Editors Choice

MT DATABASE
Tuesday, 11 December 2018
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Nothing Terribly Wrong

I run a fund. The recent 13.2% fall in the ASX 200 has caused us all to do some hard thinking. You have to decide, is this the start of a long bear market, or is it an opportunity? Whilst clearly talking my own book as a fund manager, I find myself concluding that it is more of an opportunity than a disaster, because there is nothing terribly wrong. Here is a list of some of the major market concerns and my interpretation of their severity/importance:

  • Slowing US growth. US growth is clearly the main concern, or more accurately, the realisation that growth is not indefinite at 2018 levels - which has to be adjusted for in market pricing, but it is no catastrophe.
  • The yield curve in the US is inverting, a sign of slowing growth. It means the markets think long-term interest rates are going to be lower than current interest rates. That would only happen if inflation fell and growth slowed. An inverted yield curve is seen as the precursor to recession and it has just happened. Again, slowing growth is still growth and whilst the market will clearly price in lower growth expectations we are not talking about a financial crisis.
  • Inflation is still benign globally despite a decade of policy accommodation. The recent oil price fall is keeping it down. Low inflation means narrower margins and less headline growth. It also means interest rates are not going up anytime soon. Not good for growth stocks, but its not a reason to give up on the stock market forever.
  • The trajectory of US interest rates is flattening out. The lower interest rate contagion from the US is leading interest rates lower globally. Not great for bank sector margins (we don’t hold any) although considering the market fell over in February because of the fear of rising interest rates, this should and could cut the other way for the markets. It is arguably a positive, although the growth fears dominate in the short term.
  • The fear of trade war escalation. This issue could obviously escalate but one strategist wrote an interesting story this week about the ignominy of being a one term President in the United States (George Bush senior agonised over being a one term President – “A Presidency doesn't count unless you do it twice”). Clinton beat him in the 1992 election with the slogan “Its the economy stupid”. The economy is the fulcrum of politics as an indisputable measure of growth and success. Bush was punished for the 1992 recession. Trump cannot possibly risk damaging the economy mid-term over a trade war which is avoidable, because he will not have enough runway ahead of the 2020 election to fix it. He risks his presidency over the trade issue. Surely he is not that stupid.
  • Peak earnings. This is the idea that the 20 to 25% earnings growth seen in the US this year, largely driven by last December’s Trump inspired tax cuts, is going to now drop back into the 5 to 10% range. But it is more statistics than failure. The tax cut package is almost 12 months old, earnings growth has been exceptional because of it, and as the 12 month comparable date of the tax cut introduction passes the annual growth rate falls. But, we should probably be impressed rather than disappointed. If the US can maintain any level of earnings growth after that sugar hit, let alone grow earnings by another 5 to 10% as forecast, it is impressive. US earnings growth is still forecast 7% on top of the 20 to 25% last year. That’s not bad.
  • Those tweets add volatility. Trump’s trade war tweeting is adding significant and unnecessary financial market volatility. You really have to wonder whether it is appropriate for the President of the US to express every momentary thought in the short term rather than behind closed doors. President Xi Jingping seems to manage without a Twitter account, but he is not Trump, fortunately. We just have to live with Trump and accept that investing in a Trump exaggerated world, whilst needlessly uncomfortable, is still uncomfortable.
  • The 10 year oversupply of cheap money is coming to an end. About time. Has been on the cards for years. Should not surprise. No-one can or should live on debt forever. Time to pay it back.
  • The overpricing of US technology stocks. One of the major market adjustments has been the concern that the world is approaching a technology peak just as the personal computer did. The world is more saturated than ever with mobile devices - they are becoming a commodity, are going to fall in price, and are seeing a slowing demand trajectory. Three Chinese companies already have a 25% market share of the global mobile device market, and their iPhone equivalent is half the price. A fair bit of this adjustment has surely happened already. Apple is down 23.9% in three months. Amazon is down 19.7% in one month. Alphabet is down 11% in three months. Facebook is down 15.7% in three months. Netflix is down 24% in three months. Finally the top end of the US stock market is sobering up, but it is the froth blowing off not the core blowing up.

The bottom line is that there is no sub-prime mortgage cancer eating holes in the balance sheets of the world’s biggest financial institutions. Apart from the perception of slowing growth, which is hardly a terminal issue, nothing much is wrong. My conclusion is that this is a sell-off rather than a “new” disaster. We will get through this repricing event relatively quickly, because it has happened so fast. Since the global financial crisis the average correction has been 13.72% and has taken 109 days. We have already dropped 13.2% in half the time. The bottom is close.

And for the long term investor who has done nothing in reaction to this correction, don’t worry too much, it has happened far too fast for any sensible long-term investor to react.

Footnote: What is a normal correction?

This is the stock market, there is no normal correction. But you can do some statistics. Since the GFC ten years ago (down 54.25% in 339 days) we have seen the following Australian market corrections:

  • Minus 16.34% in 55 days.
  • Minus 22.75% in 122 days.
  • Minus 21.51% in 239 days.
  • Minus 9.96% in 72 days.
  • Minus 5.13% in 111 days.
  • Minus 6.63% in 57 days (the correction in February).

If you average those then the average correction is 13.72% and takes 109 days. The current correction has been 13.2% and it has taken 59 days. On that basis we have already completed an average correction in half the usual time. It’s been pretty savage as corrections go.

The conclusion is that whilst the trend is clearly down in the short term, and you have to respect the trend, we are assuming this is a normal correction. The ingredients for a more significant long-term market sell-off don’t appear to be there and it is too late to sell. We consider this a momentary loss of poise for investors, and having sat it out this long would be foolish to do anything precipitous now.

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