Volatility is the value investor’s best friend and weeks like last week are welcome opportunities, not reasons to panic. For so long quality companies with growth traded above the prices we wanted to pay but last week’s indiscriminate selling knocked their prices down to levels sufficiently below valuations for us to add meaningfully to positions. We increased our positions in CSL, Rio Tinto, Stockland, Boral, Janus Henderson, Credit Corp, Collins Foods and Hansen Technologies. Other desirable businesses becomingly increasingly attractive include Amcor, BHP Billiton, Lend Lease, Macquarie and QBE. Even the much-maligned banks are approaching interesting levels.
This is quite a shopping list and it underlines the sharemarket’s broad value creation potential when shifts in market psychology cause mass program selling of professionally managed portfolios and emotional selling by retail portfolios.
Social media and universal access to digital commercial media have exacerbated this timeless, powerful culture of emotion as a filter for interpreting the sharemarket. The purpose of dramatic negative headlines like the “$35 billion wiped off the ASX” seen last week is to maximise clicks, views, shares and sales of copy. We are never told of the billions of dollars of value created by market rallies nor the long-term uptrends in the share prices of companies that create value.
Investment commentators could help their readers more by discussing rational valuations of stocks and pointing to discrepancies with share prices. Unfortunately this will never happen when people are more attracted to negative, sweeping headlines.
Let us put last week’s volatility in context. A sensible comparison is to a television station returning to normal programming. It is normal for sharemarkets to have annual corrections of 5-15 per cent within longer bull markets. Every year of the 2003-07 bull market did and more recently, the ASX corrected by seven to 11 per cent each year over 2013-15. Corrections reduce the dangerous buildup of speculative excess and are welcome opportunities for value investors to deploy capital.
Last week was bracing for many investors because the last correction was well over a year ago in 2016. The resulting complacency drove the growth of low-volatility strategies betting on low interest rates forever and equity funds speculating on markets going up forever. These strategies are now being hurriedly unwound and this selling would have driven much of the heavy falls of last week. The next latent risk for markets is the unknown amount of leverage in positively geared equity ETFs. Should this be unwound quickly, there would be heavier falls. It’s not possible to know if we have seen the worst with bond yields likely to move higher over time and further unwinding of short volatility positions to come.
The preconditions for a serious equity bear market are however not present. The great bear markets precede recessions; there have been very few at other times. We are a long way from the extent of monetary tightening that causes recessions and fiscal stimulus from tax cuts in the US will boost US growth, partly offsetting Fed rate hikes.
Also, dividends have not been cut and there were relatively few earnings downgrades ahead of the current reporting season. While the market volatility might last for a while as a consensus forms on the level and direction of bond yields, the current correction should in time be revealed as a buying opportunity in favoured stocks. Last week’s volatility therefore highlights the role of cash in portfolios: to preserve capital ahead of corrections and then provide capital to deploy selectively, as we did into the above names last week. We are deploying cash cautiously in case the volatility extends.
The sharemarket’s best value creation potential is out in the medium term of one to three years, when the market will have moved on from the current crisis and the share prices of the companies that survived will have recovered.
Central banks should ignore the equity market volatility and press on with plans to gradually normalise monetary settings in response to leading indicators of inflation. The worst risk right now is central banks tighten too slowly and then have to catch up by tightening faster later. If this happens, the resulting volatility will make last week look like a sideshow. It is imperative that as inflation bottoms, central banks are perceived as still in control of inflationary expectations. The global growth and earnings outlook is very positive and still improving but protracted financial market volatility is one risk to the confidence driving the world’s expansion. Central bank credibility and predictability will be crucial as post-GFC extreme monetary settings are unwound.
In Australia we think the RBA is too optimistic about 2018, when consumers are under pressure from minimal wages growth and the accelerating cost of living, but agree GDP growth should accelerate to three per cent per annum in 2019, when better wage inflation should combine with employment growth to support household spending. Consumer-facing companies which have been waiting for this to happen can be expected to respond by increasing investment. Both trends would filter to earnings upgrades for industrial companies.
Interest rates will trend upwards so for conservatism it is essential to use higher risk-free rates of return in stock valuations. Our model uses a risk-free rate of 3.70 per cent, 84 basis points above the Australian 10-year government bond yield of 2.86 per cent at the time of writing.
Meanwhile, now is also not a time to switch from equities to cryptocurrencies, all of which have zero intrinsic value and most of which will therefore go to zero. When the cryptocurrency mania is over, a diversified portfolio of quality companies paying good dividend yields and bought inexpensively will once again be proved to have been the best investment strategy.
Originally publsihed in The Australian, Tuesday 13th February 2018.
David Walker is a senior analyst and portfolio manager for Clime Asset Management.