[Please note that Ashley Owen no longer produces the Market Monitor. He has replaced it with his Monthly Top 5, linked here).
Cuffelinks has added a new feature in 2014 by publishing the Market Monitor. It is a short review of the economic conditions in major global markets including growth trends, plus our estimate of long term value across a wide range of asset classes. It will be updated each month. Part 1 of this explanation on how to read and understand the Market Monitor is a brief summary of the complex process we follow. Part 2 provides more detail for those who are interested.
Part 1: Brief summary
The Market Monitor has two major sections:
- A review of major markets in Australia, Europe, the US and Asia in the prior month, and a comment on the ‘Current position’, ‘Direction/Trend’ and ‘Pace of Growth’; and
- A review of each asset class, and a comment on the ‘Current position’ and ‘Long term returns’.
Here is what the headings mean:
1. Major Markets
The regional or country growth looks at current economic growth relative to its long term average. So 3% growth would be very good for Europe but well below par for China. We use terms such as ‘below average’, ‘stagnant’ or ‘cyclical slowdown’ to describe current growth. For example, in the December 2013 report, we describe Australia’s current position as ‘below average growth rate’ with a slowing growth trend.
The ‘Direction/Trend’ is the direction and trend of economic growth. We use terms such as ‘growth slowing’ or ‘recovering very slowly’ etc.
Readers should note that the relationship between economic growth rates and investment returns is often counter-intuitive and is often the reverse of what most people might expect. We have written about these these relationships previously.
2. Asset Classes
The asset classes we review are:
- Shares – Australian, developed markets, emerging markets
- Fixed income – Australian, bank term deposits, global bonds
- Real estate – Australian commercial property, Australian residential property
On the Asset Class page, the ‘Current position’ column is our estimate of the current valuation level of each asset class. We use terms such as ‘around fair value’, ‘moderately overpriced’ and ‘appears inexpensive’.
The ‘Long term returns’ column is an estimate of long term returns from current levels of pricing, relative to that asset class’s long term ‘neutral’ return outlook. For example, if shares are super cheap on long term fundamental pricing measures, the long term (10+ year) holding period return from current levels is probably going to be well above the ‘neutral’ return outlook, so it would say ‘above average returns’.
The ‘neutral’ return outlooks are for multi-decade holding periods, that is, several decades or could be a century. The ‘neutral’ return outlooks are unconditional (don’t depend on current pricing or current conditions) and don’t change much or very often. We may revisit the assumptions only every five years or so. The ‘current’ long term outlook is for a 10+ years holding period and are conditional, as they depend very much on current pricing and current conditions, and they do change significantly, often changes each quarter.
But readers should not assume that something being super cheap with outlook for above average long term returns makes it a current buy or over-weight recommendation. Even though things are cheap, we will sometimes underweight them (eg after mid 2008 shares were very cheap, but we were not buying), and sometimes when things are very expensive and destined for very poor long term returns, we will still overweight them, like US shares over the past two years. Something may look cheap over 10+ years but other factors may make them perform poorly over the shorter term. None of the comments should be considered a current recommendation or financial advice.
Part 2: Additional explanation for those requiring greater detail
1. ‘Neutral’ return outlooks
Our long term ‘neutral’ outlooks are not just extrapolations of historical average returns (which vary greatly depending on what particular measurement period is chosen). This is because structural characteristics that affected the market in the past will not necessarily apply simplistically into the future. Nothing is static, stable or constant in the world.
Long term ‘neutral’ outlooks per asset class:
Real economic growth rates – based on factors including: outlooks for population growth rates, the mix between natural growth and immigration (because they have different demographic and productivity impacts), changes in the ratio of employed to total population (not just participation rates, which has assumed arbitrary age cut-offs), worker productivity growth, money supply growth, supply/demand patterns for consumption, savings, investment.
Cash – based on factors including: outlooks for real economic growth rates, economy-wide inflation rates (not just CPI inflation).
Bonds – based on outlooks for cash plus other factors including: maturity premium, illiquidity premium, credit spreads required, supply/demand for debt, multi-decade structural shifts in global/local inflation/interest rates cycles, supply/demand for capital, international capital flows/controls.
Equities – based on the outlook for local real economic growth rates plus other factors including: the share of corporate earnings to total earnings across the economy, differences in the mix of listed companies/sectors versus total corporate activity in the economy (eg miners have a small role in Australian economy but have a large share of listed market value of local stock market), equity risk premium required, dividend retention rates, earnings per share growth rates, buy-back rates, returns on equity, differences in the mix of country exposures relative to local economy (eg foreign sales/costs/earnings on local companies), impact of foreign ownership of equities, international equity capital controls/flows.
Real estate – based on factors including: estimates for rental yields, distribution yields, real capital growth, gearing, capex, depreciation, retention rates, interest burden, supply/demand for international capital.
Exchange rates – includes estimates of long term fundamental value (including inflation differentials, current account, reserve backing), and medium term fundamental drivers (including interest rate differentials, supply/demand for currency from trade & investment, current account & capital account structures).
2. ‘Current’ return outlooks
The above long term ‘neutral’ return outlooks for asset classes assume current prices are ‘fair’ – ie not fundamentally overpriced or underpriced.
According to academic finance theory, nothing is ever cheap or expensive – everything is always perfectly fairly priced – every second of every trading day – whether it is at the top of the bubble just before a crash, or immediately after a savage correction. In theory, there are no bargains and nobody ever pays too much for anything.
These theories are nonsense of course. In the real world, pricing is very rarely fair or just. In the real world markets lurch from boom to bust, and the prices of every asset and security in every market swing wildly from over-priced to under-priced and back. They always have and always will, because markets are driven by humans and humans are driven by wild emotions – fear, greed, herding mentality, and a host of other irrational impulses.
We use a variety of different types of processes and approaches to measure and assess the current level of pricing for the main asset classes each quarter.
3. Asset allocation
Our asset allocation decisions for each asset class are not simply based on whether it is cheap or expensive (eg underweight if expensive, overweight if cheap, etc). Fundamental pricing on long term measures are important inputs to asset allocation decisions, but they are not the only measures considered.
For example, the US equity market as a whole has been significantly overpriced on several long term fundamental measures for a couple of years, pointing to relatively poor long term returns. But that does not necessarily point to poor returns in the short term.
Likewise, the Australian equity market was fundamentally cheap in 2011, but we underweighted Australian equities prior to the dramatic decline in mid-late 2011, even though the market was cheap to start with.
In addition, despite the US market being much more expensive on several long term fundamental measures than the Australian market (and despite the US experiencing much slower economic growth than Australia), the US market has beaten the Australian market by a big margin over the period.
Ashley Owen is Joint Chief Executive Officer of Philo Capital Advisers and a director and adviser to Third Link Growth Fund.