Since the end of August, the Australian market at one stage was down about 12%. It's recovered a little bit, but it has been a pretty hairy ride. So, has this been a healthy correction or is there something more sinister going on? Roger Montgomery explains why he is very cautious on a selection of companies that are exposed to the consumer and Ben Rundle from NAOS Asset Management explains why certain stocks are getting hit harder than others. 

However, it’s not all doom and gloom with each of our guests offering up some ideas on where they’ve found some value including a cluster of stocks that Roger believes are now pricing in recessionary conditions. Tune in as the dust settles on what some investors are calling ‘Red October’. 

Click on the video below or read the edited transcript below.

Montgomery: This selloff isn’t a gift

I do think that the correction hasn't brought the unjustifiably expensive companies back far enough. They've got a lot more to come off before they represent anything resembling value. Even high-quality businesses, some of them have fallen 20-30%. They're still not cheap. 

So for value investors, it's hard to say that this is a gift. I think there's more to come.  

I think we've got a catalyst next year in $480 billion of triple C rated junk bond debt due to be refinanced. That's a credit market record. Then another $500 billion the year after. Corporate credit conditions have changed materially since that money was extended to those businesses. So I think there are some issues - I'm always optimistic, but very cautious at the moment. 

Rundle: Happy to own equities - be selective

A few weeks ago there was a lot of people who were bullish out there, and now they've all of a sudden turned very bearish. I think Roger's point is spot on. I look at the credit markets when determining whether I want to be in the equity markets.

Where we sit at the moment there are some worrying signs in the credit markets, but largely at the moment they're still functioning okay. I look at where the equity earnings yield sits for Australia and the US market, it's about 6%. If you compare that to bond yields it's around 3% or a bit over 3% in the US and below that in Australia. 

Earnings double where the bond yield is, that's enough of an equity risk premium for me to be okay with owning equities.  

I think you need to be very selective because a lot of those high quality, high PE names ... I don't think they've come down far enough yet. But there are pockets where I think you can find some things to buy. 

Rundle: Forced sellers are creating headaches 

At NAOS, we play around in the small cap area of the market. What we're seeing, particularly from the asset allocators, is they've become a lot quicker to move around their mandates. I think in the last week, we've heard around three or four mandates being lost. The stocks that are market darlings or well-held amongst the small cap managers are the ones that are being hit the hardest. They're also the ones that generally sit at the higher level of a PE ratio, because the more money that's piled into them, the more confident people become. They're the ones that have come back the hardest. 

Weak consumers a big issue 

Rundle: I think probably the biggest area of the market that worries us at the moment is the Australian consumer. Credit conditions for the consumer have definitely changed, and we've seen that in consumer confidence.  

Montgomery: I wouldn't want to go near an Afterpay (ASX:APT), for example, for the same reasons. I think retail is going to be tough next year. We've already seen a significant drop in housing activity. By that I mean sales of properties. When people aren't buying properties or apartments or houses, they're not fitting them out with furniture and appliances.  

So we've seen Beacon Lighting (ASX:BLX), we've seen Harvey Norman (ASX:HVN), Nick Scali (ASX:NCK), all those companies have said the first quarter of 2019 is tough.  

I think it's going to get a lot tougher, because credit conditions have tightened. We've got people with maximum levels of debt; they can't extend themselves any more. So, I think we could see a decline in residential building activity resulting in less payments to tradies. Construction is the third biggest employer in Australia. Retail's the second.  

So we could see it flow back to retail next year. 

Stocks that can weather the storm 

Rundle: So if you can own stocks that don't have that sort of exposure. Like an example that we've bought recently is Servicestream (ASX:SSM), where they don't have any of those macro exposures. The free cashflow of the business is very strong. The balance sheet is very strong. So you can tend to weather the storm a little bit better in stocks such as those. 

Montgomery: I think there are companies like Challenger (ASX:CGF) for example that have fallen prior to this latest sell off. So they were reasonably resilient through the selloff of particularly the fast-moving names in the high tech space.  

Montgomery: Banks are boring but look attractive 

Believe it or not, it's darn boring talking about it. But I actually think the banks share prices at the moment, the big four banks, I think they're factoring in either a recession or some sort of GFC type event at the moment. They seem very, very well priced given the outlook for NIM and given the outlook for credit growth. Which I know is under pressure, but the share price has factored in even a worse scenario. If that scenario doesn't transpire, then the banks look reasonably good. 

Cash: 2% is better than minus 20%. 

Rundle: I think if you can keep a high level of cash and remain cautious and disciplined with what you buy. I think when you go through these market sell off events, it's a pretty good opportunity to review the portfolio and say, "Okay, which holdings am I not that confident about? Do I see potential risks coming up?" You can move to cash and potentially even buy the stocks that you prefer to have.  

I think we've seen cash holdings go up significantly in the last week or so. They'll probably stay that way as I think people will probably be a little bit gun shy to put that cash straight back to work.