The best argument is for staying the course

Roger Montgomery


December 5, 2017

When the chief executive of American Airlines, Doug Parker, announced on an ea­­rnings call with analysts, “I don’t think we’re ever going to lose money again”, I wondered whether bullish enthusiasm had crossed over into irrational exuberance.

The question was raised again when WeWork chief executive Adam Neumann told in October, “No one is investing in a co-working company worth $20 billion. That doesn’t exist…Our valuation and size today are much more based on our energy and spirituality than on a multiple of revenue.”

With commentators calling “Loss is the New Black”, citing the market capitalisations of Uber, Snapchat, WeWork and Amazon as evidence of a “new world order”, and articles with titles such as ‘Buy Everything’, ‘RIP Bears’ and ‘Congratulations Capitalism’ increasingly common, it’s worth asking whether the market downturns of the past are now dead.

As a financial adviser, you may have your own personal opinion about whether it is appropriate to be bullish or bearish; however, it is wisest to suspend your own view and ensure your clients maintain their strategy through thick and thin, investing in a business-like fashion and staying focused on the long term, irrespective of their age.

Clients will have their own biases, too, so this article seeks to give you the information necessary to allow you to conduct the conversation you need to have.

If economic, business and sharemarket cycles are dead, and a new paradigm does exist, investors should be buying shares now and ignoring both the low returns implied by historically high P/E ratios, and the warnings by central banks that low interest rates have done their job.

Weighing the evidence

Of course, if you believe the influences that traditionally determine returns are alive and well, if perhaps in hibernation, then investors need to show more caution. With that in mind, let’s explore the arguments for both sides.

To begin with, the economic backdrop is supportive. The global economy is described as displaying strong, synchronised growth; the term Goldilocks economy is used to describe the circumstances we now enjoy. The US is growing at an annualised 3 per cent to 4 per cent, China is growing at more than 6.7 per cent. The EU as a whole is also set to beat expectations, with robust growth of 2.3 per cent this year. In keeping with this theme, many point to high and double-digit rates of earnings growth for US corporations and the P/E ratio for the S&P 500, which is at an undemanding 21 times.

Before getting too excited about economics, however, it might pay to know that there is absolutely no correlation, in any geography, between economic growth and sharemarket returns. Perhaps surprisingly, if the economy is expanding at above-average rates, there’s a 50 per cent chance the sharemarket will do better than average and a 50 per cent chance it will do worse.

Furthermore, Nobel laureate and creator of the CAPE (Cyclically Adjusted P/E) Ratio, Robert Shiller, noted that among the 13 bear markets since 1870 – when the market fell 20 per cent within a year of a prior peak – almost all were preceded by strong earnings growth and low volatility. So there is nothing unique in today’s combination of high prices, strong growth and low volatility that precludes a market correcting.

Looking backwards, of course, the market has performed well. Since the lows of March 2009, the Dow Jones, including reinvested dividends, has increased more than fourfold.

Past performance should not be used as any guide to the future, though. There have been many almost multi-decade periods when the market has tracked sideways, earning a return that barely kept investors ahead of inflation.

The fate of inflation

Another argument being hotly contested is whether inflation will return. Inflation is a negative impost on quality of life and central banks globally would be forced to raise interest rates should inflation return. Rising interest rates would be negative for asset prices, which have been on a tear in virtually every asset class from equities to art.

With wage growth virtually non-existent for many years, some commentators are suggesting inflation is dead. Some even suggest that advances in technology have simply made inflation obsolete. As more jobs are replaced by technology that never sleeps, takes holidays or requests superannuation, and as salary costs fall and wages decline, increasing profits for companies.

Such a scenario is, of course, a perfect picture for equities. But what the bulls miss is that fewer jobs and lower wages mean fewer customers for the products companies sell. It should come as no surprise that Henry Ford broke with tradition and gave all his employees a pay rise because he realised they were the customers for his T-model Ford. Generational unemployment and ‘capping inflation for our lifetimes’, whether due to economic mismanagement or technological innovation, would produce deflation, which is an outcome as bearish for equities as rampant inflation.

Another argument bulls have proffered is the ‘central bank put’. Record low volatility suggests there is confidence, on the part of market participants, that any setback in financial markets will be met by central bank buying of assets until stability returns. What the argument fails to consider is the finite capacity central banks have to engage in such activity. There has to be a limit.

It is true that, in recent history, central banks have intervened following any signs of destabilisation in markets, through measures such as quantitative easing. And while it is likely that central banks will be slow and measured, they can’t control animal instincts, which would combine with record levels of margin debt to force many investors to sell shares aggressively as prices decline.

Another argument in support of bullish markets is that government-backed programs that encourage wealth creation, and a self-supported retirement, eventually find their way into financial markets. Population growth and increases in life expectancy are also proffered as reasons to expect demand for goods and services, fuelling profit growth.

Of course this contradicts the arguments put forward earlier about a greater proportion of people unemployed through technological innovation. More people living longer just means more people unemployed and reliant on the government for support.

The reality is that these theories about demographics playing an important role in predicting asset price returns are just weight-of-money arguments that have never prevented corrections in the market before. One commentator recently wrote, “As people live longer, there will be more demand for food, water, electricity and resources in general. Companies will have to fulfil…this insatiable appetite for goods. The more the companies provide and adapt, the better it is for their owners (shareholders).”

The population hasn’t only recently started ageing, it’s been getting older for decades, nay longer, and in that time, all markets and assets have corrected.

There are, of course, many other arguments put forward to suggest you should be fully invested. We agree that in the long run, being fully invested is preferred. But it is also true that the higher the price you pay the lower your return, and prices today are factoring in all of the bullish arguments with little room for setbacks, hiccups or speed bumps.

Those who are patient will be well rewarded for investing when there is blood in the streets. Remember, be fearful when others are greedy and greedy when others are fearful, no matter whether you are bullish or bearish.

TOPICS:   investment philosophy,  investor psychology,  Roger Montgomery

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