25 March 2020
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The current market correction has taken us back to valuation levels that can only be described as bargain basement. Although this will sound counter-intuitive to a lot of people, this is a time to be buying not selling.
Below is a tipping point table which is one of the tools we use when building portfolios for clients. It shows where markets sit relative to their long-term value and term deposit interest rates. We use this for guidance in determining how much is invested into each asset class. What you should notice is the small red arrow pointing to where the various indices are currently sitting and the status level of each asset class. All are registering as ‘cheap’.
To put this into perspective, if you were a bargain hunter for any other product or service this is the time you would buy because everything is discounted.
Figure 1: Tipping Point Tables as at 16 March 2020
What spooks investors in times like the present is that their perspective moves from “where we are heading” to “where we have just been”. This change in focus makes people act on how they feel rather than what is best for where they are trying to get to. In industry terms this is the tension between personal risk appetite and risk capacity. When markets are behaving rationally these tend to align; when markets do not act rationally the alignment dislocates which causes stress, panic and often reflects in poor financial decisions.
By way of examples, some people may think they are conservative investors (risk appetite) but they have plenty of cash and/or low risk investments to live from for several years (risk capacity). In the current volatile market, our role is to help these investors understand that they have plenty cash to meet their living needs, and therefore they have plenty of time to wait until markets recover. By doing this they will profit from the inevitable rebound in asset prices when sentiment returns to normal. Similarly, we hear from young KiwiSaver clients who have not seen volatile markets before and therefore have a low risk tolerance. They are freaking out about the recent drop in value of their investment, yet they have 30 or more years in front of them before they will begin to withdraw and spend it; they actually have a high-risk capacity. For these investors the worst thing to do would be to switch into a lower risk investment option as they would be crystallising the current market value losses and removing any possibility of participating in the gains when markets recover. The exception to this would be if the funds were required for a home deposit soon. Again, this is about aligning your risk tolerance to your risk capacity. Having access to a financial advisor, to help understand this, is very important in these turbulent times.
The key thing to remember is that markets will always over-react, and this time is no exception. It is important that your investment response is not an over-reaction also.
The graph below shows the progress of the ASX All Ordinaries Index against a steady growth rate of 3.5% (the red line). This reflects the rate at which we expected profits and dividends to grow over a ten-year period back in 2012. Since then, this rate has been proven to be very accurate and is a key component in how we set our tactical weighting of assets in client portfolios. Moving around this (in blue) is the actual market; what you should notice is that in the short term this is either above or below the growth rate line. The market reaction to the Covid-19 pandemic has moved the market to be significantly under the growth line. Even if we adjust the red line down, due to a pending recession, the blue line still remains under the red line; this shows there is a lot of future value to be gained by the patient long-term investor.
For NZ investors the graph is very similar with the NZX All Ordinaries showing a very similar pattern.
What does this mean? If you do not react emotionally, and rather take the long-term investor approach, this is nearly as good as it gets. Ten year returns for asset classes are estimated to be ranging between 9.5% and 12.4% per annum from here.
Figure 2: ASX All Ordinaries price growth vs 3.5% pa steady growth
Source: ASX, farrelly’s analysis
Where to from here?
It is understandable that most of you have concerns about the recent fall in the value of your portfolio. What we know is that markets will rebound and those investors who stay the course will be the beneficiaries of this. If you have funds to invest, now is a good time to seek advice and drip feed them into your portfolio in readiness for the inevitable lift in value. Keep calm and stay the course.
Sir John Templeton, one of the most respected investors and stock-pickers of all time once said, “Bull markets are born on pessimism, grown on scepticism, mature on optimism & die on euphoria”. 2019 was the euphoria and we are now in the pessimism stage. The best investment advice you can receive now is not to listen to the pessimism and be patient waiting to capture the next bull market, which will form.