Taking the market’s temperature

Bonds yieldsShelby Davis, one of the greatest value investors you’ve probably never heard of, who in 47 years turned $50,000 into a $900 million fortune, said: “You make your money during bear markets – you just don’t know it at the time”.
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In my experience the inverse is also true. We make our biggest mistakes in bull markets but we don’t know it until the market turns ugly.

So with the All Ordinaries Accumulation Index up 111 per cent since the lows in March 2009, let’s use Howard Marks’ Poor Man’s Guide to Market Assessment discussed in his book The Most Important Thing, to see what action we should be taking.

Poor Man’s Guide To Market Assessment

(1) Economy: vibrant/sluggish. Australia’s economic growth is tipped to be slightly below average over the next few years but we’ve ticked “vibrant” as the economy is performing relatively well, even though it may not feel like it.

China is still growing strongly thanks to renewed stimulus, official unemployment isn’t far off record lows and low interest rates are reducing debt repayments.

(2) Outlook: positive/negative. Bill Smead of US funds manager Smead Capital Management says: “In the latest week (October 21-25), individual investors, as measured by the American Association of Individual Investors and investment newsletter writers, as measured by investors’ intelligence, were bullish by nearly a 3:1 ratio to bearish”.

(3) Lenders: eager/reticent. In March last year interest rate comparison website RateCity warned that nearly 70 per cent of lenders were accepting mortgage deposits as low as 5 per cent. The competition has only heated up since then.

(4) Capital: loose/tight – see (3).

(5) Terms: easy/restrictive – see (3).

(6) Interest rates: low/high. Rates are at record lows, which is usually not a good sign for shareholder returns.

(7) Spreads: narrow/wide. Junk bond yields have fallen to record lows below just 5 per cent (see chart).

While defaults are very low, there’s no margin of safety if bankruptcies or interest rates increase.

(8) Investors: optimistic/pessimistic; sanguine/distressed; eager to buy/ not interested in buying – see (2).

(9) Asset Owners: happy to hold/rushing for the exits. Not only are passive owners happy to hold, but the initial public offering market has sprung to life as private equity groups and entrepreneurs take advantage of investors prepared to back companies with short histories, leveraged balance sheets and few competitive advantages.

(10) Sellers: few/many – see (9).

(11) Markets: crowded/starved for attention. Many individual investors have shunned the market since the global financial crisis, with 38 per cent of Australians owning shares. Of those, 34 per cent are direct investors, down from a peak of 44 per cent in 2004.

Things could be changing though. Perpetual recently recorded its first inflows for a while, and investors fed up with low interest rates may be jumping back in to the sharemarket to avoid missing out on further gains.

Institutional investors are also increasing their weighting to stocks and we’ve heard that local small-cap managers are winning mandates, which is a sure sign of bullishness.

(12) Funds: hard to gain entry/open to anyone. I chose “hard to gain entry” as hedge fund managers Seth Klarman and Dan Loeb are returning funds to their clients due to a lack of attractive investing opportunities. I’d weight their actions over just about anyone else’s, given their remarkable records with large sums.

(13) Recent performance: strong/weak. The All Ordinaries Accumulation Index is up 36.4 per cent over the past two years.

(14) Asset Prices: high/low. From art to stocks, asset prices across the board are being inflated by low interest rates.

(15) Prospective returns: low/high. In an article republished in the US with the headlines “Market valuations are obscene” and “The stockmarket will probably crash”, US fund manager John Hussman recently calculated that “virtually every reliable measure of market valuation we observe is now within the highest 1 per cent of historical observations prior to the late 1990s bubble.”

In Australia, Perpetual reportedly calculated that the price-to-book ratios of the big four banks have breached levels from the tech boom and before the global financial crisis.

(16) Risk: high/low. Marks recounted earlier in the year that in his career the list of risks had never been so long.

(17) Popular qualities: aggressiveness/caution and discipline. I picked aggressiveness as margin loans have been increasing despite remaining well below pre-financial crisis levels. With the amount of money flowing into property, many individual investors scarred by the financial crisis may end up swapping one bubble for another.

More importantly, though, institutions have been taking larger and larger risks as interest rates have fallen, particularly in the fixed-income markets. This could be another bubble waiting to pop.

What to do

Marks advises that for “for your performance to diverge from the norm, your expectations – and thus your portfolio – have to diverge from the norm, and you have to be more right than the consensus.”

First, that means you need to avoid highly valued, popular stocks. The best margin of safety is a cheap valuation and, right now, just about every high-quality, high dividend-paying stock is achieving record highs with regard to price and valuation.

Second, don’t lose your discipline and invest in poor quality stocks you wouldn’t normally consider. However, keep an eye open for average stocks priced cheaply because of short-term quality concerns.

Caltex is a good example of an ugly duckling that should look more like a swan in a few years, as its retail fuel business grows. Profits and cash flow should also become more predictable once the Kurnell refinery closes.

Third, control your portfolio limits. Don’t risk your wealth by getting overexposed to particular stocks or sectors.

Fourth, don’t get sucked in to chasing stocks as they climb, and let valuation and a decent margin of safety temper any greedy thoughts.

The time to be aggressive was in 2009 and 2011. Now’s the time to ensure you hang on to your profits.

Fifth, don’t be afraid to build your cash holdings. Billionaire investor David Tepper recently told a class of graduates that even in a world of derivatives and complex securities, cash was the best hedge against uncertainty.

His fund is 40 per cent in cash, which has never been the case before, and plenty of other respected value investors have 30-40 per cent cash holdings and are returning capital to clients.

Sixth, consider taking advantage of the high Australian dollar to invest overseas. As well as opening up more opportunities, this will reduce your dependence on the local economy and, by extension, Chinese growth.

Finally, maintain your focus on value. There are still opportunities but they may not be in the areas you normally expect to find them. Despite the extreme conditions, we’re still finding stocks that combine defensive characteristics and attractive valuations.

This article contains general investment advice only (under AFSL 282288).

Nathan Bell is research director of Intelligent Investor Share Advisor.  You can unlock all of Share Advisor’s stock research and buy recommendations by taking out a 15-day free membership.

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