Investment Markets Update – March 20, 2020

Week 4 – Thoughts for long-term investors

‘Wealth’ is income-generating capacity not share prices.

It has been four weeks that changed the world – especially for investors. Since share prices peaked on 20th February, the broad Australian share market has fallen by -35%, US is down -30%, and European markets are down by an average of -40%. The S&P500 index in the US is back to where it was in late December 2018 – so 15 months of share price gains have been lost, but the All Ordinaries index in Australia is back to where it was in July 2013 – that’s nearly seven years of gains lost.

This note will cover the following four questions:

1) ‘Why the sudden share price falls?

2) ‘Why the unusual speed of the falls?’;

3) ‘Should long term investors be worried’?; and

4) ‘How do I cope with the fact that I am now X% poorer?’

1. Why the sudden share price falls?

It was not the coronavirus fatalities. By 20th February total worldwide deaths were just was 2,247 (almost all in China), and this has risen to 8,951 by 18th March. This is still very minor compared to the 200,000 fatalities from the 2009-10 H1N1 ‘Swine Flu’ (and share prices surged throughout that crisis). Likewise for the 1-2 million deaths from the 1968-70 ‘Hong Kong Flu’ and a similar number of deaths from the 1957-8 ‘Asian Flu’.

The trigger for the current collapse appears to have been a combination of two factors: the dramatic government restrictions, exacerbated by policy inconsistencies and mixed messages; and also central bank announcements, also exacerbated by policy inconsistencies and mixed messages. Each of the big share prices falls and gains have come immediately following government/central bank announcements, not following announcements of rising infections or deaths (there have been only 5 deaths in Australia so far but share prices have fallen by 35%). This is relevant for the next question.

We are not suggesting here that the government actions have not been necessary or appropriate, just that it has been the government actions, and fears of possible consequences for businesses, that have driven the dramatic share price falls, not the infection itself

2. Why the speed of the falls?

There have been several share market falls of similar or greater magnitude in the past but what is different about this one is the sheer speed of the falls and the extreme volatility of market moves – both up and down. Usually, stock market falls that have led into economic slowdowns comprise a relatively steady series of falls over many months (for example the GFC crash was 16 months of share price falls). The process is usually elongated by a steady stream of bad news like corporate defaults, bankruptcies and collapses – accompanied by steadily increasing worries over whether they will have wider implications on revenues, employment, profits and company viability. The big share prices collapses in the past – including the 2008-9 GFC and the 1929-32 crash were a ‘death by a thousand cuts’ over many months.

This time it has been very sudden because it has been driven by sudden government announcements – each time a government restricts or bans an activity it instantly dooms whole industries to waves of losses and possible bankruptcies (in the minds of investors anyway). Rather than taking months of mounting speculation of the possibility of recession and corporate failures, this time we have an almost instant global recession, with almost guaranteed waves of corporate losses and failures – from large to small, and across a wide range of industries. We have not seen this pattern before, not even in the 1987 crash.

3. Should long-term investors be worried by the share price collapses?

The dramatic share price falls (and equally dramatic gains on some days) make for great headlines but ‘You only make a loss when you sell’. Every share price collapse in the past has been followed by an equally sudden rebound, so if you don’t sell out at the bottom, you will benefit from the subsequent rebound. Although the current crisis may lead to many corporate failures, the vast majority of listed companies will survive and live to fight another day.

Long term investors who rely on their diversified investment portfolios for income are primarily interested in the level of income from their portfolios. It is early days yet, but we can estimate the likely declines in income levels from different types of assets in diversified portfolios.

For Australian shares, dividends could be reduced by up to 20% or 25% in aggregate (including the big banks) if the crisis escalates into a broad economic slowdown. This would be consistent with prior episodes, including the GFC, the early 1980s recession and the early 1990s recession, but only half as severe as the 1930s depression. For global shares the level of aggregate dividends could also be reduced by a similar margin. Income from property trusts may also fall by similar percentages. This would be a far better outcome than in the GFC when nearly all listed property trusts required major reconstructions just to survive, and many didn’t. This time they have less gearing and better quality assets.

That is where the bad news ends on the portfolio income front. On the defensive side of portfolios, cash interest rates cannot be cut from their already low levels, so little change is expected there. Contrast this with the 2008-9 GFC when interest income on cash accounts, high grade floating rate securities and term deposits were cut by up to 75%, and this reduction in interest income hurt the more conservative investors the most.

For the high grade bonds in our portfolios, the capital values of diversified bond funds may oscillate from day to day but income levels are fixed on each bond until it matures. Even if we have a major economic recession over the next year we don’t expect bond yields to fall significantly from their already ultra-low levels, so we don’t expect interest income from bond portfolios will fall by much, if at all. High grade corporate bond funds will fall in value, but they will recover coming out of the recession, and the level of interest income will remain relatively constant throughout.

The fact that interest income from the defensive side of portfolios is unlikely to fall by much, or at all over the next year is another aspect that is very different from the aftermath of the 2008-9 GFC, when interest income from defensive assets fell by more than half.

All of this means that for investors in our diversified portfolios that hold a broad mix of diversified shares, property, bonds and cash, may see the overall level of income from their portfolio fall by perhaps 10% to 15% over the coming year or so if we have a broad economic recession, despite the wild swings in fund values on their portfolio statements.

Retirees generally would not need to sell significant parts of their portfolios to fund their cash withdrawals. In recent years we have been conscious that generally lower cash levels have been carried than in the past as a result of lower interest rates. Regular client cash withdrawals can be supplemented by current cash holdings, income generated from their portfolio, plus their buffers (frequently invested outside their diversified portfolios) which would in most cases hold 6 to 18 months of expected living expenses (this would vary for each investor depending on their circumstances).

At current levels, Australian shares are yielding around 5.6% for the broad market (or more than 7% including franking credit refunds), and global shares are yielding around 3.2%, which is a 5% yield on a 50/50 mix of Australian and global shares. Even if dividends were to fall by say 25% for each in a global recession, that would still deliver a dividend yield of around 4% for a 50/50 mix of Australian and global shares.

4. How do I cope with the fact that I am now X% poorer?

The other side of ‘You only make a loss if you sell’ when prices are down, is ‘You only make a gain if you sell’ when prices are up. During share rallies (like 2019) it is very tempting to look at rising portfolio values and say ‘Look, I’m now X% richer!’ (our two diversified ‘Balanced’ portfolios were up more than 16% and 17% in 2019, and our ‘Growth’ portfolios were up more than 18% and 20%).

But share prices are not important unless you have to, or want to, sell. What is far more important is the underlying income the shares generate. You would only have been ‘X% richer’ if you sold the portfolio at that time, paid brokerage and tax on it, and put the remaining cash in the bank.

In our February 2020 “Top 5” Report (published in early February) we made the following comments about the tremendous share price gains during 2019:

Share prices across the Australian market have risen by an average of 20% over the past 12 months. This looks like great news on the surface but we need to look deeper to see where those gains came from and whether they are sustainable.

The problem is that almost all of the 20% share price gains over the past 12 months were fluff – much of it is probably only temporary and should not be assumed to be ‘locked in’ at all. Why do we consider them ‘temporary’? Because the 20% share price gains were not underpinned by 20% higher company profits nor 20% higher dividends. Profits per share across the market actually fell over the period, and dividends per share rose by only 4% (and most of the dividend increases were due to temporary commodity price spikes from the miners).

Twelve months ago investors across the whole market were prepared to pay $16.25 per dollar of company profits, but over the last year they bid the price up to $20.40 per dollar of profits. They are now paying 25% more per dollar of profit than they did a year ago. Twelve months ago investors were prepared to pay $23 per dollar of company dividends (ie dividend yield of 4.34%) but over the last year they bid the price up to $26.40 per dollar of dividends (dividend yield of 3.8%). They are now paying 14% more per dollar of dividends than a year ago.

What caused this miraculous 25% increase in the price paid for a dollar of profits and 14% increase in the price of a dollar of dividends?

The main reason is confidence levels. At the start of 2019 people were very pessimistic and feared the late 2018 ‘global growth scare’ might turn into the next GFC or possibly worse, especially as the US Fed was still raising interest rates despite signs everywhere of slowing growth and Trump’s trade wars. Investor pessimism quickly turned to confidence when the Fed switched from rate hikes in 2018 to rate cuts in 2019. This makes no sense! The Fed was raising rates in 2018 because of their bullish outlook for growth – hence the need to raise rates to slow spending and inflation. Then the Fed switched to rate cuts in 2019 because they suddenly became bearish on growth outlooks. Central banks raise rates when they are bullish on the economy and cut rates when they are bearish. The crowd (investors) do the reverse!

It was only a month ago that wrote that the 20%+ share price gains in 2019 were based on investor overconfidence. What we didn’t predict was how quickly those gains would be taken away back. Two things have changed in the past four weeks. First, investor confidence has swung from extreme optimism to extreme pessimism; and second, company profits and dividends look likely to be cut in the coming year.

The message is that you are really only wealthier when share prices rise if the underlying profits and dividends rise. They didn’t rise over the past year so the extra ‘wealth’ generated by the 2019 rally was illusory and has been given back.

Conversely, share prices and portfolio values may have fallen over the past month, and may fall further, but the true ‘wealth’ represented by your portfolio is its capacity to generate income, and that is far less volatile than the wild gyrations of share prices on the TV news each night.

Share prices may have fallen by 30-40% over the past four weeks but our diversified portfolio values are down by less than half of this for the year to date, and they are still ahead over the past two years and three years.

Our expectation suggest that your true ‘wealth’ represented by your diversified portfolio (ie its income generating capacity) may fall by perhaps 10-15%, and that’s only if we do indeed get a big global recession, as share markets are predicting.

While the recent share price falls are certainly alarming, we are always concerned about protecting investors from permanent capital losses and we will seek to take actions to limit risks to long term wealth and from market volatility where we are able. We are currently ‘under-weight’ shares in portfolios (relative to our ‘neutral’ or long term positions) and the funds we hold are conservatively managed and defensive in nature. We will keep you informed of any new developments and adjustments to portfolios and you can anticipate hearing from us and your advisers in the calm, consistent and rigorous manner that you expect of us.

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