Prior to the March sell off this year, our flagship fund held almost 30 per cent in cash and our small companies fund held more than 40 per cent in cash.

In December/January the ASX200 Industrials Index was trading at a record 26 times 12-month forward earnings.  At the same time, one-year-forward earnings estimates had been declining since July 2019.  In my three decades investing I have not seen such a picture being sustained for very long, and while we didn’t predict Covid-19 would be the event that burst the bubble, in March in popped.

Today, the equities market is similarly dislocated from earnings.  Indeed the uncertainty around earnings is so extreme that more than 200 Australian companies have pulled guidance, unable to offer investors any sense of what the future may hold.

The support in the market is due to two factors.

The first is a definition of ‘recovery’ that differs from the definition that might be held by someone on the street.  The market’s definition of recovery is akin to a boxer knelling after having been knocked flat on the canvas.  He’s up on one knee and therefore that is better than being KO’d on the mat.  But the boxer is not at full strength and is certainly not ready to go another round.  The man in the street’s definition of recovery is a return to the levels of income, revenue or profits he was earning before the world went into a pandemic-inspired lockdown.

That latter definition of recovery is some way off.

Indeed, The Reserve Bank of Australia’s assistant governor Glenn Stevens recently noted, “Depending on how quickly the various restrictions are able to be eased, you could get a reasonable bounce, particularly in some of the most affected areas such as personal services and hospitality. But even on an optimistic view, the pace of recovery won’t be as rapid as the contraction was.”   A few weeks prior our longest serving treasurer Peter Costello observed, “it’s going to take some time to get unemployment back to five per cent…If we peak at 10 per cent or 11 per cent, I think we’ll get back to seven pretty quickly, but I think it’s going to be a long hard grind to get back to 5 per cent unemployment.”

The point is that senior officials with some experience running this country’s monetary and fiscal policies believe the journey to prior levels of incomes will be slow and halting, rather than the easy and quick return implied by the stock market.

Which begs the question, why is the market now more expensive than it was prior to the economic lockdowns?

Part of the reason is that markets are lauding, and rallying on the back of central bank counter-measures.  One of those measures is the announcement by the US Federal Reserve to buy individual corporate bonds.

This occurred after the market for corporate leveraged loan-backed Collateralised Loan Obligations (yep, nothing has been learned since the GFC, which was inspired by the collapse of mortgage-backed Collateralised Debt Obligations) collapsed between February 22 this year and March 23.

The market cheered the entrance, for the first time in history, of the US Federal Reserve into the primary issue market for corporate junk bonds.  More recently it has announced its entry into the secondary market.

Importantly however, it should be noted that such buying activity only has the effect of maintaining low interest rates for companies that would otherwise already be bankrupt.  It does not generate revenue or customers for those companies.

And of course, all of this bond buying support must be funded by the printing of money, something markets are also currently cheering.

But think about this, what is the money being used for?  If the US printing of money with gay abandon and without limit, under the auspices of Modern Monetary Theory, was helping to finance military or economic domination, which in the current geopolitical environment is probably wise, it would make sense.

Instead, however the printed money is merely being used to buy the bonds of, and support low interest rates for, rubbish, Triple C-rated, junk companies.

Nothing is being created except the appearance of something desirable.  Nothing is being built, growth isn’t being generated.  All that is happening is rubbish is being allowed to continue rotting and investors are being attracted to speculate on that rubbish.

Witness the recent speculative fervor in the US-based car rental company Hertz.  Hertz declared bankruptcy on May 22, this year.  The shares subsequently rallied five fold, which prompted the company to seek US Federal Court approval to raise a billion US dollars.  Hertz said its shares would be eventually “worthless”, but the sale “could benefit creditors seeking to recover more of their claims during the bankruptcy process.”

The Wall Street Journal recently reported; “Jared Ellias, a law professor at the University of California Hastings College of Law, said he has studied hundreds of bankruptcies and never seen a company try to fund a bankruptcy case with an equity offering at the start of chapter 11.

“Hertz looks at the market and sees there is a group of irrational traders who are buying the stock, and the response to that is to seek to sell stock to these people in hopes of raising some amounts of money to fund their restructuring,” Mr. Elias said.”

If such behaviour is not a sign of a market dislocated from reality or another bubble, I am not sure what is.

With that in mind we are continuing the business of investing but doing so in companies with lower leverage to the all-too-optimistic expectations currently built into aggregate market prices.  It might be prudent for you to do likewise.

Roger Montgomery is the chairman and chief investment officer of Montgomery Investment Management.
Leave a comment