Panic is normal?

At MB, one our key reasons for being is to expose ‘the spruik’ wherever we find it. Many of the bloggers at the site have very successfully done so for the perma-bullish housing brigade that used to dominate the national media.

No doubt readers have noticed the insistent call to “buy” shares over the past week coming from commentators in all quarters of the national media. I could have chosen any number of articles to expose this poor investment thinking, but one article using the motto of “buy when others are fearful” nicely highlighted three common mainstream misconceptions of equity markets and their role in your portfolio.

The first is a lack of understanding of how secondary asset markets work. The second is why asset allocation matters as much as simplistic stock picking. The third is the common lack of consideration of downside risk, either through opportunity cost or the consideration that stock markets can continue to fall and stay down, sometimes for a decade or more.

The article asked:

What’s driving the sell-off?

Standard caveat: Who knows? Markets do crazy things. More than 60 per cent of total volume is done by high-frequency computer trading using brainless algorithms. The past two weeks have understandably shaken confidence. Fearful of GFC2, investors have been fleeing the market. Broker TDAmeritrade said it processed more than 900,000 trades last Monday, with four out of five days last week hitting record levels of trading activity. Many were buying. But if the market is any guide, plenty were panicking.

Well actually half were buying, half were selling – that’s how markets complete a transaction. But the buyers wanted lower prices to take on the higher risk. But to get to the key word: confidence.

Just like the property bulls tend to confuse investment with speculation, equity and other risk markets are not places to efficiently allocate capital: they are for speculation on asset prices, driven by sentiment and confidence.

And this works both ways – for prices to rise, investors must be confident that future market prices are likely to be higher. When does this shift happen? No one knows – and for Japanese investors they are still waiting for this confidence to return, 20 years later, whilst American and European investors have waited for 10 years.

Back to the article, we then find an example of our second violated investment principle, that asset allocation matters:

Over in the US, the earnings yield on 10-year Treasuries is the equivalent of 50 times earnings. By contrast, Apple, possibly the fastest growing mega-cap company ever, trades at 11 times earnings. Which investment would you prefer?

I’d prefer the one where I get a return of my money, not just on my money. What if Apple trades at 9 times earnings (the average during a US bear market), and those earnings are 20% less because of tapped out consumers or higher taxes?

The article goes on to state:

Many Australian banks are still offering one-year term deposits at well over 6 per cent. If it’s the safety of cash you’re after, and with markets betting Australian interest rates are heading sharply lower, 6 per cent is a mighty fine deal.

You cannot compare different asset classes and value one as “better” than the other based solely on an earnings multiple (or lack of earnings). This is a misconception shared with physical gold, which has no yield, and thus is considered “worthless” by conventional asset allocation theory. In the same vein, negative real yield US T-notes (CPI in the USA is above 3%, so the yield is -1%) are also considered worthless or nearly so using this paradigm, which explains this from the article:

If you’re one of those willing to lend money to the US government for a decade at 2 per cent, we need to talk. Even a renowned dividend miser like BHP Billiton is yielding more than 2 per cent.

Again, this misunderstands the real role of money – exemplified by the run to gold experienced now, in almost every currency. This is not an investment or a willingness to get a return on your money (although many are speculating in the non-physical markets), it is to ensure, as best as possible, the return of your money and displays of a lack of confidence in risk markets.

And that brings us to our third ignored principle. What we really need to talk about is the downside – risk management, or the consideration that you may not get a return of your money, either through time decay, opportunity cost or outright physical loss.

The examples used in the article, Apple (AAPL), BHP, QBE and Woolworths are considered either blue chip and/or growth “stories”. Yet each face risks that will impact either their earnings and the multiple (and hence the real valuation, the price a buyer is willing to pay and a seller is willing to dispose at) applied to those earnings.

As I said during my piece (co-written with Q Continuum) on the Great Volalitility:

Price Earnings (P/E) ratios are not a valuation technique in of themselves, but a gauge of what the market is usually willing to pay for the earnings of a company (invert the ratio and you have the earnings yield to compare to a savings interest rate or bond yield)

The last 20 years have seen the US market average a PE ratio of 25, whilst the Australian market over the same time period averaged 17-18x.

What causes these PE ratios to drop? Why are investor’s less willing to pay for the same amount of earnings as before? The answer is a mixture of sentiment, unclear inflation expectations and of course, a removal of exuberance – i.e. money creation.

From Wilson HTM

During the last sideways market (1969 to 1982), P/E ratios ranged between 8 and 14 – not the recent aberration of 17-18 times. Where is consumer sentiment (i.e the actual force that determines if businesses can create the “e” in earnings) heading? Where is the money creation – margin lending is disleveraging, the house ATM is turned off, governments are loath to stimulate and central banks “printing” is sitting in excess reserves that won’t be lent out.

Investors who don’t understand market dynamics need to understand history first, and not ideology. Markets “move” sideways as often as they go up or down. Sometimes these secular trends last a decade or more. The brave who hold on during these periods – even if they purchase the bluest of chips and receive a nominal dividend, run the second risk of this yield eaten up by inflation or a reduced payout ratio. Which is why the real focus needs to be on the underlying business robustness, as Q Continuum explains here not on a notional consideration of “cheapness”.

All major western equity markets in the last decade have not appreciated – the current “panic” is just another reversion along a decade long bear market. To repeat, the US, Japanese, UK, German and Italian stock indices have not yet recovered their 2000 highs. A similar fate is likely to have befallen Aussie equity markets if it weren’t for the rise of China (particularly there inclusion in the WTO)

The time to buy is not when others are fearful of missing out on a bounce, which is effectively what the falling knife brigade are hoping for, but when they are despondent that nothing will make them go back up again.

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  1. Sandgroper Sceptic

    Nice article and hits the right note abotu investor psychology.

    So we should buy when the Aussie markets trades at 8x, 6x? They imply something like a further 40-60% correction from here = ASX 2000!

  2. This is a high quality piece. Very well done.

    What is your background/resume, or do you prefer anonymity?

  3. Top notch stuff Prince. Maybe Buffett’s famous quip “Cash and confidence in a time of crisis is priceless” should be changed to “Cash, confidence and competence in a time of crisis is priceless”. Buying when others are fearful is only a good strategy (great in fact) when you know the difference between a good company with a deflated share price and a bad company that is being justifiably punished by the market. JB hi fi and Bluescope being good examples respectively.

  4. I agree on many points. Would like to highlight the following too:

    – I do not think it’s just a question of investing in the ASX or not: it depends on how your portfolio is balanced. If you are 100% cash, around these levels I would suggest to put some of that money into shares. 10% , 30% , 50% it all depends on your goals.

    – It mainly depends on how much risk you are ready to tolerate and what is your investment time frame.

    – Above all, if the ASX goes the way of the Nikkei or S&P 500, so will interest rates in this country and house prices too and basically every other asset class.

    – I think it is better to buy when everyone is scared rather than when every one is euphoric (my personal preference).

    – Even if the ASX will be flat across many years, there will be cycles and money to make.

  5. It is really brilliant and I have to confess I am addicted to MB. You are all a very high quality analysts, not made in China as everything else. Please, do not follow the path of Business Spectator, keep the high quality of MB.

    • Totally Agree. MB is rather addictive and the quality is outstanding. Please keep up the excellence if you can. Even the comments section adds great value in many instances, and that is very rare for most blogs.

  6. Thanks for the kind words folks – I’ll be putting up my post on asset allocation and risk management, including the method I use (the barbell method) whenever this market volatility passes…

  7. “Just like the property bulls tend to confuse investment with speculation, equity and other risk markets are not places to efficiently allocate capital: they are for speculation on asset prices, driven by sentiment and confidence.”

    You’re confusing primary and secondary markets here. Sure in the short-run secondary markets are subject to speculation, driven by sentiment and confidence. But primary markets are an efficient place to allocate capital – that’s why primary equity markets exist and why they will continue to do so.

    Your chart of the S&P, FTSE and NIKKEI is also misleading as you exclude income return from investing in equities (which we all know exceeds the capital return over just about any period you wish to consider). Let’s see that same chart but showing the accumulation index.

    • I’m not confused, as we are all talking about equity indices – all of which are secondary asset markets.

      The primary asset market, particularly here in Australia, is weak and shallow, and whilst they do exist and fulfil their intended role, they are just a conduit (e.g IPO’s) for speculative activities on the massive secondary asset markets.

      This is one of the prime reasons why superannuation in Australia is very poorly allocated – not enough to primary asset markets (e.g corporate debt and venture capital) and too much to speculation (e.g listed shares in established companies).

      You are quite right, the charts are indeed non-accumulative. However, I would suggest you check out the dividend yield for those markets, all of which are 1-3% at best.

      Your comment “we all know” is incorrect – Australian equities are aberrantly high in terms of dividends, mainly due to our franking credit system – almost all Western equity markets have very very low dividend yields.

      Further, these returns are not adjusted for inflation and the nominal losses wipe out even the best dividend huggers.

      • Fair enough, but you refer to an Australian newspaper article, on an Australian website, read predominately by Australians, and then you use charts of the S&P, FTSE and Nikkei to illustrate your point that markets may go nowhere for 20 years.

        Then when I point out you should show a chart of the AORDS accumulation index, you state that Australian is a unique case due to franking.

        Now surely the Australian market is the most relevant to Australian investors?

        And your comment about inflation wiping out even the best dividend hugger is unsubstantiated. From my calculations, $100 invested in the All Ords Accumulation index was worth $3,022 yesterday, while $100 ‘invested’ in inflation over the same was worth $398 as at the end of June 2011.

        Put it another way, inflation since January 1980 has averaged 4.4% per annum (1.1% per quarter), while the All Ords Accumulation Index average monthly growth rate over the same period is 1.04%.

        The value of the All Ords Accumulation Index in Jan 1980 was 1,034, it’s now at 31,266 – roughly an 11.6% compound average annual growth rate.

        Seems like ‘dividend hugging’ ain’t so bad after all?

  8. the cme report says:
    But primary markets are an efficient place to allocate capital

    I beg to differ. Tell that to long suffering Telstra T2 investors ( I mean speculators) , Myer float investors ( at $4.10 ) ..and whilst we’re at it CBA float investors ( at $5.40) .

    regarding The Prince’s fine piece ..more examination of volatility and its mispricing would be much appreciated .

  9. The Prince’s last paragraph is my bible!

    After trying (and failing) to pick the bottom in early 2008 I came across the saying “the bear market ends when every bull is a bear”.

    So I held off for a while until one day I was reading the SMH and EVERY single article was negative. That’s when I jumped in.

    This was in March 2009. Sold down in September 2009 on another macro blog’s predictions around Europe. Now the wait is on for another 100% bearish indicator from the MSM…

  10. Great piece Prince.

    When mum and dad investors are talking “its a good buying opportunity”, its definitely not.

    When those amateurs have a revulsion to stocks ala Rothschilds often analogised ‘blood in the streets’ maybe then.

    Some napkin retracement drawing (I’m in a pub in Hobart) makes me think mid to high 2000s ramping up to 3800ish…then down to high 1000s…then up to high 2000s…what am I doing? The Nikkei over 22 years, a bear market.

    I always look forward to yours posts. First class.

  11. Plenty of dip buyers out today!

    Anyone notice that the ASX is rallying much harder on up days than other markets ATM? Seems us Aussies are much more optimistic than the rest of the world.

  12. Prince, am I to conclude that you are now actively selling your wonderful companies that were presumably purchased in times of higher PE ratios (notwithstanding that you acquired with a decent margin of safety) in favour of cash and better buying times ahead?

    I really do wrestle with this issue.

    • I’ll take that q Porty. We only purchase at a decent discount to our valuation to allow just for this very thing – incorrect assumptions in our valuations or unforseen chnages in the market. We’ll be keeping our Wonderfuls because we bought them at a decent discount. Even with lower PE assumptions they are still good investments (in our opnion). As we revalue eveything this earnings season we’ll be reviewing (and most likely lowering) our eanrings multiples assumptions. The way our system works is if they valuations tell us to sell (whether the price increased or the value dropped) then we’ll sell. It’s all in the numbers after you;ve made you best guess at the qualititive vriables.