What is the market thinking?

In Poor Charlie’s Almanac, Charlie Munger wrote that investing in the stock market is like betting at the racetrack, what he calls a ‘pari-mutuel system’.

It’s a place people go to place bets. And the odds change depending on who’s betting on what, and how much they’re betting.

The more money placed on a horse, the more it moves into favouritism, and the lower the potential payout becomes.

It’s exactly the same in the stock market. It’s a place where people go to place bets. And those bets move share prices around and change the potential payout.

For this reason, the stock market is like a handicapping system. Handicapping is the process of trying to predict the outcome of an event by analysing a huge number of variables.

To be a good handicapper, you need to have good judgement. You need to be able to process lots of information and work out whether the ‘odds’ (the price you pay) are in your favour.

Unlike a day at the races, in the market the odds you receive are implied. You might think you’re onto a well-priced winner, but the reality could turn out to be different. It’s very difficult to know.

As Munger writes:

"In the stock market, some railroad that’s beset by better competitors and tough unions may be available at one-third of its book value. In contrast, IBM in its heyday might be selling at six times book value. So it’s just like the pari-mutuel system. Any damn fool could plainly see that IBM had better prospects than the railroad. But once you put the price into the formula, it wasn’t so clear anymore what was going to work best for a buyer choosing between the stocks."

In other words, price matters. A poor-quality stock can end up being a better investment than a high-quality stock if the price is such that it adequately compensates the investor for the risks.

Which brings us to today’s market. In my view, there are very few good bets to make in the market today.

Sure, there are pockets of value here and there, especially at the smaller end of the market. But in general, ‘the market’ is expensive given the risks.

And it’s not as if these risks aren’t well known.

We have a residential property market at the start of what appears to be a protracted downturn. We haven’t even seen the employment implications from a sharp fall in activity from this sector yet.

It’s still early days.

Meanwhile, the RBA has its hands tied thanks to an economy devoid of any productivity growth. The latest national accounts show GDP per hour worked falling 0.2% in the year to 30 June. Real unit labour costs rose at a 3.6% annual pace in the June quarter.

Both metrics are moving in the wrong way for anyone hoping the RBA will cut rates soon. Businesses are paying more wages for less output, putting pressure on them to increase prices to recoup higher wage costs.

For this reason, the RBA will have a tightening bias to ensure any increase in demand doesn’t spark a breakout in inflation.

On the fiscal front, you have the Federal government increasing taxes on wealth creators to fund their (unproductive) spending programs. It’s a mess.

Elsewhere, the US/Iran war continues despite Trump declaring victory 35 times. This is putting real strains on global supply chains for refined petroleum products, and now key agricultural prices are moving higher too.

This is all short-term inflationary and, in the medium term, demand sapping.

Compounding these woes, Australia’s energy policy is a shambles, adding to our inflationary pressures.

Imagine pumping hundreds of billions into an energy transition that increases energy costs? It just increases the cost base for economic activity and hurts productivity.

Globally, bond yields are rising in response to increasing nominal GDP growth, fuelled by fiscal largesse and the increasing borrowing needs of hyperscalers to fund the AI infrastructure buildout.

Yet the equity market has barely blinked.

It’s betting that strong nominal economic growth and profits from the AI boom are more than enough to offset the risks posed by higher borrowing costs. In the US you can argue that’s a reasonable bet.

In Australia, not so much.

Just look at the banks. Do investors think they’ll get through this property downturn without going through even a mild bad debt cycle? They might, but the price you’re paying largely already assumes that.

Aussie 10-year bond yields are well over 5%, signifying a rising cost of capital.

Yet the Commonwealth Bank still trades on a forward dividend yield of 3.2%.

Wesfarmers, highly exposed to housing spend via Bunnings, trades on 28 times forward earnings.

Our supermarket duopoly, Coles and Woolworths, trade on 24 and 27 times forward earnings respectively.

These are just a few examples of the hefty prices the market is paying, especially at the larger end of the market.

The equity market isn’t at all fazed about rising bond yields, a lack of productivity, sticky inflation, poor economic management, and a structural rise in energy costs.

What is it thinking?

Who is handicapping this market at around 18-20 forward earnings given the risks?

It makes no sense to me.

Have the algorithms taken over? Is it passive flows coming into the market from former property investors looking for a new source of income and gains?

Is it just too much capital chasing too few opportunities, driven by institutional investing mandates to be fully invested at all times?

I don’t know. But whoever the marginal price setter is, in my view they’re not a good handicapper.

There’s an old racetrack saying – ‘odds on, look on’. That is, when a favourite is so short that you get less than a dollar return for one dollar placed, you’re better off just watching and not taking the risk.

It’s a good analogy for the market right now.

You don’t always need to bet. More than anything, investors need to be patient, and wait for the inevitable opportunities to come. They always do.