinnings for real economic growth and governments can’t realistically solve a debt problem with more debt, even if they will keep trying to kick the can down the road. Government interference in markets ultimately makes them less productive, not more productive and entrenches low growth.
We are arguably living in poorly run Ponzi economies and an epic era of fake and unsustainable wealth, which is hard to escape or even recognise unless you start thinking very differently from the mainstream. It is an incredibly dangerous time to be a long-term investor while following mainstream investment dogma.
Further crises should be expected and will be highly destructive of most people’s wealth. It is this understanding which helped me predict a US recession in early 2020 and the Coronavirus crisis. Without an understanding of the substantive macroeconomic and market vulnerabilities, I fear investors could lose great wealth, which is a shame given these risks can be greatly reduced while still achieving return objectives.
Don't like equities, but cash looks no good either?
Investors may feel frustrated given equities look like an accident waiting to happen, while cash offers a negative real return. The popular acronym TINA stands for 'There Is No Alternative', however this is simply not true. The alternative is ensuring genuine diversification by avoiding mainstream dogma and investment products.
Given central bank action in markets has boosted all asset prices and made cash unappealing, this means active management is now absolutely necessary to provide an alternative return stream.
A good multi-strategy approach combining different underlying investment strategies can achieve this diversification, whereas passive investment can’t. Of course, this needs to be skilfully implemented to work well. Most people can’t pick or access good investment managers and know when to hold them and when to fold them. This approach requires educated and professional management to achieve good results. Furthermore, most people – including most investors - don’t have the discipline to avoid overpriced assets and manage the downside risk, ahead of speculating on further gains (this is really important for long-term compounding). It is important to partner with the right advisers and investment firms to ensure the appropriate balance.
Overweighting cash and bonds is problematic in the long-term. This is likely to simply guarantee low real returns and isn’t necessary to manage risk if you are investing in a multi-strategy manner that diversifies skilfully.
Be wary of very large investment portfolios, such as those run by large institutions and superannuation funds. These are generally inflexible, bureaucratic and unable to access many of the most attractive strategies available in markets the current time, which are generally highly capacity limited. If you’re a small investor or a financial adviser, why do you want to give away your greatest strength - your small size? Why not instead invest with someone who will use your small size to your advantage, and who will actually do the hard work of selecting your assets carefully based on real research and your objectives, rather than simply copying what everyone else is doing and hoping for the best.
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Superb piece, I totally missed the March madness as I thought I had plenty of time to get my act together and make some worthwhile investments. Struggling to understand the state of markets right now and clearly those risks still abound! I am mighty interested to see what a Biden win would do to markets and sentiment.
Thank you Chady. It is great to hear such positive feedback and I appreciate you making the effort.
Jerome, I think I need to print all your articles and pin them up on my wall in front of me when I'm looking at our SMSF...Thanks...love your stuff
Thanks Mark, that's a terrific compliment and I very much appreciate it. There are so many articles I could write, but my predominant focus is producing results for our investors that delight them.
Another great article Jerome: you and Damien Klassen seem to be some of the very few who can clearly see the Ponzi market we are all swimming in (because you've seen it before, and your pattern recognition is fine tuned) and have the appropriate strategies to make the most of it. Of course, if the rest of the investor world was listening & thinking properly, we wouldn't be in the bubble we are in would we?
Thanks Jerome. Great article and I suspect you are right. The macro policy settings in Australia are wrong with too many being given too much for too little. This is a Ponzi scheme and when the music stops it will get ugly.
Finally someone has flagged up the elephant in the room that I have been warning the governments for years. Australia is living on borrowed time by playing the property debt ponzi scheme. We have the general public (safe as house), monetary policy (0% and money printing), fiscal policy (first home buyer grants, stamp duty exemptions) and the private sector (banking, brokers and agents and loan holiday) that actively propping the property price by throwing billions after billions at it including the most recent stimulus packages. There are better affordable housing model around the world (look at Singapore with more than 90% ownership). This is done at the expense of the rest of industry including the new industries and technology. Now we have managed to reduce four export sectors (mining, education, tourism, agriculture) to only one sector that manages to growth. Time for all level of governments and wider population to re-thinking our economy model.