Today's Like Today Suck
Newsletter sent to our clients today
Let me start by saying what I’m sure you are all thinking. Days like today suck. They hurt. I’d imagine that some of you reading this are now feeling nervous or concerned about your portfolios. That is completely understandable, in fact, you probably would be inhuman if you felt happy about your portfolio had dropped.
The broad market ASX200 index fell 246 points today or 3.55% with the low being a whopping 116 points below the closing price of 6,686. A significant drop from all time high of 7,592 points back in April.
Today’s price action had a couple of contributing factors so let’s get into the details. Firstly, on Friday evening while our market was closed the US inflation data came in higher than anticipated, secondly our market was closed on Monday and then last night the US market fell further as investors/traders further embraced Friday’s news. Needless to say with a 2 day significant fall to be priced in, it was almost a certainty that our market would fall today.
What’s causing these falls?
As written numerous times, these falls are being driven by high inflation numbers and what are sure to be further rate rises by central banks globally. Bond yields are rallying, bond prices are falling, stock prices are following and there are very limited pockets of safety for an investor in the broad and in my opinion indiscriminate selling that we are seeing across almost all asset classes.
The data that is concerning markets is that US headline inflation is currently sitting at 8.6% and the market is thinking that the Fed will raise rates by a larger than expected 0.75%.
The market is starting to price in more and more rate rises, alongside larger than previously thought rises and if you remember from past emails the value of an investment is the sum of the projected cashflows from that investment with a discount for the margin of safety and a discount to account for the returns generated by a safe asset (government bonds) over the holding period of that asset.
This is the reason we have seen such a dramatic collapse in ridiculously priced growth stocks (particularly in the technology sector). The bigger the discount you are forced to apply in order to these stocks, the cheaper the price you must pay in order to generate an adequate or appropriate return on your invested capital.
The market is acting as though the strong the strong and enormous inflationary pressures we are seeing are of a permanent nature. As mentioned previously, energy prices have skyrocketed and the latest joke of the week is people offering to trade lettuces for items such as houses and cars.
Most economists are as valuable as meteorologists. They are almost always wrong and yet somehow people keep watching the weather or economic forecasts and taking it as gospel. In my opinion, to be polite, this is misguided thinking at best. It wasn’t too long ago that the consensus amongst economists was that this inflation was fleeting in nature while today the consensus is that it is a more permanent or structural nature. While macro-economic data has a place in our research process, we disclose that over 90% of economic thought and commentary is not worth reading and even the rare pieces that are enlightened, informative and high quality are often wrong.
Locally our inflation numbers are better than the US however in order to minimise some of the pain that households are feeling the crucial number I will be looking out for is relating to wage growth in the next RBA announcement/minutes.
It is my opinion that the inflation we are all feeling is mostly energy driven and will dissipate with higher levels of supply. The old saying is that the cure for higher prices is higher prices. This might sound perverse but when marginal and high-cost players are able to produce and sell at high margins, the market becomes flooded with supply, far outstripping demand and ultimately prices will reduce as a result. The inverse is also true, the cure for low prices is lower prices as more of those marginal players cease operating and only the lowest cost producers remain diminishing supply until the point where prices being to increase as a result of lower availability.
Alas however, I could be wrong. Afterall, I did just write that most economic projections are almost worthless.
Is there a recession looming?
Historically there has been a strong correlation between periods of extended rate hikes and an over hot economy being followed by recessions. One thing that I want to make clear is that the word recession is not what most of you would be picturing. I would wager that when thinking of the word recession your mind turns to high unemployment, the financial world ending, job loses, businesses closing, and scenes of mania as depicted in the Big Short.
In real life, recessions are just 2 consecutive quarters of negative economic growth, meaning that the economy has shrunk over a 6-month period. I’m not going to pretend that recessions are pleasant or fun, however like when your pasta starts to boil over it is necessary to take the heat out of the pan. Or in terms of economies, letting the heat out to prevent rampant and prolonged inflationary pressures.
At this point in time, I am of the belief that if we were to fall into a recessionary period it will not be terrible for most. In fact, if you look at the last prolonged recession the US had it was the time where some of the greatest businesses on the planet today were formed.
What does this mean for your portfolio?
I am a little concerned about the impact of rising interest rates on loan serviceability and property prices (hence underinvestment in the sector), home builders (terrible businesses mostly in the sense that they require large amounts of debt, regular cashflow and generally have thin margins) and discretionary retailers (i.e. if you are concerned about the future of your job, are you really likely to go to JB HiFi (JBH) and buy a new $6,000 tv?) but there are some incredibly high quality businesses that are starting to trade at close to appealing prices today.
As you would be well aware, our number one focus in managing your portfolio is to ensure that your underlying investments are durable in nature, have a strong balance sheet (meaning that they don’t have excessive debt or need to constantly raise fresh equity/debt) and while not being immune to the economic cycle posses the ability to grow earnings at a rate greater than inflation/the economic at large.
At the moment we believe that our clients are widely exposed to high quality investments and despite the current volatility are largely likely to do well over term. In fact, with some of our preferred holdings we are seeing prices where if we did not own at mostly much lower prices for you, we would be looking to add into your portfolios. Do not be surprised if in the near future we actually recommend dividend reinvestment into these names rather than allowing that cash to accumulate into your cash holdings.
Unfortunately, the trade off for owning higher growth assets is that they are going to come with more ups and downs than owning safer and more boring assets. Although, as you may have seen recently even defensive options such as credit is not immune from market volatility. The only way to escape it is to move into unlisted asset classes but this presents its on set of risks including: marking of the book, internal valuations being as accurate as predicting the weather on September 17th 2034 and most importantly as these assets are not liquid it can be very difficult to move your money both in and out of these vehicles.
One question I have been asked a few times today is “should we go short the market?”. I’m going to answer this conclusively here. In my professional opinion short selling is highly risky, we are not going to be able to time the bottom to exit and if the market has fallen enough for you to ask the question we are probably closer to a bottom than you think.
Speaking of market bottoms, historically the average bear market in the US has lasted for 16months on average and has a total top to bottom fall of 34%, so far the SP500 is down roughly 22% from its all time highs 6 months ago, while the technology heavy NASDAQ is down 34% from its highs 9 months ago. So on a historical average basis we are half way through the downturn and their may not be much more selling to go. However, history does not repeat but instead rhymes.
I understand that you are hurting on days like today, in an ideal world all of the investments you own would be flat or up slightly and everything on our watchlist would be down big. Alas, it is not the case. While many of the great investments that we want to own have fallen, so have the investments that we hold. This will always be the case. Fortunately, though, as I mentioned previously if these are now becoming tempting enough again for us to consider increasing our allocations, it is likely that others will be sharing the same mindset.
While I am willing to pull the trigger on new investments at the moment, the key factor that we must remember at all times is that the price is what we pay, the value is what we get for what we buy. As always, I will continue to be cautious with your money and treat it as if it was my parents for many of you have become like family to me. It is in times like this when we must exercise prudence and not throw the baby out with the bathwater due to a bad couple of days, weeks, months or even year.
As this correction grows, and the ASX is only down 11.67% from all time highs, the amount of the high-quality companies that we like, believe in and would like to own but haven’t been able to buy due to valuation but are now starting to increase in appeal is growing. While this list is not enormous, it does grow larger on days like today. We view this as being a positive to come from the pain.