Reflection on the markets

The last 3 months have seen a swing in sentiment and investment markets have fallen – while the economies of the US, Australia and other countries have remained strong.

Why can economies be strong – with low unemployment and low interest rates, yet investment markets show falling prices? Why can companies report strong profits – yet their share prices fall?

It’s in reading widely, and combining ideas from various investors who you respect, that you come to a personal understanding or philosophy of investment markets.

Warren Buffet is often quoted as the most successful of current investors. In his 1987 letter to shareholders, he wrote of his teacher Ben Graham – who talked of “Mr Market”:

“Imagine you own a business that is very stable and profitable… Each day Mr. Market quotes a price at which he’ll buy or sell shares in your business. Sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the good factors affecting the business… in that mood, he names a very high buy-sell price”.

“At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price”.

Buffet advises that when others are afraid and selling, it’s a good time to buy. The idea of buying a quality product when it’s on sale, seems to be common sense.

Russell, a large worldwide fund manager, describes the Cycle of Emotions that investors go through: Optimism > Excitement > Euphoria > Denial > Fear > Panic > Despondency > Hope > Relief >  and back to Optimism.

It mirrors Buffet’s ideas on Mr Market.

Howard Marks’ 2018 book, “Mastering the Market Cycle” has a similar idea, but uses a pendulum to explain the cycle. In Marks’ model, the swinging ball can represent the share’s price. Even a stable, profitable company can have its share price pushed to extremes – high and low. Investor fear drives the price towards A; investor excitement pushes the price towards C. And B is the average position of the price.

Marks also uses the pendulum to describe sharemarket price returns – which are a combination of the prices of all companies on the sharemarket. Some years, returns are pushed higher towards C … some years they are ‘dragged’ down towards A.

However, the return of the sharemarket spends very little time at the average or B position. Marks looks at the S&P 500 – the list of the 500 biggest companies in the US, based on share price. Over the 47 years from 1970 to 2016, the average S&P500 return has been 10% each year. So how many years has the return been between 8% and 12%? Only 3 times!

And how about the extremes? 13 times (28% of the years), the return has been either greater than 30% or less than 10%. So the average is more a rarity. As the ball moves through B towards C, it picks up speed and keeps going until it reaches C and reverses.

Many things affect each cycle – forces that change the timing of each cycle – so that no-one can know when the cycle is going to change. If market prices and returns are based on so much unpredictable emotion, it’s advisable to avoid worrying about what you can’t control. Choose an investment approach that takes into account your temperament and goals – and stick to it.

A strategy to help manage this unpredictability, is to design your investments into 3 buckets – a concept promoted by actuaries Rice Warner. Bucket 1 has cash or very defensive investments – enough to cover 2 to 3 years of planned spending. Bucket 2 has investments whose prices will rise and fall, but will be reasonably stable over any 5 year period – and provide income. Bucket 3 is for long term growth – and over 10 years should grow – even though over shorter periods its prices may fall.

So where are we in the market cycle now? No one knows for certain …. only that we might be moving towards A or towards C. However, Vanguard, one of the largest fund managers in the world and owned completely by its investors is fairly positive: “We expect the global economy to continue to grow, albeit at a slightly slower pace, over the next two years … In 2019, US economic growth should drop back towards a more sustainable 2% as the benefits of government policies abate (Montgomery estimates that Trump’s tax cuts gave a 22% boost to US companies!). Europe is at an earlier stage of the business cycle, and we expect growth there to remain modest”.

“In emerging markets, China’s growth will remain near 6%, with government policy to help maintain that (growth). Unresolved US-China trade tensions remain the largest risk factor.

So work to have an investment strategy with which you are comfortable.

 

0

Like This