As we have been commenting for many months, the Australian share market has been great value buying for some time (since at least early this year), as long as you expect the financial instability caused by the GFC to be abating. (Maybe the market isn’t such a great bargain at today’s higher prices – but that’s for discussion below). But let’s be clear about what this means – it’s not my position that we are poised at the start of a recovery, that is something which is yet to emerge and although the signals are relatively positive, it is definitely to early to call the start of a recovery. So how do we make sense of the (still confusing) range of contradictory data that is bombarding us right now?
Like Warren Buffett, we’ve been saying that calling good stocks as representing good value doesn’t mean that the bottom of the sharemarket is behind us, or that the market will keep going up. As we have noted in detail in previous LPAC student e mails, the perception of good value simply reflects that quality companies trading at low share prices are good buying for long term investors. This is very different to asking whether the market will go lower or higher in the short term - as that is completely irrelevant unless you are a share trader or a mainstream managed fund which focuses on what the benchmark index is doing. But the key point in this debate is whether financial instability is abating - and the current market rally tells us that, indeed, the market does believe that the waves of monetary and fiscal policy.
This is an absolutely critical point to think through. What I am hearing from institutional investors (who thus represent the market consensus, for what that is worth) is that the buying that has driven the ASX 200 up from below 3100 in February this year to over 3800 now, is NOT a perception that the problems of the GFC have been cured, but rather that there is now emerging clarity around the PATH TO RECOVERY. This is not to say that further weakness will not emerge in the financial system (it will, as the soon to be announced US bank stress tests will show); rather it’s a position that believes that the co ordinate global measures and ongoing analytical process will restore financial system stability. We discuss below some of the depth of this analysis and measures as a guide to the accuracy of this assumption.
By “path to recovery” we simply mean that:
- The detailed analytics of the causes and cures of the GFC are becoming more accurate, timely, and capable of being decisively acted upon. The US Treasury, Fed Reserve, IMF, and G20 nations are getting their mix of monetary and fiscal policy measures largely right;
- Financial system instability is thus abating, balance sheets are being repaired, and market functions are starting to re establish themselves;
- As the positive feedback from these sets of measures and processes grows, so does the combined effectiveness of the measures.
What this all means is that share prices are now rising to the “fair value” levels that would be seen in a “normal” bear market. We noted in the last LPAC student e mail that the market’s savage drop was its way of getting the equity risk premium up to levels suitable for the unstable and risky world which prevailed at the peak of the GFC, ie just after the demise of Lehman Brothers. That has been a logical conundrum for some time - eg, if economic and equity market growth going forward is going to be slower than it was during the last bull market, then why would you invest in equities? As we noted in the last couple of LPAC student e mails, the rationale for buying equities in the last few months has, for smart investors, simply been that the abnormally discounted share prices for blue chip stocks was really a way of ensuring that the return to investors who enter those stocks at low levels will be sufficient to justify that investment.
That is the position we have been taking regarding buying equities over the last 6 months, and the market now seems to agree with that stance. Again, this doesn’t mean that the market won’t fall back from these levels, nor that it will continue to rise at its recent pace. In fact, fundamentals do suggest that the market won’t keep rising like it has in the last 6 weeks, and it is also clear that fundamentals still depict a very nasty global economic downturn still unfolding over the next 6 to 12 months.
What about all the bad news?
The IMF “World Economic Outlook” report for April 2009 is an exhaustive report on the causes and cures being implemented for the GFC. It is sobering reading and it’s written in the same vein as Warren Buffett’s statements that the response to the GFC is like being at war - with serious new challenges and battles to be fought almost on a daily basis. You can view the full report at: http://www.imf.org/external/pubs/ft/weo/2009/01/
The essence of the IMF WEO is consistent with the analysis set out above, that things are getting better but that we aren’t out of the woods just yet:
The global economy is in a severe recession inflicted by a massive financial crisis and an acute loss of confidence. Wide-ranging and often unorthodox policy responses have made some progress in stabilizing financial markets but have not yet restored confidence nor arrested negative feedback between weakening activity and intense financial strains. While the rate of contraction is expected to moderate from the second quarter onward, global activity is projected to decline by 1.3 percent in 2009 as a whole before rising modestly during the course of 2010 (Figure 1.1). This turnaround depends on financial authorities acting decisively to restore financial stability and fiscal and monetary policies in the world's major economies providing sustained strong support for aggregate demand. (WEO, April 2009, IMF, page 1).
The IMF WEO report highlights that the better developing and emerging economies, eg China, are still growing and that these are one of the drivers for global economic recovery. They also confirm that overall global economic growth is expected to return to positive levels later this year and into next year, as shown in Figure 1 below.
Source: IMF staff estimates
This view is consistent with the most recent RBA statement, made by Governor Glenn Stephens on 5 May 2009:
The global economy contracted further during the first few months of this year. While the near-term outlook remains weak, there are further signs of stabilisation in several countries. The Chinese economy in particular has picked up speed in recent months and many commodity prices have firmed a little. The considerable economic policy stimulus in train in most countries should help contain the downturn and support an eventual recovery.
Conditions in global financial markets remain generally on a path of gradual improvement, with equity prices off their lows, term spreads declining and capital markets re opening. Nonetheless, confidence remains fragile and balance sheets are under pressure from the effects of economic weakness on asset quality. Credit remains tight. Continued progress in restoring balance sheets remains essential to durable recovery.
The Australian economy contracted in the latter part of 2008, and this has continued in 2009 to date, with both domestic and international demand weaker. Capacity utilisation has fallen back to about average levels, and will decline further over the rest of the year. With demand for labour weakening, growth in labour costs will probably also fall. These conditions are likely to see inflation continue to abate, though this is occurring only gradually so far, as the effects of the decline in the exchange rate are pushing up some prices.
Australian markets have seen a decline in term spreads and firmer equity prices over recent months. Borrowing for housing is picking up, particularly among first-home buyers. Business borrowing, on the other hand, is declining, as companies curtail investment plans and seek to reduce leverage, in an environment of tighter lending standards.
Monetary policy has been eased significantly. Market and mortgage rates are at very low levels by historical standards and business loan rates are below average, reducing debt servicing burdens considerably. Much of the effect of these changes is yet to be observed. The stance of monetary policy, together with the substantial fiscal initiatives, will provide significant support to domestic demand over the period ahead. http://www.rba.gov.au/MediaReleases/2009/mr_09_08.html
Conclusion
The current Australian sharemarket rally simply reflects the market perception that the path to recovery from the GFC is becoming increasingly clear and plausible. This is backed up by reports from the IMF and is also the position being taken by our own RBA. This doesn’t mean that the Australian or global economy are poised to surge, and it’s likely that share price growth will start to moderate as levels rise to those normally seen in more traditional bear markets. Shares remain a great long term investment. We remain cautious about the volatility in the sharemarket and maintain the stance that prudent investors will focus on active stock picking as well as using well designed and priced risk management/capital protection as part of their overall sharemarket portfolio.
