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Monday, 25 November 2019

Phases of the market cycle

Late cycle indicators

Howard Marks, master of the market cycle, says that we're 'in the eighth inning' of the stock market cycle, and because prices are high exposure should be reduced because expected future returns are poor.

But Marks himself has said that doesn't necessarily mean the market will turn down yet, and bull markets can run for much longer than you think.

In fact, the period since March 2009 has now been by far the longest bull market in history, with well over 10 years since the last bear market (defined as a 20 per cent correction) and the S&P total return far outpacing sustainable earnings growth in more than quadrupling over the past 127 months.

Cycle indicators

I recently re-read one of the my favourite books on Aussie stock markets, in which Colin Nicholson discussed how to identify when you're into the third (rampant speculation) phase of a stock market cycle, so you know to reduce your market exposure. 

Of course, there can't be one simple indicator; if there was then everyone would know about it and the indicator wouldn't work. 

It's a subjective issue rather than an objective one, and the point is not to make forecasts - which always prove to be wrong - but simply to position yourself accordingly. 

If you're interested, read Nicholson's case studies from 2007 and 2008 where he runs through his checklist of indicators - they're both brilliantly insightful and brutal. 

Where are we at in Australia today? Let's run through his checklist of questions and try to apply them logically to today's market:

Is the general public in the market? New small private investors experiencing their first cycle? Disregard for valuations?

Yes, heavily. There's been a huge increase in passive investing in index funds and ETFs, which some argue is a bubble. These products don't make up a major share of the stock market capitalisation, so bubble may not be the right term. But there's no doubt the general public is in the market. 

Have stockbrokers rediscovered private investors? Are there lots of new floats? Takeovers?

2017 was a bumper year for floats in Australia, but no, 2019 hasn't seen a particularly high level of initial capital raised. Forthcoming floats include a few small resources companies and an online consumer lender. 

The US, on the hand, has been something else in 2019: Beyond Meat, Uber, Lyft, Pinterest, and a range of others helped to make the June quarter the biggest in years in terms of both performance and capital raised. 

Professional investors often aren't keen on IPOs because of the information asymmetry, inevitable hype, and the frequently unfavourable timing. WeWork had planned to list by the end of the year but investors eventually realised the valuation was absurd and the listing was pulled.

I don't know if brokers are successfully promoting speculative companies (presumably, yes), but the cryptocurrency mania was an indicator of speculation writ large, albeit mainly in a different asset class.

There haven't been too many major takeovers in Australia. In the US, Munger and Buffett say they've never faced more competition than they do today from private equity prepared to use more leverage.

Has the media discovered the bull market?


Is there more day trading?

I've certainly heard of more people getting into market trading; though in my experience many were into virtual currencies rather than stocks.

Are trading systems being promoted?

They're everywhere, but again seemingly more crypto-focussed this time around. 

Are speculative companies changing their names?

Long Island Ice Tea Corp renamed itself as Long Blockchain and saw its stock price go up 289 per cent as a result. It’s since been delisted and gone from 6 bucks to 20 cents. Do we need to look at any more daft examples? This was more of a 2017 thing, though.

Are governments selling off their enterprises?

Only to some extent. Ausgrid was sold off for $16 billion and New South Wales went through a $20 billion asset sale and recycling program. 

There's a huge raft of public infrastructure and other assets which could be sold off to reduce state debt (WestConnex, energy, water, etc.), but that hasn't really happened yet en masse. 

Much of the selling in recent years has been of government land and property assets, including public housing such as at Millers Point, and hundreds of Department of Education properties.

Are fundamental ratios at high levels?

In Australia, yes, though not ridiculously high. Previous cycles have seen corrections from PE ratios lower than 12 times or as high as close to 20 times or above, while the global financial crisis crash happened when the ASX had a PE a bit above the long term average. 

The Australian market may not be wildly overvalued, but some sectors (e.g. biotech) are arguably in the midst of a speculative mania. Financials are priced above their long run average, commodities and resources companies have generally been out of favour, but other sectors are enormously higher than average.

As for the US, valuations are extremely high on virtually any metric you care to look at. 

The interesting thing here is that if you think long-term interest rates are going to stay below 3 per cent for the next few decades then stock markets may arguably not be overpriced at all. 

Earnings yields slipping to 6 per cent or below Down Under would be considered expensive territory in historical terms...but then again look at how low bond yields are. The 10-year bond yield has been as low as 1 per cent! Valuation on its own is a nebulous concept.

Is everyone bullish?

Not everyone, though it's noticeable how many are defensive or argumentative if you mention downside risk.

Are new paradigm theories being advanced?

In 2007 and 2008, Nicholson cited the rise of end-of-the-world scenarios related to global warming, China growing at a fast pace for the next 50 to 100 years, and a forecast 'soft landing' for the global property boom.

Global warming is back in the headlines, but other new paradigm theories have abounded, from the genius of technology entrepreneurs, to Blockchain, cryptocurrencies to replace fiat currency, cyber trucks, low interest rates causing an endless bull market, and more. 

Relatively high interest rates, high/full employment, inflation?

Not in Australia. In fact, interest rates are as low as we've seen. Employment growth has been high for some years, but we haven't seen full employment as we did in the lead up to the financial crisis, or significant price inflation (except in some property markets).

In the US, however, the unemployment rate recently hit the lowest level since the 1960s.

Interest rates are not high. You could argue that they're relatively higher as compared to zero, but the tightening cycle has already ended for now. This could support the higher valuations for longer as central banks become more influenced by holding up asset prices. 

Is there speculative activity going on?

Is there ever! See Beyond Meat or any one of a thousand other examples, in Australia or overseas.

Are stock markets more volatile?

Not at the moment. There was a sharp correction in Q4 2018, which quickly rebounded before it could become a bear market. 

Leverage and risk

Margin loans are less popular in this cycle, but have been replaced by CFDs and other forms of leverage.

Business credit growth hasn't been especially high. The book value of gearing for listed non-financial corporations is rising, but isn't especially high either after several years of deleveraging by major resources companies such as Fortescue Metals Group and others. 

Positioning & posture

As you can see, there's never going to be a perfect checklist that can show you when a market will turn down. The indicators are quite mixed for Australia, but are less so for the US.

Australia's valuations may not be obscenely high, but most indicators from the US suggest - as Marks has pointed out - that it's a late cycle market in its 'eighth inning'. And if the US comes down it will likely bring the rest down with it as we saw in 2008-9.

How you choose to invest then comes back to your own strategy. For example, the legendary John Templeton increased or reduced or increased his allocation to stocks according to market valuations.

The general idea is to avoid giving back the strong gains of the past 10 years through adopting a more defensive position.