Investor Newsletters

Dear Fellow Investor

BACK TO BASICS

Like Warren Buffett we dare not invest in expensive equities/stock markets.

Question:
Why not?

Answer:
As there is a high probability of losing a significant portion of our investment over many years to come.  For example the Nasdaq composite index took from March 2000 to May 2015 and the S+P500 from March 2000 to Feb 2013 to break even and embark on a sustained uptrend.  From March 2000 to March 2009 these two markets suffered two crashes of 45%+.  (Source: Yahoo Finance.)

Question:
How expensive is the S+P500 today (23/06/2020)?

Answer:
The price-to-earnings (PE) ratio is the most common method to determine the expensiveness of a stock market.  This ratio is the price you pay today for a share in e.g. S+P500 companies relative to the earnings of these companies over the last 12 months. Currently this ratio is 26.9 which is 67% higher than the historical average of 16.1. (Source: Shiller PE ratio/guru focus.)   This means it will take 26.9 yrs to earn back every dollar you invest in the S+P500 should earnings remain the same as over the last 12 months.  Should earnings decline then PE ratios will increase as explained hereunder.

The very high PE ratios of some shares e.g. Amazon (145), Netflix (106), Tencent (51) reminds me of 1999  pre-crash.

Question:
How does the current S+P500 PE ratio compare to ratios before or during prior stock market crashes?

Answer:
Dotcom Crash (1999-2002).  PE ratio increased from 33.4 (March 1999) to 46.7 (March 2002) whilst the S+P500 crashed by 47.6% from 20/03/2000 to 30/09/2002.

Great Recession (2007 – 09). The PE ratio increased from 22.4 (1 Dec 2007) to 26.5 (1 September 2008) and then to 123.30 (1 June 2009) – highest in history.  The S+P500 crashed by 56.13% from 1/10/2007 to 2/3/2009.   (Sources: Yahoo Finance, Shiller PE ratio/guru focus.)

Question:
Why do PE ratios increase during a recession?

Answer:
Earnings drop faster than share prices during a recession.    Daily share price movements give you a false

impression that share prices lead and earnings follow.  Reality is the opposite. Note earnings are reported quarterly in arrears while stock markets try to look 12 months into the future.

Question:
The S+P500, Nasdaq and the JSE is going higher and higher, from their lows in March, should we not go along for the ride and get out before the next crash?

Answer:
No margin of safety.  This will put us on a far more risky path as no person can tell you when exactly the next crash will occur nor how fast or deep it will be.  For example on 19/10/1987 the Dow dropped by 22.61% and on 16/3/2020 by 12.93%.

Another dangerous sign is the rampant speculation/ trading on US markets since March.  I have seen and experienced this type of speculation in 1999.  It ended in tears as I wrote in the February newsletter which is available on our website.  The success rates of individual and day traders are very low.  Brazilian study showed only 3% of day traders actually make a profit and less than 1% more than the Brazilian minimum wage.  University of California/Charles Schwab found that individual traders substantially underperformed the market over a six year period.   Short term rich, long term poor.

Please contact me should you have any questions/comments.

Dear Fellow Investor

Economic Recession/Expensive Stock Markets?

Please see relative performance graph hereunder:

Question: Where would you have preferred your local money to be invested since Jan 2018?

(Olympiad BCI Managed FOF – 5/161 unit trusts in SA Managed High Equity category at lowest risk over 3 years till 31/3/2020, 5/179 over two years and 5/193 over 1 year.  Source: Morningstar).

Is this global stock market rally sustainable or should we expect a serious correction/crash of ±50%? The speed of this relief rally caught myself and many seasoned investors including Buffett by surprise.  The rally is built on the US Central Bank (Fed) printing new money to the tune of $3 trillion following an announcement in early April.  The Fed’s total balance sheet (new money) increased to $7 trillion by the end of last month and is expected to increase to $9 trillion from less than $1 trillion in 2008 pre last crash. 

Some of the $9 trillion will be used to purchase corporate junk bonds which it has never done before.  This of course will keep corporations afloat which should have gone bankrupt in a normal, capitalist economy based on competition and private ownership of money.  The question is whether the Fed will be able to prop up all these junk bonds of which 540 issuers show a high probability of default. So the bond and stock markets are artificially supported by the Fed.  The minute this support stop these markets will in all likelihood collapse.

The US Government Debt increased from $22 trillion a year ago to $25,7 trillion in May 2020.  This debt plus corporate debt of $9,6 trillion and the Fed’s $7 trillion result in a total of $42,3 trillion. This is almost double the $21.2 trillion worth of goods and services produced by the USA in 2019 i.e. GDP.

With the current unemployment rate of 13.3% (3.5% in Jan 2020) plus record high levels of debt and negative economic growth forecasts for 2020, I believe the current stock market values are not sustainable.  Based on Prof Robert Shiller’s CAPE Ratio, price/earnings ratio of the S&P500 companies with earnings adjusted for inflation over the last 10yrs, as an investor in the S&P500 over the next 10yrs you should expect to lose 1.6%pa. This ratio is currently 79.4% higher (more expensive) than its historical mean and has proven quite accurate in the past.

 

Please feel free to contact me should you have any comments or questions.  

Dear Fellow Investor

WHERE ARE WE NOW?

We are in local cash and shorter dated bonds.  As a result we did not partake in recent stock market crashes and returned to positive +0.56%, excluding money market interest, in April.  Please note that interest earned on 33% of our money, in BCI money market, will be credited after the end of every month.  As money market rates drop, bonds offering higher rates become more attractive resulting in the capital appreciation of bonds.  This should of course increase our investment returns.

STOCK MARKETS

As at 27 April 2020 the JSE ALSI and S+P 500 (top 500 US companies) indices were back to the levels they recorded in May 2014 and 22 Jan 2018 respectively.

THE FUTURE

It is highly unlikely that we have seen the bottom of the US and by extension global stock markets including JSE.  The S+P 500 is about 57% more expensive than its long term average.  At the end of the Great Recession (March 2009) it was more than 10% below its long term average i.e. cheap.  At the time it offered us a significant margin of safety.  Not so now.

Stock markets went from “fear mode” in March to the recent “relief rally” and are now in “frustration phase” where they do not know which way to go.  Relief rallies, recovering about 50% of losses, are common.  For example during the Great Recession from 8 Sept 2008, there were six such rallies averaging 13% per rally, only to hit a bottom in March 2009.  Most of the rallies in 2008 like now were based on Monetary (Government) and Fiscal (Fed) stimulus optimism.

The reality that is unfolding however is that:

  1. More than 30 million US workers lost their jobs over the last 6 weeks.  All the jobs created since the Great Recession wiped out.  Imagine the shock of workers/consumers to go from 3.6% unemployment rate, lowest in 50 years, to a very high rate.  It is expected that the US unemployment rate will increase to about 20% over the next couple of months. In the Great Depression and Great Recession this rate topped 24.9% and 10% respectively.

  2. Due to increasing unemployment numbers the consumer share of the US economy at about 70% is diminishing fast.  Expect less spending and more savings from US households with jobs.

  3. It is further expected that it will take US corporations 12 – 18 months to increase their revenues/gross income back to where they were before the crisis.

  4. Dr Anthony Fauci, Director, US National Institute of Allergy and Infectious Diseases stated that he is “almost certain” that a second wave of Coronavirus will hit the US later this year.  If so, it will be a repeat of what happened in 1918 when the outbreak in Jan 1918 was followed by a second wave in Oct 1918.  (Spanish Flu.)

To summarise, although the JSE is cheap the S+P 500 is not.  We know from history that when the US stock markets crash the impact is felt globally so we need to be conservative for now.  I think Wall Street (S+P 500) needs to catch up with Main Street (realism).

Please feel free to contact me should you have any questions/comments.

THE COVID-19 DISEASE AND ITS IMPACT ON THE ECONOMY AND FINANCIAL MARKETS

The fear caused by the spreading and mortality rates of the Covid-19 disease wreaked havoc on financial markets – until governments and central banks intervened. That halted the free fall and contributed to some recovery in the prices of shares and bonds worldwide. Central banks reduced interest rates and made sure enough liquidity is available, while governments and private sector companies provided assistance packages to companies and households in distress. But for markets to recover further, “a fast decline in the spreading of the virus” is needed.

The key to the end of the crisis is in a vaccine. But, in its absence, the alternative is measures to reduce the rate at which the virus is spreading. In this respect, social distancing and lockdowns are implemented around the world. Its success will be determined by the growth rate of new cases – that is when new cases the next day is lower than the current day. A number lower than 1 (declining fast to 0) is what is needed for these approaches to be successful. The growth rates are increasing in some countries (e.g. USA) and declining in others. Although the rolling weekly average for the world is still more than 1, the good news, as the graph below shows, is that the daily world growth rate is declining – as “lower high” and “lower low” growth rates are registered. But, it is happening very slow – the next two weeks will be crucial for success. If successful, lockdowns in some countries may be replaced by strict social distancing measures. If not, lockdowns may continue for longer. 

News - Covid-19 graph

In South Africa, the weekly moving average growth rate declined from 1.32 on the day of the lockdown (26 March) to 1.05 on 4 April. The same numbers for the world are 1.13 – and also 1.05. At this early stage it seems as if South Africa’s measures are working – but as the growth rate is still more than 1, chances are slim for the lockdown to end on 16 April. 

This indicator should also signal the outlook for the resumption of economic activity, as well as market movements. The faster the decline, the higher the hopes for a resumption of economic activities – and vice versa. Due to uncertainty, it is difficult to make economic forecasts. However, several institutions attempted this exercise. For instance, JP Morgan worked on the assumption that the pandemic ends by end June. If so, a two-quarter GDP contraction is expected in the USA (-10% in Q1 and -25% in Q2) and the Euro Area (-15% and -22%). Thereafter, economic growth is expected to increase by 6% over the final two quarters in the USA (assuming that social distancing policies are significantly relaxed by mid-year.) China’s Q1 growth may experience a huge decline of 41%  but can register a V-shaped recovery, rebounding by 57% in the second quarter. China’s full-year GDP growth forecast is 1.1% (from an initial 5.9%). The world is expected to register growth of around 0.3% in 2020, increasing to 3% in 2021.

In South Africa, the best-case scenario is for the economy to shrink by 2% in 2020, but It can be 4-6% in worse cases. South Africa’s woes were aggravated by the inevitable decision of Moody’s on 25 March to downgrade the country to junk status with a negative outlook. And the economy will be confronted by huge job losses amid electricity shortages. Under these circumstances, the South African Reserve Bank will have little choice but to reduce the repo rate further. Markets, on the other hand, recover before economic indicators. If things work according to plan (growth factor declines fast), the partial recovery over the past two weeks may continue. For instance, at its lowest point the JSE ALSI was down 34.9% since the start of the year, but recovered to end the month 22.1% down. Similarly, the All Bond Index was 16.6% down, but improved to be 8.7% down by end March. However, continued volatility in the markets will persist – as international and domestic economic indicators emerge to indicate the magnitude of the virus’ impact. This, the growth rate of the spreading and other government measures will impact markets going forward.  

JOHANN VAN TONDER
M.COM (ECONOMICS)
ECONOMIST

Dear Fellow Investor

STOCK MARKET CRASHES

The lesson from history is that stock market crashes occur much faster than recoveries.  What we have experienced over the last month or two appear to be the start of a crash:

JSE (ALSI)
JSE (PROPERTY INDEX)
USA (FTSE USA TR USD)
EUROPE (Morningstar Europe GR EUR)
UK (FTSE 100 TR GBP)
CHINA (Morningstar CHINA GR CNY
(Source:  Morningstar.  Note:  Performances in local currencies.)

-26.71%    (18/1 to 15/3/2020)
-27.09%    (18/1 to 15/3/2020)
-24.71%    (19/2 to 15/3/2020)

-36.57%    (19/2 to 15/3/2020)
-29.24%    (20/2 to 15/3/2020)
-15.35%    (13/1 to 15/3/2020)

At this stage of an economic cycle it is important to remember the following:

  1. Do not try to catch a falling knife.
  2. Bottom of a stock market must be determined by other investors not us. Must we rush to get back in? No.
    “If this is the bottom of the market, there will be a 30 to 60 day period where equities can be purchased at these levels” – Don Brown, US Investment Manager. He has a better track record than Warren Buffett over 55 years since 1960 in underperforming the S&P 500 in only 2yrs whilst about 80% of equity fund managers cannot beat the market they invest in over most years.  (Source: The gazelle of Wall Street, Fin 24, 18 Feb 2016.)
  3. To recover losses from JSE crashes over last 44yrs, till end of 2019, took an average of 2.6yrs. The long term comparable figure for the S&P 500(USA) is 4.4yrs. Note however that it took the S&P 500 from 20/8/2000 to 16/9/2007 and from 16/9/2007 to 24/3/2013 to break even. JSE crashes are normally accompanied with devaluations of the Rand against the US Dollar due to Americans withdrawing their investments back home. Since 2000 significant recoveries followed these devaluations. For example the Rand recovered from R11.64(Dec 2001) to under R6 (Jan 2005) to the US Dollar.    

In the meantime our Olympiad funds interrupted their steady increase every month with a drop of about 1% from 24/2/2020 to 15/3/2020 due to local bonds exposure.  We are currently decreasing our local bond holdings in favour of cash and shorter dated bonds(less risky) resulting in an approximate 50/50 split. With US interest rates dropping to nil, local interest rates are expected to be reduced which in turn will be supportive of local bonds. Over the medium term the higher local interest rates should attract foreign funds and support the Rand. Cash we need because as Buffett said “cash combined with courage in a time of crisis is priceless”. Courage in getting back into stock markets like after 2009 which is a history that we shared.

Please feel free to contact me should you have any questions. Remember about 90% of my own local investable funds are invested with your funds in the Olympiad unit trusts.

In a landmark paper, published in 1986, Determinants of Portfolio Performance, Brinson, Hood and Beebower concluded that asset allocation is the primary determinant of a portfolio's performance and accounts for some 90% of the return experienced. Ibboston and Kaplan later confirmed this in 2000 with a finding of 75%.

Source: Financial Analyst Journal, 1986 and 2000

WORDS ON WEALTH

MARTIN HESSE | martin.hesse@inl.co.za

Saturday, January 12 2019 | AFFLUENCE

It wasn’t a good year for investors in equities

OH DEAR. Last year was not kind to investors. It was the worst year for the JSE since the Big Crash in 2008. And it started off so well, with all the optimism around our new president.

I won’t go into the reasons for the malaise, which differ according to the analyst you speak to. But let’s look more closely at the figures, which make for enlightening, although somewhat depressing, reading.

The FTSE/JSE All Share Index ended 2017 at 59 504 points

(after breaking the 60 000 mark in November 2017). It ended 2018 at 52 736 points, a drop of 11.4%. That’s low compared with the 27.5% drop in 2008, but here’s the rub: there hasn’t been a crash. Just lots of volatility, with most of it occurring in the last quarter.

Looking at the total return index (which measures share prices with

dividends reinvested), the drop was a slightly more palatable 8.5%. This is the better indicator when considering the performance of your equity unit trust or exchange traded fund investments, because, unless you’re drawing an income, you’re likely to be reinvesting your dividends.

So how did our equity fund managers do in the tough times that were 2018?

Not too well, sadly. The average South African general equity unit trust fund was down 8.9%, according to Profiledata. Of the 163 funds in this sub-category, only two did not end in the red after costs: the Kagiso Islamic Equity Fund (up 1.7%) and the RECM Equity Fund (up 0.47%). The worst-performing funds were down as much as 20%.

It’s likely that the better performing funds had a substantial

exposure to our resources sector, the only sector to have done well in 2018. The worse-performing funds were most likely heavily invested in industrials, which had a miserable year. The darling of these stocks, Naspers, which featured large in many an equity portfolio, lost 16.5% of its value in 2018.

High-equity multi-asset funds also did poorly. These funds can have a maximum of 75% in equities, but the managers can reduce their equity exposure if the markets are looking dicey, switching to safer options such as bonds and cash. Of the 174 registered high-equity multi-asset funds, only a handful emerged in the black at the end of the year.

The average fund in this subcategory was down 3.7%, according to Profiledata. Star performers were the Gryphon Prudential Fund of Funds

(up 5.4%) and the Olympiad BCI Managed Fund of Funds (up 5.24%).

Cash and short-term bonds were the best-performing local asset classes, delivering northwards of 7%.

GLOBAL MARKET

The JSE was in good company on its downward slide. The Visual Capitalist website, which contains informative financial infographics, recently published a infographic titled “How every asset class, currency and sector performed in 2018”. It shows that most asset classes ended 2018 in the red, with the S&P 500 (which measures the 500 top American stocks) down 6.2%, emerging markets down 16.9%, and non-us developed market stocks down 14.5% (all in dollar terms which, it must be said, strengthened against world currencies by 4.6% in 2018).

SOURCE:  INDEPENDENT ON SATURDAY | AFFLUENCE | Page 10

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