The Weekly - Rational investing

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16/07/2019
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One of the key lessons to learn from investing in the equity markets is that the current level of any share price or index, such as the FTSE-100, is the result of deep analysis by many employed to constantly perform this role in the world’s financial centres. This means that, for the casual investor who reads the weekend press or researches elsewhere, any opinion he or she may have will already have been assessed and priced in. This is also the argument that many passive investors use when they are debunking the belief that active management and the application of apparent investment skill can add value over time. The point that many dismiss is that there are individuals out there who have a talent for reading markets and interpreting business models and can add value consistently over time. However, and this is important, as soon as their apparent skill becomes more widely known due to a commercial asset gathering drive, they often become swamped by new investors and can no longer repeat the results.

Right now, it would be entirely rational for any current investor to conclude that we are facing a challenging second half of 2019 in terms of global growth expectations. This is supported by the dovish comments coming from the central banks and bond market movements which are suggesting that additional stimulus is required to prevent a recession from taking hold. This pre-emptive approach from central banks has been in place ever since the credit crunch in 2008, following the realisation that investor appetite to borrow is highly correlated to confidence in the stability of the banking system. If the central banks can give the impression that they will shore up any development that threatens economic growth, then investors will not panic. The issue today is that the supposedly one-off policy of quantitative easing was used to stop the capitalist system imploding, whereas it now seems to be part of the standard central banker toolkit.

As stories go viral on social media we often see human psychological investor behaviour change at light speed. There is so much competition in the marketplace that, as soon as a doubt emerges over the financial stability of a business, consumers immediately go elsewhere.  The barriers to entry are often so low and it is very easy for consumers to switch. If the Bank of England had stood by Northern Rock over ten years ago, the banking system would probably have largely stayed intact and we would still have Alliance & Leicester, Bradford & Bingley and Royal Bank of Scotland in its previous guise.

However, one of the benefits of a recession is that it is a process of natural commercial selection where the weak fail and the strong survive. Some say there are a plethora of ‘zombie’ businesses which only exist because interest rates are so low, and this contributes to the low productivity of the UK economy. Perhaps there is something in this, although the lack of infrastructure investment since the Brexit vote is also influential as businesses choose to employ more junior level employees than invest in the kit they so desperately need. Doing so requires a five-year payback projection, plus with many senior executives paid on a three-year horizon, with share options to boot, that needs to be considered too. Consequently, it is far safer, and more certain, to simply reinvest profits into buying shares in your own business than go on some investment crusade with huge execution risk.

The US second quarter earnings season kicks off this week and a key question is whether the subdued growth and outlook, which many suspect lies ahead, will be reported by businesses and sufficiently priced into markets as the US indices hit new highs. Again, psychologically, it is very easy to get sucked into the headlines that a record closing level on an index must mean that markets are expensive. Everyone loves a bargain, but in contrast to buying a car or a sofa, the attractiveness of the product is not constant when it comes to equity investing. For example, if a new car drops in price, buyers sit up, take note and become more likely to make a purchase. When the equity market suddenly becomes 10% cheaper, it would feel like a very large elephant has joined the room causing investors to sell and run for cover with bearish headlines to boot. You can buy the same assets 10% cheaper, but are they worth that discounted price when considering the reason for the dip?

In today’s markets we have an unconventional White House incumbent with a tendency to create turmoil and react to any criticism with vitriol. That said, as President Trump seems to measure himself by the level of the stock market, this means that whatever is viewed as good for his re-election prospects should be good for the equity market. We have seen this over the last few months from both the US and the European Union (EU). Both have said they will cut interest rates and even reintroduce quantitative easing if necessary in Europe. The political motivation for economic stability in the US and Europe is overwhelming, with the Eurozone’s resilience starting to raise its head again as Italy has started breaching its EU budgetary constraints. Even if Eurozone stability does develop once more, with Italy rather than Greece, there is absolutely no way that Brussels will start playing hard ball by placing heavy sanctions on third largest economy in the Eurozone. With the UK leaving the EU, collaborative support from the Euro membership is vital.

We have returned to an environment where bad news is good news and the interest rate cycle has peaked. If we avoid a global recession but experience a slowdown as expected, major businesses which appear in investor portfolios are likely to continue to prosper. Technological innovation lies ahead with the introduction of 5G telecommunications set to take us forward once more, with or without Huawei, enabling self-driving cars and yet more consumer benefits from enhanced connectivity between service providers and consumers. Market highs never feel like an attractive entry point for a new investor but then again, as stated before, waiting for a 10% correction can mean that the recently emerged elephant scares you off. Time in the market usually always wins over timing the market, so decide on your long-term strategic goal, design an investment phasing strategy and stick to it. Otherwise you will continue to wish you had invested earlier than today. There is a completely different psychological feeling when looking at an investment which has lost money to one which has gained. A 10% fall in a holding that has already risen by 25% leads to an acceptance that this is what happens, and you are still ahead of cash. A 10% fall in a holding which has just been made seems like a huge mistake and a generally depressing outcome. The longer you have exposure, the more profit potential there is and the more likely you will feel comfortable with the inevitable gyrations and catastrophising that goes on.

Greed can influence an investor’s rational approach to taking profit along with a rational approach to taking advantage of a correction, with the latter scenario meaning the investor wants a bigger discount. Many investors like property due to its inherent stability and tangible asset qualities. However, with this comes illiquidity and maintenance whereas the stock market, if invested in wisely, can provide daily liquidity with limited maintenance. As with all investment opportunities, diversification is key between the liquid and illiquid, higher risk, higher growth opportunities, lower risk, lower return, and everything in between. So, you should consider not having too much in cash. With inflation at 2.5%, £100 loses over half its real value in 30 years if held as cash with no return. The annualised return of global equity markets over the same period to date has been 7.8% (Source: MSCI World £ from FE Analytics). The same £100 would be worth around £950, illustrating the effect of compounding over time. Of course, the latter would have endured the technology bubble bursting and the credit crunch, when cash would have seemed an attractive alternative at the time. Both the technology bubble and the credit crisis were very large elephants which caused equity markets to almost halve in value at the time.

It is utterly bizarre that we will readily snap up a car purchase, one of the most highly depreciating assets which we can buy, when it is offered at a 10% discount but shy away from an equity market purchase on a 10% discount, when it is one of the most highly appreciating assets. A message for all those tempted to display their latest purchase which they can’t really afford in the longer term.

 

US equities pass milestones as Fed chair hints at rate cut

Major equity indices were mixed last week; however, US markets stole the headlines for purely symbolic reasons with more than one key index surpassing a landmark figure. The large-cap S&P 500 index rose +0.8% for the week and the Dow Jones Industrial Average climbed +1.5%, reaching new record highs and passing respective thresholds of 3,000 and 27,000 for the first time.

Markets have responded positively year-to-date to the growing expectation of loosening monetary policy.  Last week’s Federal Reserve minutes and more pertinently Fed Chairman Jerome Powell’s testimony at Capitol Hill appeared to prepare investors for an interest rate cut at their next policy meeting at the end of July.  Powell pointed to uncertainties around global growth and trade that continue to weigh on the outlook and suggested the Fed wants to use its tools to keep the economy in a good place.  Futures markets suggest a 25-basis point cut is most likely. The probability of a larger cut has now reduced in the wake of a strong US labour report last weekend.

Domestically, the FTSE 100 dropped -0.6% to close the week at 7,505.97.  The UK became embroiled in the growing tensions in the Gulf last week as British warship HMS Montrose, escorting a tanker through the Strait of Hormuz, was forced to turn intervene with three Iranian gunboats attempting to impede the tankers passage.  The price of oil was up last week as geopolitical factors call supply levels into question. Brent crude rose +3.9% for the week to $66.84 per barrel.

In Europe, The French government defied US trade threats and approved a tax on overseas technology companies last week in a move that President Trump sees as unfairly targeting US tech giants. The White House immediately responded with an order to investigate the planned 3% tax hike. The French CAC 40 slipped -0.4% over the course of the week.

 

The week ahead

It’s a busy week for headline domestic numbers, kicked off today by the latest ONS employment statistics. Both unemployment and annualised wage growth are expected to have held firm during May at 3.8% and +3.1% respectively. CPI inflation covering June is released today as well with retail sales and updated borrowing statistics from the Bank of England due the following day.

Retail sales covering last month are also due in the US alongside several key housing sector figures. On Wednesday, the Federal Reserve releases its ‘Beige Book’ which gives a run through of how the economy has performed over the past 6 weeks. Meanwhile on Friday, the University of Michigan releases its closely monitored consumer sentiment indicator.

Inflation is the standout release from the Eurozone this week with CPI likely to have held firm at just 1.2% last month. Updated trade data and German economic sentiment are amongst the other notable releases on the Continent. In China, a slew of economic data has already been released yesterday morning, the most notable being Q2’19 GDP which was confirmed at an annualised +6.2%, the slowest pace since the early 1990’s. Headline Japanese data is in short supply on this occasion.

Data sources - Datastream and Forex Factory - Accessed 15.07.2019

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