I have been reluctant to add to this conversation. To quote Mark Twain, “Better to remain silent and be thought a fool, than speak and remove all doubt”.  Nevertheless, we believe we owe it to you to provide some context about recent market conditions.

The fall in U.S. stocks is indeed the largest ever in terms of points lost. Even though the Dow Jones Index is one of my least favourite measures, I will use this as an example. From a record high of 26,616, the DOW fell a total of 2,837 point to a low of 23,779 – a fall of 10.66%. this is significant, but doesn’t even make the top 20 of all time percentage losses. Since then, the market rebounded by some 6.2% and now fluctuates within these ranges. Those of you who were around at the time will recall in 1987 the DOW fell by a then record 508 points in a single day. However, this represented a fall of 22.6%. A 22.6% fall in today’s terms is equivalent to over 2,000 points.

This ‘correction’ is not unexpected. Even after the above, the Dow Jones index is over 24% higher than this time last year. Australian shares have suffered less so, but this reflects the fact they have generally underperformed compared to global indices, over the past year. The All Ordinaries is up just over 5% for the year to date. Note, these indices do not include dividends, they are merely the change in market values.

The triggers for this correction have been blamed on a number of issues. However, the key factor, we believe, is rising long term interest rates. This is not a sudden phenomena. U.S. 10 year bond rates are almost 0.5% higher than a year ago. This reflects both the reduction in Federal Reserve buying (quantitative easing) and the strength of the U.S. economy. Rising interest rates as a result of strong economic growth is, actually, a net positive. It partly reflects a higher demand for capital and a virtuous economic cycle. Nonetheless, a higher cost of capital has an impact on valuations. It has clearly taken equity markets some time to realise this, but realisation often triggers a ‘panic’ such as we have seen the past few days.

We have been suspicious of market valuations for a little while and the rise in interest rates is not unexpected. Indeed, these events may not yet be complete; the ‘correction’ may yet have some way to go. Market volatility was extraordinarily low for the last year or so. It is now reverting to long term averages – normal, if you like. We have deliberately positioned portfolios with these factors in mind. Our general exposure to rising interest rates has been below that of our peers, as has the general exposure to Global shares. This does not mean your portfolio is not affected by recent movements. Our more conservative positioning has been something of a headwind over the past year, we expect it will now be a tailwind in the context of risk adjusted returns. By and large the specific investments and managers chosen to populate your portfolio continue to do the job we expect. Nonetheless, we continue to review these investments on a regular basis.

We hope this information provides you with a sober basis for reflection. However, if you have specific concerns, we invite you to contact us and share your concerns with us.

Sincerely,

David Graham, MApp Fin CIMA® CFP® SSA

It has taken us a long time to get here. Since the unpleasantness of 2008/09, recovery has been fitful, uncertain and lacked confidence. For several years markets have been concerned about the sustainability and longevity of the recovery. Given the depth of the downturn and trajectory of the recover to date, this has probably been reasonable, in hindsight.

The trepidation and hesitancy of recent years has been effectively dispelled. We are now experiencing a good old fashioned bull market. The most overvalued of major stock markets is the U.S. Records are being broken on a daily basis. While company earnings have supported this strength, the market is extrapolating earnings growth ad infinitum. This supportive environment has spread to Europe, where the cycle is perhaps some years behind that of the U.S. Emerging markets are also being supported by this virtuous cycle. Good times.

We maintain the view that long term asset market returns are mean reverting. Long term earnings growth, valuations and other key metrics always over/under shoot, but they always revert to long term averages. However, the timeframe in which this occurs can vary widely. We are perhaps finally seeing some ‘mean reversion’ in residential property prices, but this has taken a very long time to occur. Financial markets tend to revert more quickly, a reflection of the relative ease of transacting and liquidity.

Variations from long term averages reflect the impact ‘non-rational’ behavioural. I specifically use this term instead of ‘irrational’ because it separates normative human behaviour (what should be) from actual human behaviour (what is). Evolution inclines us to balance emotive and rational impulses. Both are necessary to function effectively, but it is clear that emotive impulses become more prominent as we diverge from long term averages. Put simply, our ‘fear & greed’ impulses increase as markets rise and fall.

Managing these impulses is the hard part. In the current environment ‘fear of missing out’ is a natural reaction to headlines individuals becoming Bitcoin millionaires etc. In the words of J P Morgan “nothing so undermines your financial judgement as the sight of your neighbour getting rich”. Part of our job is helping you to manage reactions that may be hazardous to your long term wealth.

There are few specific threats to current market conditions. The slow winding back of central bank accommodations are intended to proceed at such a pace that markets can factor this into long term assumptions, and economic growth is strengthening. Nevertheless, there are a number of indicators suggesting we are towards the latter part of the market cycle. These include:

• Increased leverage – U.S. margin lending is near record levels. Corporate bonds spreads are thin at both the investment grade and high yield level.
• Increased corporate actions – mergers and acquisitions, Westfield, 20^th Century Fox etc. (It is also interesting that these two examples come from magnates that have historically been builders of empires).
• Increased interest in ‘exotic’ assets – artworks, cryptocurrencies, non-conventional industries (symptomatic of too much money chasing diminishing returns).
• Further to the last point, less interest in the quality of company earnings and more interest in ‘potential’. Not unlike the ‘dot-com’ boom.
• Lack of fear – volatility indices are near historic lows.
• A narrowing in the breadth of market components making record highs – U.S. markets have mainly been driven by tech stocks i.e. Facebook, Amazon, Apple, Netflix, Google (FAANG stocks. You should always be concerned when a new acronym is created).

The catalyst for a market downturn is always a little different. It concerns me that we cannot identify a specific source of weakness, but this is the nature of markets. If it wasn’t a surprise it would already be priced in, relatively to the probability of the event.

The key question is what do we do now? While U. S. markets are particularly overvalued, the same cannot be said for markets like Australia. While our market is at 10 year highs, they remain some way off all-time highs, and forward return estimates remain reasonable. Nevertheless, we know if the U.S. market corrects there will be a short term impact on the Australian market.

No one can pick a market top or bottom. Anyone claiming to do so suffers from the illusion of control, correlating a random call with a random market event. Markets will reach a tipping point, before which you are too early and after which is too late. If you had of sold out of markets in 1996, following Alan Greenspan’s ‘irrational exuberance’ statement, you would have missed nearly four years of exceptional market returns. Returns in 2006/07 were strong despite signs the U.S. housing market was already in decline.

Our asset allocation processes are designed to fit the returns you need with the risks you are willing to tolerate. Higher risk has been rewarded over the past year or so, and may continue to do so in 2018. However, a market correction of perhaps 10% – 20% is likely in the next 12 – 18 months, so you will need to be prepared for an impact on your portfolio. I stress, this may follow further strong gains within this timeframe, and I do not pretend to have any predictive super power. As J M Keynes once remarked “markets can stay irrational longer than one can stay solvent”.

In the interim, we will continue our review process, analysing the various markets, managers and investments to identify where risk can be mitigated. What we will not do is make a binary call to be in or out of a market. This would require a second heroic call on when to re-enter that market in due course and would, effectively, be a gamble. This is not what we do. What we will do is try to ensure any downturn has only a temporary impact on your portfolio and remained focussed on your long term objectives.

Sometimes you need to stand back to stand out.

David Graham CIMA® CFP® SSA – 10^th January 2018

We are aware there are active managers who can pull this off and a great many who cannot. Hence the assertion by the passive supporters that ‘on average, active managers cannot beat the index’. Identifying which is which is extremely difficult. So much so, we decided some time ago that it is our basic investment philosophy that matters, and identifying fund managers that align with this philosophy is the key. This alignment ensures we are pursuing our key mandate – helping clients achieve their financial objectives. These objectives are rarely as simple as generating the highest return over a given period, for a given level of risk. However it is defined, people just want to know if they will have enough.

Paul Keating (channelling former NSW Premier, Jack Lang), once said “in the race of life, always back self-interest. At least you know it’s trying”. When assessing the merits of the arguments between passive and active management, consider the underlying motivation of the author. A recent article by an active manager called passive management ‘lobotomised’.  Not only is this churlish, but the manager was, ‘talking his own book’. His base argument, that any strategy has its ‘time in the sun’  and become victim of its own success is reasonable, but it works both ways. The article quoted the performance of one Hedge Fund Strategy, that has outperformed Warren Buffet, since 1987. But it ignores the bet Buffett made 9 years ago, where he challenged anyone to pick 5 hedge fund strategies that would out-perform the S&P 500 over 10 years. With one year to go, the only people to take him up on the bet, Protegé Partners LLC, have all but conceded.

Markets are adaptive. A preponderance of active management can effectively arbitrage away its own alpha. Similarly, the growth of passive strategies can provide increasing opportunities for active managers.

Human psychology is such that we will tend to herd towards what we perceive as better value. This perception will generally follow a period of superior performance, be it a winning share or a winning investment strategy. However, we will tend to overweight the potential of the company, or the investment strategy and stick with it longer than should be reasonable.

We believe there is a right investment strategy for each portfolio, each client. This can be active, passive or some combination of both. In our opinion the keys to good portfolio management are:

• Be at once open minded and skeptical.
• Avoid ‘fashion’. Chasing the next best thing will deplete your most valuable resource – time.
• Know the difference between marketing and research.
• Understand that investment markets are dynamic, the fortunes of specific strategies will ebb and flow over time.
• Context. Always keep in mind what the portfolio is seeking to achieve.

Enjoy Federal Budget week. Don’t be surprised if we see a change to CGT thresholds – my long shot call.

David Graham CIMA® CFP® SSA

So is the growth rate of residential property a rational reaction to a supply/demand mismatch, or is it out of control, in terms of rational expectations? For the most part the residential property market is difficult to analyse using basic investment principles. If the value of an investment is the discounted value of future cash-flows, the only rational way to accept current prices are reasonable is to assume large part of the future cash-flows comprises a capital sum at maturity greater than the discounted value of the initial investment. Or put more simply, net income by way of rent is largely irrelevant. Given the popularity of negative gearing, this is self-evident. If this is the case, then what you are describing is speculation. This in itself is not a bad thing, but you need to be realistic and accept the potential pitfalls in speculating, rather than investing. The key expectation is that someone will pay more for the asset than you paid, some time in the future.

Professor Steven Keen, has been a serial pessimist on Australian house prices for some years. He has been way early (by his own admission), but his analysis of the relationship between credit growth and house prices is compelling. Indeed, the key to his miss-timing on house prices has probably been the growth in credit exceeding his initial expectations.

So can it go on in perpetuity? If the key to rising house prices is credit growth, the question is, can credit growth continue at the same pace. Moreover, if credit growth has been a product of lower borrowing costs, can that continue? I would argue, no. If borrowing costs rise, can household disposable income rise more quickly, to offset increased borrowing costs? Maybe, but ‘in perpetuity’ is a long time.

I am a believer in cycles, and I also believe behavioural biases exacerbate cycles way beyond what would otherwise be considered rational.

Compared to the equity market, the property market is opaque and inefficient (why we still pay real estate agents 2% commission for what is essentially property market BETA is beyond me). These factors can hide signals until it is too late. What John Mauldin describes as “fingers of instability” through a structure cannot easily be observed in the property market. But it does not mean they don’t exist.

The late Hyman Minsky proposed that booms sow the seeds of there own busts. Minsky became very popular after 2008, when it all seemed obvious (hindsight is a wonderful thing). In the 30 July 2016 issue of The Economist, they published an article on Minsky as part of a series. The following is an except from that article:

“Minsky distinguished between three kinds of financing. The first, which he called “hedge financing”, is the safest: firms rely on their future cashflow to repay all their borrowings. For this to work, they need to have very limited borrowings and healthy profits. The second, speculative financing, is a bit riskier: firms rely on their cashflow to repay the interest on their borrowings but must roll over their debt to repay the principal. This should be manageable as long as the economy functions smoothly, but a downturn could cause distress. The third, Ponzi financing, is the most dangerous. Cashflow covers neither principal nor interest; firms are betting only that the underlying asset will appreciate by enough to cover their liabilities. If that fails to happen, they will be left exposed”.

While referring to ‘companies’ in regards to financing, the application can be made for any investment where borrowing is the dominant funding source. The third phase is the crescendo, after which a market reaches a ‘Minsky Moment’. This is moment when it all comes crashing down. Loans are defaulted, property is offered for sale to recover loans at a time when buying and new lending dries up, fearful consumers direct more income to loans to save their homes, thus causing economic contraction, job losses – the cycle is in full reverse.

As indicated above, everybody can spot a Minsky Moment, after the fact. The few that can spot it before are cranks a priori and geniuses afterwards. Ironically, if we could all spot the moment, it would not happen because we would act before the moment was reached. If there was one common denominator I have observed prior to various crashes over the past 30 years, it is emotion. This is difficult to quantify but when the fear of missing out becomes tangible and widespread, the end is usually nigh. Are we at that stage with the property market? I do not know. I see anecdotal evidence, but I am not at all certain if this is widespread. When you start looking for something, you tend to see it wherever you look (the red car effect). However, this works both ways. If we have a vested interest, we tend to look for information that confirms our view (confirmation bias).

I can only go back to some basic but sage words.”There are many ways in which speculation may be unintelligent. Of these the foremost is I) speculating when you think you are investing II) speculating seriously instead of as a pastime, when you lack proper knowledge and skill for it and III) risking more money in speculation than you can afford to lose” – Benjamin Graham (no relation).

Be careful.

David Graham CIMA® CFP® SSA

Early in the year we indicated our uncertainty and took steps to help moderate the impact of the improbable on investment portfolios. The past 24 hours have provide the best example of why we thought this was a good idea. Not only did the improbable eventuate, market reactions have, thus far been equally as improbable. Sharp falls in equity markets are being quickly recovered as we speak. The usual trader mentality of ‘shoot first and ask questions later’ applying itself firmly to the macro events we are witnessing.

However, all is not well with markets. The fall in bond markets overnight has been every bit as dramatic as the equity market ructions we have witnessed. You will not read about this in the general press – it is something they neither understand nor see as exciting enough to put in print. Nonetheless, in my experience the bond market tends to be far more prescient as a guide to the future.

The reasons for the fall in bond prices are many and those commentators who are actually aware of this are postulating various theories. Underpinning most of these theories is the fact that bond markets are sensitive to inflationary expectations. You remember inflation, it was all the rage in the 70’s and 80’s. The bond markets seem to be reflecting the risk of a revival in inflation triggered by increased Government spending. Increased Government spending and lower taxes were just two of the President-Elects campaign promises. This spending can thus only be funded from additional borrowing, which means issuing more bonds. Then the old rule of supply and demand kicks in – the more you issue, the lower the price.

In a world full of surprises, a revival of inflation has hitherto been ‘off the radar’ of conventional wisdom. As we have seen time and again, ‘off the radar’ appears to present the greatest risk. As Mark Twain once said “…it ain’t what you don’t know that gets you into trouble, it’s what you know for sure, that just ain’t so”.

From a portfolio perspective, we are not anticipating any wholesale changes. For most, your portfolios are generally below the relevant benchmark for growth assets. This means your portfolio will do relatively better in down markets (a lesser loss than what would otherwise have occurred) and relatively worse in up markets (you won’t make as much as the guy at the barbeque who always seems to pick these things before they happen). In our opinion we cannot control the ride but we can hopefully make it a little smoother.

Please feel free to comment or contact us if you need further assistance.

David Graham, MApp Fin CIMA® CFP® SSA