How to avoid being crunched

Is the current period of higher market volatility, which began in January, just a foretaste of a tougher investment landscape ahead?  All the indicators point in that direction.

While the current bout of weakness may only cause the market to fall 5-10 per cent, we believe it may be a dress rehearsal for a much more sinister period in the next 12-24 months. When volatility rises, risk rises. When risk rises, appetite for paying high earnings multiples dissipates. When P/Es contract, prices fall. It’s not complicated. An extended period of low volatility is always followed by a shorter period of heightened volatility.

In late January, when the market briefly corrected we referred to Benoit Mandelbrot’s observation that volatility clusters. The March volatility which began March 9 – coming just six weeks after the previous dose – should therefore come as no surprise.  Volatility tends to cluster. With each episode of market weakness, investor commitment to high-risk, high-growth and low-quality stocks and sectors deteriorates.

Black swans coming in to roost?

In the 2nd century, Roman poet, Juvenal, the author of the collection of satirical poems known as the Satires, characterized something as being “rara avis in terris nigroque simillima cygno” (“a rare bird in the lands and very much like a black swan”). When the phrase ‘Black Swan’ was coined, it was presumed not to exist. But black swans do exist, and the importance of the metaphor is its comment on the fragility of any system of thought.

In equity markets, especially in the final and maturing phases of the recent boom, the system of thought has been that central banks would raise interest rates only modestly and certainly slowly, growth would return, inflation would remain at bay and cash would remain a liability continuing to force investors into risky investments amid a prevailing fear of missing out.

A year ago, nobody was talking about black swans such as a blow-out in corporate bond spreads, a jump in Libor or Sino-US conflict being duked out through threats to globalisation. Even our many references to the credit market record level of CCC-rated junk bond debt due to be refinanced in 2019 was slightly off the mark. It will now become more prominent in the mind of the market and add to volatility.

With the cost of private debt now rising - 3 month US Dollar LIBOR interest rates have risen almost four-fold from 0.61% in January 2016 to 2.29% even in the absence of central bank intervention - investors are being surprised to discover that emerging doubt about the prospects for earnings growth can manifest itself in lower price-to-earnings multiples.

Once again, as some investors leave the party, even as the band keeps playing, many are only beginning to wonder whether stocks can fall. Indeed, a record US$34 billion recently flowed into equity index exchange-traded funds in a week.

And when it comes to equities, be certain of this: there are market darlings today, whose share prices will decline 50, 60, 70 and even 90 per cent in the next 12-24 months. The argument for a reversal of financial conditions is not only becoming more plausible. It’s actually now visible.

And be sure to zip up your wallet if someone suggests that because Australia’s stock market didn’t rise as much as the US, it won’t fall as far. That kind of nonsense has no place in a world where the most basic investigation reveals correlations increase as markets dislocate – the baby always gets thrown out with the bath water.

Speed bumps are already emerging for highly-prized companies, questioning earnings multiples that can only be justified on the basis of an unblemished path of high double-digit profit growth rates.

Amazon good for competition?

When e-retailer Kogan (ASX:KGN) announced it will offer Pet Insurance, its shares shot up 14 per cent. The market also reacted positively to Kogan’s announcement it will start selling fixed-line National Broadband Network connections, partnering with Vodafone for its NBN product. In other words, its share price rose on an announcement it is entering an industry where reputable, larger and more established players such as Telstra (share price down 31 per cent from one year highs), Vocus (-44 per cent) and TPG (-20 per cent) are suffering from intense and arguably irrational competition and declining margins.

And on the subject of Amazon’s intention to launch in Australia, in direct competition with smaller and less financially liquid players, Kogan told News.com.au: “We’re excited by Amazon’s launch, anything that can be done in Australia to bring more significance to our online retail industry to make more people aware of it, the better.” Shortly after the comments to News, Kogan’s founder announced he had sold $50 million of shares in the company he founded.

a2 Milk following Kogan's footsteps?

Similar, and arguably misplaced, optimism is evident over in the market for infant formula.  Listed distributor a2 Milk (ASX:A2M) has seen its shares soar more than 700 per cent in little more than two years amid optimism about sales success in China.  On March 28, 2018 Nestle, the world’s biggest food and beverage company, announced the launch in China of an infant formula that uses the A2 beta-casein protein made popular by a2 Milk.

A2 Milk’s response to the entry of a super competitor is almost identical to Kogan’s: “[we] consider that new entrants should assist in building credibility and awareness for the A1 protein-free proposition, and hence build the overall category more quickly.”

How can it be that more competition, especially the arrival of global giants, is universally good for everyone.  Wake up! Ask Myer what happens when Amazon, Zara and Uniqlo turn up to compete.

Time to be careful

Equity investors are still flirting with market highs and pumping record amounts of money into ETFs undaunted by the prospect of Amazon hurting Kogan’s plans or Nestle disrupting a2 Milk’s.

But globally, corporate bond investors are evacuating the scene. The Bank of America Merill Lynch BBB bond spread has widened to its highest level in six months and yields are near the highest levels seen since 2012.

The most recent equity bull market can be characterized by a concentration of investment flows into a narrow band of concept stocks. The prices of these concept stocks imply uninterrupted earnings growth estimates of 30-40 per cent per year for the next decade.  Such growth paths transpire much less frequently than the preponderance of companies whose share prices reflect such hopes.

It’s time for investors to be very, very careful.