The Downside of Up

One of The Intelligent Investor’s key con­tributors, Tony Scenna, got a call from me recently. I’d been away and wanted his take on what had been happening in my absence.

“Tony, what’s been going?” I asked. ”Every­thing’s been going up,” came the reply. “The Aussie dollar’s up; interest rates are up; oil is up; gold is up; inflation is up and the sharemarket is up. There was a time when things went down,” Tony lamented, tongue now firmly in cheek. “Nowadays, everything just seems to go up.”

Tony Scenna started in funds management in the early 1980s at Perpetual. He was followed by the likes of Peter Morgan (452 Capital) and Anton Tagliaferro (Investors Mutual) in building one of Australia’s premier funds management businesses. Scenna’s own boutique operation, Selector Funds Management, is smaller but his returns are impres­sive and he’s seen his share of market cycles. With a few pithy, light-hearted sentences, Scenna made a powerful observation. The sharemarket is awash with investors who have only a distant memory of falling prices, let alone recessions, if they can recall them at all.

It reminds me of investment property spruiker Henry Kaye. I once saw footage of one of his semi­nars where he said “any moron can make money in real estate because real estate prices always go up, right?” The camera panned to the audience to show nodding heads mumbling assent. Kaye is now being investigated by ASIC and many of his investors have had their beliefs directly contradicted by pain­ful experience.

Yet the belief that prices always go up seems to be quite widespread in the sharemarket at the moment, despite recent events that should dent that belief. Any first-year finance student will tell you that rising interest rates are bad news for the sharemarket. For one thing, the opportunity cost of taking your money out of a bank has risen: it’s more attractive to leave your cash in a good online term deposit at around seven percent than it was a couple of years ago, when it was less than six per­cent. And yet the stockmarket is trading at record highs after (as I write this) five consecutive rate rises. How so?

The problem is that Australia seems to have a two-speed economy and is hampered by a one-size-fits-all tool to deal with it. Higher rates are needed to dampen demand in rampaging areas of the economy such as Western Australia and Queensland. But the consequences of higher rates for thousands of mortgage payers in, say, Western Sydney, could be disastrous. And, so far, the higher rates haven’t had much of an impact even for these people. Those sectors that should be affected by higher rates, such as the banks and retailers, have simply carried on with business as usual because people are still spending despite the rate rises.

Recent figures showed an increase in underly­ing inflation. A continuation of that trend would put our central bankers in a bind. To really calm the burgeoning sectors of the economy requires much higher rates, but those rates would adversely affect those areas of the economy that are still struggling. The surging oil price is another issue for consumers and the strong Aussie dollar means lower profits for most of our exporters.

With advance warning of these events, and the recent global credit meltdown, you might have thought hard about selling your stocks. Yet the market has continued to power ahead in the face of these ominous trends. At some point, I suspect Scenna will see things going down again. And, for some at least, the reality of falling prices challenging the belief that these things don’t happen will be a very painful experience indeed.