This article appeared in the December 2014 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
By Roger Montgomery, The Montgomery Fund
Having been asked to write about the top investment issues for 2015, it is easy to create a headline that has the power to instill fear. Before I launch into what you should be watching out for in 2015 - and what to expect with property prices, index funds and shares - the first thing to note is that there will always be something to frighten you.
Concerns about wars, epidemics, pandemics, financial crises, inclement weather, recessions, commodity price crashes, inflation and stagflation will, to varying degrees, be with us at some point or another.
Such fears make rational decision-making more challenging and so my preference is that you concentrate on what you do best and what you enjoy. If, however, you are going to invest yourself, your job is straightforward.
Simply put together, at rational prices, a portfolio of extraordinary businesses - those with bright prospects and the ability to reinvest large amounts of capital at high rates of return with little or no debt, and whose earnings are virtually certain to be materially higher in five, 10, and 20 years from now - will stand you in good stead. If you do this correctly, you will not need to follow the daily, weekly or even monthly share prices.
Certainly, in the short run, share prices will rise and fall amid fears about the issues I have mentioned, but over the long run those share prices will follow the increasing value of the businesses you have successfully selected.
The reason to fear these stated influences is the adverse effect they can have on share prices, but you should consider whether you believe the price impact is likely to be permanent. Perhaps the following story will help put the fears of price declines in their place.
A case study: Coca-Cola
Consider the US IPO of Coca-Cola in 1919 at US$40 a share. A year later the stock was trading at US$19.50, the result of rising sugar prices and a perpetual contract Coca-Cola had with its bottlers to supply syrup for a fixed US$1 a gallon.
Think what would have happened if your grandparents or great-grandparents bought a single share in 1919 at US$40 and held on through the subsequent decline to US$19.50 in 1920, then through the Great Crash of 1929, the subsequent Depression of the 1930s, World War II, a baby boom, dozens of other wars and skirmishes, an oil crisis, assassinations, the fall of the Berlin Wall, yuppies, innumerable recessions, booms, busts and scandals. And a war in Vietnam, two in Iraq and a global financial crisis.
If they kept this share in the family and reinvested all the dividends, they would in January 2010 have had 126,321 shares and their investment would have a market value of US$6,966,603.15. In the nearly five years since, there have been another 14 dividends and a two-for-one split.
In August 2014, that original US$40 investment would be worth US$11.7 million, a compounded return of just over 14 per cent per annum.
Key issues for 2015
It is fair to say the past 94 years has had its share of issues that investors could have been fearful about. Yet consider the returns from making just one correct decision (like Coca Cola) and leaving the rest to the business in which you have entrusted some of your wealth.
Think about this as I look at some of the issues you may need to consider for 2015.
- Markets tend to fall ahead of interest rates rises
- Impact of Financial System Inquiry
- China/Further declines in iron ore price
- Domestic property market weakness
In fact, there are not many sectors unaffected in 2015 by fear. With the exception of healthcare - which could continue to bolt higher, dragged up by ageing baby-boomers - every sector appears to have the potential to be impacted by something.
1) Market correction from higher US interest rates
IMPACT ON: All stocks
I cannot tell whether interest rates will head higher in the US next year or the year after. It is possible that strengthening employment in the US will lead, perhaps inevitably, to wage pressures. In turn, wage pressures could cause inflation to spike beyond central bankers' upper bounds.
If that happens, the fact that central banks have been targeting economic growth rather than inflation could mean that central banks will be behind the eight-ball. This would see rising interest rates and, perhaps most importantly, a change in expectations about future interest rates.
When expectations change, so does asset buying behavior, because advisers start guessing not about if or when rates might rise, but how far and for how long.
US Federal Reserve officials are already warning investors and foreign central bankers to brace for market turbulence as the Fed prepares to raise short-term interest rates.
In a speech to central bankers in early October in Paris, Federal Reserve Bank of New York President and Federal Open Market Committee vice-chairman, William Dudley, said: "This shift in policy will undoubtedly be accompanied by some degree of market turbulence. If all goes according to our forecast and the US economy continues to make progress towards the Fed's dual mandate goals of maximum sustainable employment and 2 per cent inflation, the Federal Reserve will likely begin to raise its federal funds rate target off the zero lower bound sometime next year."
According to Sam Stovall, S&P Capital IQ's US equity strategist, "in 13 of the 16 times the Fed raised rates [since WWII], the market went into a pullback, correction or bear market", in the six months before the increases began. He found the pullbacks lost an average 16 per cent.
In the years since 1946, Stovall found six pullbacks (a 5 to 10 per cent decline), four corrections (stocks fell 10 to 20 per cent) and three bear markets (a drop of 20 per cent or more) began in the six months before the Fed started tightening.
In other words, 88 per cent of the time, "the markets were thrown into a pullback or worse when an initial rate hike was a possibility or reality," according to Stovall. This suggests there is some possibility (and that's not really committing to anything) the S&P 500 will begin a decline of 5 per cent or more within six months of the Fed's first rate rise.
2) Financial System Inquiry
IMPACT ON: Banking stocks
The Montgomery Fund expects returns from Australian banks to be more muted in the next few years than in previous years.
Share prices will (only) remain supported while relative dividend yields are superior to cash returns. Because of the Financial System Inquiry we also think it is inevitable that rates on term deposits will fall. Therefore, while rates are low and declining for cash, people will be forced into higher-yielding bank shares.
But strong credit growth and interest margins will be offset by inevitable increases in capital requirements (banks being forced to hold more capital) under the Financial System Inquiry. Also, if interest rates rise locally in 2015 (it may not happen until 2016), the appeal of owning banks, at above rational estimates of intrinsic value, declines.
If rates rise globally, the global "carry trade" under which investors borrow in countries with low interest rates, such as the US, to invest in higher-yielding countries, such as Australia, becomes less attractive.
Thus far, low interest rates locally and globally have inflated the valuation multiples of Australian banks. Inevitably, however, the pendulum swings back.
3) China/Further declines in iron ore price
IMPACT ON: Resource stocks
It is somewhat comical that investors listen to analysts who now say the iron ore price could fall to US$65/tonne, when only a short time ago they were suggesting US$100/tonne was likely to represent a floor before the price plunged through it.
Iron ore supply for Australia alone has nearly tripled in the past decade. Any first-year university economics student can tell you that when demand remains constant and supply increases, the price falls. The only difference in the real world is that demand is not constant.
China is slowing and demand for iron ore is slowing with it. For 30 years before 2004 the price of iron ore traded at between US$10 and US$20/tonne. To think it can't fall lower than its current level of US$75/tonne is optimistic.
Further declines will have an inevitable impact on the share prices of major iron ore producers, which in turn, we currently believe, will affect the S&P/ASX 200 index (due to the weighting of resource stocks) and anyone invested in an index fund.
4) Domestic property market
IMPACT ON: Retail stocks
Investment property loans are growing at more than 10 per cent annualised. This suggests house prices will continue to rise in 2015, and certainly while interest rates remain low. Yet property prices do decline. They fell 10 per cent during the GFC (in Sydney, Mosman house prices fell 40 per cent) and nobody bat an eyelid. They fell by the same amount in the early 1990s and they fell in 2010.
A third of all property is owned by investors and a significant number of loans are interest only. In a rising interest rate environment, these loans could look like the subprime loans of the US during the GFC.
Any correction in property market values will have a detrimental impact on consumers through the negative wealth effect.
Don't fear, there are probably a couple of years of growth ahead and Australia needs to find homes for another 15 million people over the next 35 years. So within our lifetime there is demand for perhaps two million new properties that needs to be satisfied, or demand for a smaller number of new properties and an inevitable rise in the value of existing properties.
Currently, Montgomery has between 20 and 30 per cent of the funds entrusted to it by investors in the safety of cash. That reflects the fact that the Australian sharemarket is about 10 per cent overvalued on our aggregate company valuations, and although we are not predicting any immediate decline in stocks, we are ready to take advantage of it. If any of the four issues above cause good-quality stocks to fall precipitously, you should be ready too.
About the author
Roger Montgomery is the founder of The Montgomery Fund. It has returned 51.95 per cent since inception in August 2012 after all fees and assuming reinvested distributions. Performance statistics and application forms can be found at The Montgomery Fund.
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