Is your portfolio patrolled?

So how is the water? Is it safe to go in? By the time you finish this note, you will at least feel that if you don’t know the answer, you know what to look out for.

It is pretty clear there were three really bad times in which to take a long-term view on the stock market in the last 100 years. Around 1929, 1970 and 2008 (the chart shows the return over the prior 10 years). That’s pretty obvious in hindsight. 1970 was the inflation/energy crisis. The other two were the 1929 stock market crash presaging the Great Depression, and the 2008 housing crash presaging the Global Financial Crisis. Evenly spread about 40 years apart. Great, that means about 30 years until the next one…Hmm, I’ll come back to that.

We can make a few observations. Two negative return years in a row has not happened since 1982. Paradoxically, that was the birth of inflation targeting central banks, under Paul Volcker at the US Fed. Prior to 1982, it was relatively common. Five times over 50 years, or once a decade roughly. No wonder our grandparents weren’t enamoured with stocks.

So since 1982, a negative year has always been followed by a (good) positive year. Made 2019 an easy call right? And is a strong year always followed by a bad year? Biased that way, but mixed. If we look at years where returns were over 20%, there are 15. In 9 instances (60%) the following year was negative. In 3 instances the following year was up more than 20% as well. But 2019 was just below 20%. And there are plenty of clumps returning 15-20% over a number of years. So it doesn’t look too concerning.

So what do you do? A simple review of 10 year returns and one-year returns might suggest let it roll. Don’t look. Don’t think.

Maybe. But can you afford another GFC? Or even a wild ride? Because I think over the next 3-4 years we are in for a wild ride.

How so? Ok, bear with me, because here we dive deep into the fundamentals.

First of all, the worst thing for the stock market is a recession. The market can ride out a slowdown, but a recession will universally slam earnings. We haven’t had a “proper” recession in Australia since 1990, in which year our market fell 22%. But we have suffered from global slowdowns/recessions since then. You can see that in 2000, 2002, 2010, 11, 14, 15 and 18. Flat to down 10% or so. But one’s eye can’t help being drawn to 2008, the Global Financial Crisis, the GFC. Minus 42%. Disastrous.

What about a “bubble” bursting. Is one about to burst? Well to answer that, we have to identify one first.

Let’s start with the equity market (we could talk about bubbles in the housing and credit markets as well). I’m going to look at the US stock market because that is the biggest market in the world and what happens in the US reverberates around the world.

Nonetheless, the CAPE still says the market is expensive. Should we not be cautious? Yes, if you believe the CAPE is the best way to look at it. And it used to be. When long term US government bonds typically averaged about 5%4. But the world has changed. Only recently, on January 6th, 2019. The Powell Pivot day. The day the Fed gave up on any notion of normalising rates.

This is massive for how you value equities. Hamish Douglass knows it.

"If you tell me what interest rates are going to prevail in the future, I can tell you whether the market's cheap or expensive."

He explains in the AFR article;

Take a business growing at 4 per cent a year, with a cost of equity of 10 per cent based off a 5 per cent risk-free rate and a 5 per cent market risk premium: you would value that at around 16.6 times free cashflow.

At a 3 per cent risk-free rate, the cost of equity is 8 per cent, and the multiple is 25. Finally at 2 per cent – "which is where the world is at the moment"  – the same business would be worth around 33 times free cashflow.

So do you value that 4 per cent growing business at 16 times or 33 times? That is the biggest question true investors should be thinking about

"It's amazing, people go, 'the markets are overvalued or they're fully valued at the moment', and the multiple is higher than it was over the last 10 years. But they're not asking what the interest rates are.

"If you tell me what interest rates are going to prevail in the future, I can tell you whether the market's cheap or expensive at the moment. But without answering that question, people are just making irrelevant chitter-chatter."

Thank you Hamish. I will now tell you what interest rate is going to prevail. Or more importantly, what interest rate the market will assume. About 2 to 3%. Let’s call it 2.5%.

US growth should hit 3% this year.

I don’t think so. Not this year. As I said the central banks are going to be very slow to raise rates. Very slow. Maybe in 2021, more likely 2022. Why even then? Because by then it will be very clear they have inflation. I’m kidding right? Everyone knows we will never see inflation again. Well, no I’m not. Wages are already rising. Pretty much everywhere in the world now…

Eventually this will lead to inflation. But it will take time. The analogue is the late 60’s – the last time the US Fed believed inflation would never rise and kept interest rates too low for too long. It took 3 years before they realised their mistake…

So get your board! There are going to be some big waves out there. But also, in all likelihood, some submerged rocks and some big rips. As always, there is the potential for conditions to change and if they do, I will keep you appraised.