MB Fund November Performance: International boom!

November was a stark reminder of the power of narrative in driving returns. World stock markets rose almost 5%, but earnings broadly were downgraded. Our portfolios handily beat all benchmarks over the quarter as our exposure to international stocks offset our large cash holdings. We have been trying to keep enough exposure to international stocks to offset our conservative stance, and in November that trade-off worked particularly well:

Nucleus November 2019 performance

Both of our equity only portfolios also outperformed over the month – International up 5.1% and Australia up 5%. Assets are priced for perfection, and we are expecting conditions to be far from perfect:

  • corporate earnings are weak globally,
  • inflation is almost nonexistent,
  • central banks know that they are out of ammunition and are begging governments to borrow,
  • largely governments are ignoring these central banks.

What is a bad increase in a stock market?

It is hard to mount an argument against stock indexes going up. But, not all changes in price are of equal quality. For example, say the US S&P 500 increased by 10% in a year, but earnings went backwards. I would consider this to be a lower quality result than a year when the price increased by the same amount, but earnings increased by 20%. i.e. a change in price that is justified by a change in earnings is more sustainable than a change in the multiple that investors are prepared to pay.

If you made the greatly simplifying assumption that all markets were priced off 12 month forward expected earnings then we can examine the quality of stock market returns from year to year by looking at how much of the return came from the following:

Change in Price =

+/- Growth expected in earnings from the first year to the second year
+/- Revisions in growth expectations from the first year to the second year
+/- Earnings surprise as first-year earnings go from a forecast to an actual
+/- Change in valuation multiple

Looking at price changes in this way, the US market growth doesn’t look quite as bad:

Rational Optimism or Irrational Exuberance?

We posed the question last month that with the price/earnings ratio back above 18x, is it:

  •  Investors bidding prices up in front of another earnings boom?
  • Or is it a sign prices have run in front of fundamentals?

The last few times the P/E ratio hit 18x:

  • In 2003 the US was recovering from the tech wreck, spurred on by loose monetary policy and a nascent housing boom.
  • In 2009 the market was recovering from the financial crisis, just about to post a 30%+ increase in profits.
  • In 2017 Trump tax cuts were just about to turbo-charge profits.

It is much harder now to find the reason for profits to boom from here. Most investors arguing for rational optimism point to:

1. Trade war resolution

Some say a trade war resolution will spur earnings growth. I would argue:

  • It is a little unclear what deal has actually been done – different insiders have different stories
  • the preliminary agreement has little that will spur earnings
  • given the problems getting a preliminary deal over the line, the larger deal is a long (long) way away from being resolved

2. Central bank support

The other core argument is central banks have moved from tightening to loosening, which will turn economic conditions positive. I have sympathy for this argument eventually, but not yet. In the meantime:

  • each successive round of easing has less and less of an effect on the economy
  • the amount of central bank loosening is still relatively limited
  • it is likely economies will need to get worse before central banks act more decisively

For my part, it is too early to invest based on central bank support.

3. The goldilocks zone

A different argument notes that stocks are in a goldilocks zone – enough growth to keep profit strong, not so much growth that central banks need to raise rates. Inflation, in particular, wage inflation, remains low. This means costs will remain constrained, which is good for profit margins. There is plenty of truth in this argument. The more important question is how much do you want to pay for stocks in the goldilocks zone given:

  • being in the goldilocks zone helps keep profits grinding high, but it isn’t a reason for earnings to rocket higher
  • there is a risk that stocks leave the goldilocks zone

I’m arguing that stocks in the goldilocks zone are attractive – just not so attractive that I’m prepared to pay the same price the market usually pays just before a massive earnings boom.

So where does an asset allocator turn?

If the increase in valuations is a rational response by markets to improved economic conditions, then we should be buying stocks. We don’t think it is. Another argument is that there is no alternative. Stocks are expensive, but so is everything else. This is partly true. Bonds are expensive, but cash is always fair value. We are also of the view that Australian bonds have room to become more expensive. That said, we have been moving our asset allocation around a little recently. We have topped up on 5 year bonds as rising bond yields conflict with our negative view on the Australian economy. We also added some more UK exposure and continue to shift our stock selection into stocks that we believe will benefit in the medium term from companies moving supply chains away from China. Longer term, stagnant growth is going to be on the menu until we see governments spending money. And probably “helicopter” money. Given the current state of economics, that will probably take a sizeable economic crisis. Until then, we expect more of the same – slow growth and a grind lower.

November Performance

We are comfortable with the view that the defensive position is warranted. If markets shoot higher, then we will underperform, but we think the trade-off is justified. Downside protection is more important at this point in the cycle than chasing stock markets higher.

Investment Outlook

Australian shares are still considerably more expensive than most international comparisons with weaker growth expected. We retain large cash and bond balances to hedge against volatility and with the expectation capital protection will be necessary for the next few months. Our key focus is on:

  • Chinese growth, gauging the extent of the slow down and the policy response to the trade war
  • Trying to work out how sustainable the effect of the Australian election will be on house prices
    • Gauging the damage that a Boris Johnson led Brexit might cause

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Damien Klassen is Head of Investments at the Macrobusiness Fund, which is powered by Nucleus Wealth.

The information on this blog contains general information and does not take into account your personal objectives, financial situation or needs. Past performance is not an indication of future performance. Damien Klassen is an authorised representative of Nucleus Wealth Management, a Corporate Authorised Representative of Nucleus Advice Pty Ltd – AFSL 515796.

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Comments

  1. Well, here’s the rub. I joined and said just one thing at that time…I don’t want to take any losses as I might need to withdraw my super anytime. So I’m in just about the “safest” combination you offer. But, on the basis of this report I took a look at my balance this morning. I now have roughly $13,500 less super than what I opened my account with earlier this year. To say I am concerned is an understatement, I was doing way better than this when I was managing it myself

    • I assume your losses were due to paper losses on Aus, US bonds and USD allocations?

      I’ve made slight paper losses on recent purchases of these, too (still managing it myself). I’m not going to sell anything though, as I think the Aus economy is in for a hard 2020…

      • I’ll try to work out where the losses came from, when I have gathered enough reserves to do the data work. Will post if this thread still has anyone reading it in a day or so.
        Nevertheless, when every number for every category of MB investment is apparently positive (see summary chart in this report) I am seriously concerned how my own super balance dived like this

        • Diogenes the CynicMEMBER

          If you are in that position Arthur you just about need to stay 100% in cash. All assets move up and down (except cash), even bonds or gold. The other way I have seen this done is to work out what is the maximum amount you might need to withdraw in the next 1-2 years put that in cash in the bank and then everything else can be invested (from conservatively to aggressively). My own experience of Nucleus has been positive with very good returns but then I am in 100% international.

    • Damien KlassenMEMBER

      Thanks Arthur – maybe you can contact Tim to go through the details? We are seeing nothing like your figures at our end so I’m thinking there may be a reporting issue that we would like to get to the bottom of. At 30 Nov (the period which this report is to) we had your account in profit. Bonds have pulled back in December but nothing of the scale you are talking about.

      Note also that we don’t “mark our own homework” for the performance reporting – all of the figures are from a third party (Praemium).

      Best way to get the data that you need is to log into Praemium and go to the performance page where you get a line chart showing your daily changes.

      • Thanks Damien. Figures come from my online Nucleus/Praemium Account at 8:00 Sat am. (just re-confirmed 1 minute ago)
        Money in about 6 months ago…$x23 k
        Account balance now…$x09 k
        I am quite pleased that you and Tim (below) have responded to my small problem. I will be talking to Tim Monday.
        I will report back what the outcome is for the interest of others

    • Tim FullerMEMBER

      Hi Arthur – Echoing Damien above, I am not sure how you arrive at those figures, but happy to set up some time tomorrow or when suitable, to run through it all. I have sent you an email now. Cheers.

  2. Even StevenMEMBER

    That’s a really good investment rationale summary, Damien.

    I haven’t yet joined MB but the more I see of your writing/logic, the more I like. Good stuff.

    • Blast! This reply was intended to be at the level above (i.e. direct to post). Sorry Even Steven.

      Update: Damien and Tim, plus anyone following this. This morning I found an error in my own records. In fact I opened my account with $10 k less than I thought I had deposited.
      Therefore, my accumulated losses are not slightly less than $14 k, but are in fact slightly less than $4 k. As you can imagine, this has me hyperventilating much less than I was above. Percentage-wise, it’s a loss far easier to understand and swallow than $14 k. over 6 months.
      Immediate apologies to MB/Nucleus for this error and great embarrassment felt by me. Admittedly, there is still a loss. Further updates as I work out how this (smaller) loss occurred.

  3. Well, MB readers, I had my talk with Tim F about my Super account and my concerns laid out above. Let’s start by noting how utterly unlikely it is that one of the principals of any other Superannuation fund might talk to an account holder about their concerns. Inestimable plus.

    My big apology. As already noted in comment above, I made a book-keeping error in my own records to the value of $10 k. I did not deposit the initial amount into my Nucleus Super fund that my records showed I did. I opened the account with $10 k less that my records show. Therefore, my account is down not the roughly $13,5 k figure I said above, but is in fact down slightly less than $4 k.

    Having gone through my accounts and chatted with Tim, I’m comfortable that this smaller loss is due to unfortunate timing; in the sense that I chose to join the Nucleus Super fund at more-or-less the exact time when the USD was absolutely at a top, and so were US Treasuries and Australian Government Bonds. Nucleus conservative options are long all of these things. In the ensuing months, the Australian dollar has slowly risen against the greenback, and bonds in both countries have increased their yields and lowered their market price on the back of the global risk-on mania. If I had joined up at almost any other moment in time, just a few weeks either way, I would not have made a loss at all. Most of these movements have been in December, after the end of the November reporting period used by Damien above. Therefore, this is just one of the vaguaries of investing, and it seems quite likely that this relatively small amount can be recouped before H2 of next year if the Australian economy continues it’s contraction and the RBA lowers rates in February.

    I want to thank Damien and Tim for taking my concerns seriously and for making ridiculously over-and-above efforts to help me work out what was wrong. I don’t think this would happen anywhere but Nucleus/MB. The ethics of this business seem to be rock solid and I consider I have just unintentionally put it to a stress test.

    MB Fund / Nucleus Wealth highest recommendation and sincere apologies. I was a hot-head and posted before checking my numbers properly.

    • Thanks for the update Arthur. Presume that means you’ve got an extra $10k somewhere you weren’t expecting it?

      Nicely done Damien and Tim.

    • Tim FullerMEMBER

      Always happy to help Arthur – and thanks for the vote of confidence and clearing it all up for the MB readership.
      Greatly appreciated.