Why the bulls are wrong

We recorded this outdoors in Swain gardens, Killara, and following all safety protocols. There is some inevitable background noise and have made the full transcript available for you below. We hope you enjoy the interview. 

Full transcript

Secondly, we have valuations at all-time record forward earnings levels (outside of the tech bubble), notwithstanding the economic settings we have.

And thirdly, I think the bulls really ignore the overall picture, which is that we have had unsustainable amounts of debt driving our economic growth for many years now and that we may well be coming to the end of a long-term debt cycle, which makes it really very difficult to be optimistic about the returns that you're going to get from traditional asset classes.

There's a lot of people out there who just seem overly optimistic to me given the settings we have at the moment for investment markets. 

So if we think about where we're at, we have economies which are really operating unsustainably still, we keep on putting on more and more debt. We have an unsustainable situation whereby we keep trying to pretend that we can just put on layer upon layer of extra debt and create some sort of normal growth, and that somehow, we're going to be able to continue doing that forever.

And I think the bulls really ignore those things. So, the bulls often focus on very short-term settings and they're overly optimistic by nature, I suspect. So, I think when you're investing, it's ideal to be flexible. So you want to be bullish sometimes, bearish sometimes, neutral at other times and be able to adjust yourself to the settings and the opportunities that you have.

If you think about where we're at now, we're in a position where valuations are expensive. When you price what the market is going to deliver just normally based on historical context, given how they're being priced, you come up with very low returns from traditional asset markets.

If you then layer on top of that where we're at economically, we really look to be coming towards the end of the long-term debt cycle whereby it's becoming increasingly obvious and increasingly challenging to actually keep economic growth going given the type of economic settings we have.

We have a very imbalanced economy, so we have a lot of wealth in the hands of relatively few parties and we have a lot of people living unsustainably on the basis of the fact they can keep on borrowing money to buy what they need and that doesn't really create a virtuous circle in the long run or a situation which can really resolve itself favourably.

If you look at a traditional bear market, it takes place over many months. You don't suddenly see the bear market over in a one-month period of time. If we are in a bear market there would be a strong reason to suspect that it will take many months for it to play out. We might, for example, see a significant default cycle over time. We might see further waves of virus infestations should we not be in a fortunate position to come across better treatments or we're unfortunate with mutations.

We might see all sorts of ramifications, further shocks the system from geopolitical risks. There are lots of X-factors that can still occur that mean that people re-assess whether the prices they're paying at the moment in this rally are actually supported by the fundamentals.

At the moment the rally, the bear market rally is supported by the fact that daily new cases have peaked, by optimism around that, but mainly really by massive central bank liquidity. That central bank liquidity, there is a fight between the bull case which is really based upon central bank liquidity, and bears based on fundamentals and the strong possibility of a high default cycle, poor consumption and poor investment spending, et cetera going forward.And so that's going to be the tussle back and forth. 

Now, this bear market doesn't have to be like any other bear market we've seen before. It can definitely be different. I think while history can inform what we might expect going forward, it could equally be very different. The thing that's of concern to me I guess is that many investors are assuming that we're going to go back to normal or that the asset prices are justified, and I think that they're not. 

There's been lots of work done on this to say, well what is a supported valuation for these markets? And if we think about what earnings are doing this year and where bear markets get to, historically we've seen valuations bottom at much lower multiples than what we see now. 

We've obviously got earnings coming off a long way this year. So, it's very easy to come up with figures around 1600 or 1800 on the S&P. Obviously we're up at 2800 on the S&P at the moment. So that would be a fall around circa 50%  to get to what you might argue is a fair valuation level for the market.

Now, clearly, we're not in a situation where central banks have any interest or are wanting to allow valuations to fall to a normal valuation level, or experience that sort of situation. So they're fighting very hard to keep the bubbles alive and they're providing massive amounts of liquidity and stimulus to keep asset prices afloat.

Now at the end of the day will that be successful? We don't know. How long will they be able to do that for? We don't know. But there's clearly a lot of risks to the downside should for any reason central banks not be successful at continuing to stimulate asset process and support asset prices.

One of the things I raised concerns about was the valuations of commercial property, unlisted property and where that would go to going forward. So you think about the situation now with everybody having, a lot of people being at home, working from home and a lot of people actually saying, look, we can actually work at home effectively and employers saying, well actually we can have our employees working from home and they're more productive.

You simply aren't going to have the same sort of demand or need for office space coming out of this crisis than you did before. Not to mention the fact that unemployment levels will be higher probably, substantially higher. So the demand for commercial property won't be what it was. And that means that a lot of those valuations probably are not sustainable and you're likely to see a lot of pressures on property valuations moving forward.

Also, with respect to residential property, we have to ask ourselves, depending on what the unemployment picture does and how ugly this gets, are those valuations justified? Can we really support valuations purely on the basis of cheap money or do we have to have people in employment with good employment prospects being able to grow their incomes over time and people with the confidence to be able to take out big loans, banks with the willingness to lend people in those situations lots of money so that they can continue to pay the higher prices that we have on property more generally.

One of the other issues I raised was the valuations that are being used in unlisted assets within super funds and so forth. And there's now been more published on that whereby people have raised the fact that valuations arguably weren't being priced fairly such that if you take the short term bottom of the market back in March and the recovery since that time, a lot of super funds haven't actually recovered with the markets over that period.

So if you had actually invested in one of these super funds, you were actually buying into unlisted property prices, unlisted infrastructure price, unlisted private equity prices at prices which were inflated, which didn't really reflect reality or fair valuation, and those valuations will need to now gradually come back to what they're really worth. And that means is that there's an inequity in the way those investors are actually being treated.

There is actually a much higher risk of conflict post a pandemic interestingly enough, and certainly when you start doing funny things with your money, then also there's a higher risk of conflict. When you look at political cycles and you think about people trying to retain power, there's also an incentive there for them to try and remove ... trying to move the attention of the populace onto some external focus because they know that if you're at war with someone you're much more likely to vote in the incumbent to be conservative in that regard. So you can certainly come up with situations whereby the likelihood of conflict, you can certainly assess the likelihood of conflict as being higher now than what we've seen before.

Now, of course, we already have a lot of conflict in the world. We have a trade war that's been going on for some time between China and US, fight for supremacy there. We have cyberwar going on, which is not something that people necessarily focus on or talk about. But we have lots of that going on at the moment already. So the war doesn't have to necessarily be in the ... in terms of physical confrontation. We have economic war going on at the moment and that could certainly be exaggerated. There's a lot of focus in the media recently on what was the real because of this virus? Did China handle this appropriately when they did certain things and certainly can point to those things very easily and be quite upset about the fact that maybe this problem should have been contained a lot earlier than it was. And it shouldn't have been the problem ... it shouldn't have become the problem that it did if certain state actors had of behaved very differently than what they had have ... had that they may have done.

So there might be a focus of attention turned towards that and that might create de-globalisation in terms of people looking to move supply chains to become much more resilient out of this, to move certain industries which are strategic and necessary or at least diversify them and move some of them back to kind of more familiar territory and more home territory to ensure they have supplies of essential goods and services for their economy.

So there's a lot of things that can happen out of this and there is certainly a much higher risk of conflict than I think is being appreciated and it's one of those X-factors that's out there.

It's not just China, there's obviously the possibility of conflict in the Middle East again. The oil prices have dropped very significantly. That's going to be putting a lot of pressure on those budgets and a lot of those countries, there's obviously the tensions with Iran. There are tensions with Venezuela, there are lots of powder kegs in places around the world where things can go wrong.

Some things are definitely going to change as a result of this shock to the system. I think certainly we're not going to go back in a hurry to the levels of unemployment that we had previous to this shock very easily. So we now have in the US unemployment fast approaching about 20% of the population and although we may on the other side of this, once we do and if we do get to a solution to the Coronavirus have a rapid sort of come back and unemployment, it won't quickly come back at all to where it was before.

So we're going to come out of this with a lot more unemployment and certainly a much more challenged consumer than what we had before. And that will mean that we'll come back with a lot of people much more hesitant in the way they go about their daily business and the way they choose to interact with the world. Is it safe to go and do the things you did before? Are you willing to sort of travel overseas and go to exotic places like you were before? Are you in a situation financially where you can even afford to do that? Will you be confident in your ability to take on longterm debt and your ability to pay off that debt given the fragility that you've just learned with respect to your employment prospects? There's a lot of reasons to think things will ... some things will change permanently as a result of this crisis.

One of the concerns I have is that when you look at the big picture, we have an economy that's operating at this size say, we've got an economy sort of this size and we have asset prices which are this size. So, there's a massive misalignment between the size of our asset prices and the size of our asset markets and the size of our real economy.

And furthermore, we're not really growing this real economy. This crisis is really going to accentuate this even further, but we've got a kind of low productivity economy. We haven't actually got the right settings to grow the economy strongly. And it's laden with debt basically, and we've ... the debt's been used to boost asset prices to these levels and that's just not a sustainable picture longterm.

So investors really should be conscious of that. In the back of their heads they should be thinking, am I really safe if I just go and buy a broad basket of equities, if I just invest in a traditional way, am I really safe? Or am I really taking the risk that one day these big, these asset prices that are all the way out here, this massive ... on the back of this massive financialization, massive easy money that central banks have provided gets collapsed towards the size of the real economy.

Alternatively, do I really believe with the way we're operating the economies today are we going to grow those economies rapidly? So they grow into the asset prices, so to speak. I think if you look at either of those situations, there's strong reason to think that there's going to be at some stage, there's a gravity there that's pulling asset prices down. There's a force there that asset prices actually naturally want to collapse in the settings right now, we have massive deflationary forces operating on asset prices. They want to collapse. The only thing that's keeping them up is really central bank easy money. And that's becoming harder and harder to do.

And the real question mark out of this is whether we're going to get one more bubble, whether they manage to float those asset prices higher again into one more even bigger bubble. How long will that last if they manage to do that or whether this is it, this is the end of the longterm debt cycle and we have to change the way we ... everything will change basically. 

A lot of things will change to mean that the returns you get from being invested in a traditional way, long equities, long property, or long debt basically, a lot of debt-driven assets, gets collapsed down.  I can't sleep at night if I was operating under that paradigm. With what I know now, I couldn't sit there and look at that setting and say I should put all my investors into that sort of risk in a very concentrated fashion and just hope it's all okay. Because I think there's no reason when you look at it, to think that it will all be okay in the long run. So you have to operate on the assumption that that can collapse and therefore you have to do things very differently from the way most people are actually doing it.

Most investors are really operating under a traditional or historic paradigm, so they've got their equity dominant portfolios and they really operate under the assumption that this is a strategic asset location type framework, which is based on historical returns and they're basically assuming that the portfolios they had for the last 40 years are the right portfolios to run with going forward.

Now I don't believe that is the case. I think that quite clearly we can mount a very strong case for why real returns will be very low from here looking forward on the basis of valuations, on the basis of the unsustainable economic settings we have and on the basis of all the risks that are out there that the world's facing, that investors are facing that just aren't being priced into markets.

And on the basis of that, I think you really need to, if you're really assessing the world and thinking about how risky it really is and also thinking about what investors really want for their money. Investors don't want a roller coaster ride. They don't want to go up and down like a yoyo and end up going nowhere at the end of that. They want to actually have absolute returns with low risk of large substantial losses and have their money protected and genuinely diversified.

And if you're just running a portfolio, which depends purely upon interest rates moving from very high to very low and upon debt levels continuing to expand at extraordinary and unsustainable rates, you're not really running a portfolio that's suited for what we're facing in the next five or 10 years. I think one of the things investors often underappreciate as well is that it's geometric returns that matter to most investors over time, it's not arithmetic ones.

So if you return 10% this year, 10% next year and 10% the year after that, but then you do minus 30% you've actually lost investors a lot of money overall and achieved nothing. So the whole aim of the game investing for the longterm is to make sure you avoid large losses because if you experienced large losses and you're exposing investors to large losses, then you're not giving them what they need or want and you're not really doing a good job for them.

And I think our industry really at the moment, under the traditional paradigm it's operating under is really giving investors that experience and it's really necessary for a lot of people to sit back and think, given what the ... from ... operate from first principles, is this the way I would design a portfolio for today? Or is this the way the portfolio has been designed a long time ago on a very different investment settings

You've got to assume that asset prices are going to be very low in the long run. You've got to assume that crises are a normal part of the way you manage money.  Your portfolio has to be resilient to crisis basically because this isn't going to be the last crisis we face. We can't just sit here and say this is a one in 100-year event, and it's going to go away. And even if we do somehow manage to get over the coronavirus very soon, which as we've talked about, there's no strong reason to think that will be the case. But, let's say that we do, there'll still be further crises because of the way we've set everything up because of the risks that there are in the real world. So we have to build a portfolio that's resilient to crisis that can still make us money and still meet the objectives that we have. Now, unfortunately, we can't all do that by just investing in a traditional way. So we can't say, let's go and invest in a risky way. Let's go and chase equity risk and property risk at inflated valuations which is what just about the entire industry does. So what I'm saying is that the way the entire industry operates is flawed. It's based on a historical paradigm that probably isn't going to work very well. So we have to think, how do we get away from those risks? If the stove is going to be really hot and really dangerous to touch, how do I try to avoid touch that? How ... I have to think very differently. So I have to do something very different to what they're doing. I have to minimise that risk basically. So you need to have a lot less risk exposed to the traditional long-only type of investing and you have to move much more into a more conservative, more active, more sort of long-short way of looking at the world. So more skill-based strategies. A lot of what I focus on is finding skilled strategies that I can use, combining a portfolio to mean that I can get a return which is aligned with what investors actually want, which isn't as dependent upon traditional asset prices and traditional asset markets remaining inflated.

Because that's a very binary risk. So if you really want to build a diversified or balanced portfolio, you need to think about how do I minimise the exposure to interest rate risk? How do I minimise the exposure to this asset price inflation risk? How do I make sure the portfolio can survive the crisis that we're going to face going forward?

So with LAIF basically what we do is we look for skills underlying investments managers and strategies that really bring something different to the portfolio that's not heavily dependent upon markets. So we want to find sources of return that don't depend upon the markets going up to achieve a good result for our investors. And that's why we've had such resilient returns and such resilient results in part because we've managed to find those returns and we've managed to combine them in a way such that we manage a lot of the risks that are out there and ensure that, investors have a true to label type experience.

Investors in LAIF are basically looking for absolute returns with low risk of large capital losses. One of the things I've published on as an example of something we have used in the portfolio, which is a more traditional sort of type of exposure in a sense, but which even other investors could be using a lot more of is precious metals. Precious metals have been in a bull market for some time now. There's still strong reason to expect that bull market might continue.

It's amazing when you look at your average Superfund or average large institutional investor out there, how little, if anything they have in precious metals. It's incredible giving the settings we actually have at the moment. And it's just an example of what I was talking about before that most investors really aren't thinking outside the square and aren't really try to adjust their portfolios from a historical paradigm to one which is better suited to the sort of situation we face today.

If you actually looked under the hood of the way a lot of these investors operate, you would realise that bringing in an idea that's non-consensus, and getting it into the portfolio, is actually quite difficult. There might be into individual investors within large institutions who actually believe and who are themselves investing in gold, but they won't be able to get it past their investment committees or their investment boards and get it into the portfolio in any meaningful degree. I saw a study recently suggesting that even though historically institutions had a couple of percent of their portfolio in gold, more recently, it was only half a percent, which is incredible in this massive bull market that we've actually been on for some time now. It's amazing.

So some of the long-short exposures we have, for example, one of the strategies that's worked for a long period of time is in a long short land is basically being long, higher-quality companies and short lower-quality companies. Those are generic sort of buckets. There are a lot of companies on the stock exchange, which really aren't good companies. You shouldn't be investing in them. So when you buy an index fund, you've got an exposure automatically to all these crappy companies. You've got exposure to everything. You're not actually differentiating between the good companies and the bad companies. People are actually adding economic value or creating value over time and people who aren't

So the benefit of being long-short is that you can actually say, look, these are actually good companies. These are actually adding, creating value for their shareholders over time. And on the other hand here we have a whole bunch of, let's call them bad companies. And sometimes these bad companies are really bad companies. They're fraudulent for example, there's a lot of frauds, fraudulent companies that are on stock exchanges around the world and in the long run they're going to burn their investors.

So if you're able to create a basket of shorts to sort of fraudulent companies or mismanaged companies or highly indebted companies at a time when the economy is turning South, all sorts of different strategies you can use as a long-short manager to have that bucket of low-quality companies. And over time there's strong reason to expect you'll get a relative return out of that, that the good companies will actually outperform the poor quality companies and you'll be able to extract a return that's not dependent upon whether the markets go up or down. But it's dependent upon whether those good companies outperform those bad companies over time. And that sort of strategy is one of the strategies we use.

If you think about traditional assets, the original asset classes are things like equities, bonds, cash, property, these are all considered sort of traditional asset classes. The ones that make people feel most comfortable, most familiar with, the ones that are most mainstream and most used in a traditional sort of paradigm.

If you think about alternatives, they're really everything else. So alternatives can be alternative asset classes. So things like precious metals are often considered alternatives. Some people even think about unlisted versions of listed asset classes as being alternative. I don't really see them as alternatives. I see them as unlisted versions of the listed version, but they're still exposed to the underlying similar economic risks.

When I think about alternatives, I'm thinking more about liquid alternatives. So ways of taking traditional asset classes but operating with them very differently. So for example, market neutral, so you are long one company, you short and another company against it. You're taking out the market but you're taking it down to another level and saying, within that asset class, what is there that I want to own? What is there that I don't want to own? What can I ... what is going to outperform something else? So you're totally getting a different return stream out of it and that's an alternative strategy in my book.

It's understandable that investors are confused because lots of things are changing and it's important that your investment approach also changes, that would be my message.

If you don't believe valuations are attractive, that settings are sustainable, that we don't have a debt bubble. If you believe everything's okay, then you can continue to invest in a traditional way and have your portfolio or your wealth and your future dependent upon that. 

But if you think things aren't like that, you think the world's different place from that then I think you really need to think, have I got the right investment approach at all? Have I got the right investment partners? Do I need to do something very differently than what the industry at large offers me? And I think you do. I think people absolutely need to think differently about how they manage money and what they're actually trying to achieve for their portfolios. 

The truth is most of us don't want a roller coaster ride. We don't want to be on this seesaw and end up going nowhere. We want to actually have, steady, more reliable, more skill-based returns for investment managers that aren't dependent upon everything being okay and don't expose us to so much crisis risk that's out there.

So my message to investors will be just that, really think about whether you've got the right alignment for what you're trying to achieve. And is there a better way? Is there a different way? And do I need to think, do I need to make sure I've got the right investment partners for that?"