Mojitos For the Long Run

Here we are in the second half of the calendar year. And the last three years give you absolutely no clue about what to expect. Today’s Markets and Money endeavours (to persevere) and to determine the future of corporate cash flows and the equity risk premium in emerging markets. But let’s start closer to home with a brief history of the last three second halves of the calendar year.

In the second half of 2007 – for the six months between June 1st and January 1st – the All Ordinaries finished essentially flat. In 2008, that six-month period in the second half captured some of the shock-horror of the GFC, with the All Ords down 38%. But the liquidity driven rebound of 2009 saw that same six-month period deliver a 25% gain on the index.

So in this case, history teaches us nothing, except to expect volatility. Morgan Stanley analysts say that the range-bound Aussie market could deliver some volatile profits, if you’re willing to load up on risk. In other words, it will pay to add risk now, according to the Morgan analysts.

“We continue to think now is the time to add back risk to equity portfolios, given cheap valuations on 2011 earnings,” writes equity analyst Toby Walker. “Having said that, we think range-bound and volatile markets could continue near term before a final quarter rally towards our year-end index target of 5207 [on S&P/ASX 200].”

A lot depends on what you think 2011 earnings will be. And that depends on how much growth in the real economy – if it grows it all – comes from confident consumers and business and how much comes from government-generated stimulus (less and less). The bear case is that the growth will come from neither, making it “not-growth”, or “contraction” as some of us call it.

More out of curiosity than anything else, we ran a five-year chart of the All Ordinaries this morning to see what the gross return would have been for a buy-and-hold investor. The results are in the chart below, and they’re not so flash. But then, it’s been a pretty bad five years. If you start that same chart in 2009 and roll it forward through 2014, what do you reckon it will look like?

Five Years Treading Water on the All Ordinaries

Using rolling five-year periods to determine the performance of equity markets is a favourite technique of people who tell you to buy and hold stocks for the long run. The embedded premise – which may or may not be borne out by the data – is that the longer you hold stocks, the less risky they are. Therefore, a buy-and-hold technique is the best strategy for dealing with unpredictable preiods of volatility. Set and forget!

But that strategy will turn out to be a dud if any one of several scenarios turn out to be true. For one, there is the “weight of money” argument here in Australia. With retirement contributions being compulsory, there’ an argument to be made that the share market will always push higher because it’s fed by a captive stream of money that flows only one way and generally into one asset class.

It will be interesting to see how fund managers behave in the coming years. For the most part, fund managers buy shares because it’s what they get paid to do, the way bakers bake bread and chandlers make candles.

True, buying stocks because it’s what you’re expected to is not terribly imaginative. But in a world of relative returns – where your performance is judged on matching the index – it’s almost a self-fulfilling argument: buy the same stocks everyone else is buying and you’ll at least match the market. Chandle away by day and drink mojitos by night.

That works out well for the fund manager, but maybe not as well for the individual investor (especially if you don’t like mojitos). But the individual investor does have an advantage over your average institutional fund manager: he can think freely and act independently.

If he’s a thinking man’s investor we think he’ll ask himself something like the following question: will stocks consistently deliver a rate of return over and above the so-called risk-free rate of return in government bonds in the next ten years?

This question about the equity risk premium – what stocks are expected to return over long-term government bond yields – is an especially fascinating question right now. Right now, investors are absolutely in love with long-term government debt. This is one way of saying that they expect a much lower equity risk premium in the coming years. But what does that mean?

Well, stocks can only pay dividends or grow earnings by growing their business. And a company can only grow its business if people are spending money. A lower equity risk premium means investors expect lower earnings growth. And it should follow that lower corporate earnings growth in the aggregate should mean lower GDP growth.

All of this, by the way, is an inherently deflationary argument. Asset prices fall as the equity risk premium collapses. The balance sheet recession in which households and businesses pay off debt, increasing saving, and reduce spending, becomes the balance sheet depression and stocks fall further. This is the scenario in which investors begin to choose a fixed income strategy – a regular payment from a creditor – over equities.

Mind you, we still find it mind-bogglingly stupid that investors would loan money to the United States government over a long-period of time and expect to beat inflation. To be fair, maybe that’s not what’s going on. As a trade, if you believe the austerity measures by the public sector will combine with the deleveraging of the private sector and households, then yes, bond prices could go higher as stocks go nowhere. This, however, is a play for capital gains from bonds and not a true income strategy.

None of that answers the question of whether the equity risk premium will rise or fall in the coming years. We reckon it will fall, but not because sovereign bonds are truly “risk-free.” They’ve never been riskier. Investors crowding into them now are setting their saving up to be consumed when the Feds unleash inflation. But we’ll save that argument for later this week.

For now, we had hoped to go back and cite a study we’ve previously analysed that looked at corporate cash flows in the post World War Two era. It showed, if we recall correctly, that corporate cash flows were anomalously high in that period, mostly as a result of the Baby Boomers, instalment credit, and the gradual establishment of the dollar standard. It showed that cash-flows were set to mean revert, meaning a lower equity risk premium for the next generation of investors.

In other words, several generations of corporations and roughly fifty years of corporate earnings benefitted enormously from the population boom of the post-War period. That boom itself led to a consumption boom, driven both by demographics – a large percentage of the population with growing incomes and access to credit – which led to even higher earnings.

But in the Western world, at least in America, real average income growth hasn’t improved much since 1974. Households have increasingly borrowed against home equity and stocks to finance consumption. And even all that seems to have hit the proverbial wall in the last few years. Mean reversion alone would argue for lower aggregate corporate profits. Mean reversion plus demographics (ageing populations) plus credit depression conspire to predict lower earnings too.

We’ll wind up, though, with two qualifiers. You are not required to buy the stock market. But you can choose to buy certain stocks. And even in an economy with ageing workers and mean-reverting corporate cash flows, some businesses (like healthcare and probably energy) will see earnings growth. Equity investors may be willing to pay an even higher risk premium for those earnings outperformers in future years.

But all along we have been referring, in a general, to equity risk premiums in Anglo countries that benefitted from the same post-War trends of a booming population, pent up demand for durable and consumer goods, access to credit, and assets up on which further consumption could be financed. What about China and India for Australia?

That is, can and should you as an Australian investor allocate a larger portion of your equity portfolio to shares in emerging markets? Those markets are driven by some of the same forces – rising levels of consumption and access to credit – that drove corporate-cash flows so high for so long in Western markets.

Is there a responsible way to capture some of those rising cash flows as an equity investor – if indeed they exist? We’ll take up the subject of alpha and beta and asset allocation tomorrow. Until then…

Dan Denning
for Markets and Money

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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51 Comments on "Mojitos For the Long Run"

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Ross
Guest

Watcher, haven’t had time for the railways. This, or some one offs, is what I am expecting to uncover on top line line revenue. UPS and Fedex I am expecting the same … taking cost out. Could still be proved wrong, but we also look in the rearview mirror with these things.

http://blogs.barrons.com/stockstowatchtoday/2010/08/03/yrc-slumps-q1-profit-beats-sees-higher-q3-ebitda-2/?mod=yahoobarrons

Biker
Guest
One of your better analyses, Dan. You’re probably right on track. An issue you briefly touch is the likelihood that the BB generation, about to leave the Accumulation Phase, is now moving into a defensive position. We’re choosing safer refuges for our cash reserves. It’s what my family and friends are doing. If this is more widespread than my immediate circle, you’d expect to see some of the following: – Maximisation of Super, to sieve as much from that source as _safely_ possible. This includes a preference for cash or balanced, as opposed to heavy ASX. Super income is untaxed… Read more »
Ross
Guest

Biker, following is the closest you get to a bureaucratic expression of terror.

http://www.financialstabilityboard.org/publications/r_100510.pdf

Ross
Guest
3 things I noted in the “The Financial Crisis and Information Gaps Progress Report” 1. “The balance sheet approach” indicates they understand the problem and that the big ever expanding balance sheet mop is their only solution 2. They admit they don’t have a clue what goes on in household economics or between class groups and are panicking about it. Measure introduced to investigate by Australia and Canada. It tells us they fear households libailities setting themselves up to go under and they wantto know before time but more importantly they are freaking out because they may stop discretionary spending.… Read more »
Biker
Guest

Thanks for that info, Ross. I’ll read it carefully at length when get back down south. Currently riding north of Perth*, with only my laptop and slow(er) Telstra dongle… . :)

* No bargains, despite what we’re reading in PerthNow and WAToday…!

Ned S
Guest
“the likelihood that the BB generation, about to leave the Accumulation Phase, is now moving into a defensive position” – You got it! Accumulation mode has to become some sort of Preservation/Draw Down mode combination for boomers now unless they fancy working until they drop dead. So seriously, tell me what % of boomers you figure won’t be in draw down mode over the next three decades? Kind of hard to imagine how liquid assets might go up in nations that are demographically heavy in boomers over the next three or four decades then – For mine – In real… Read more »
Biker
Guest
From tonight’s news: “About 6.4 million of those enrolled to vote on August 21 are older than 50 …almost half of all potential voters.” We certainly are a very large pork sandwich to digest, Ned. I see the pollies are just starting to realise that, too. I rang the firm conducting the ‘eighty buck survey’. As I suspected, they’re researching on behalf of a WA developer. No prize for guessing which one; but they’d neither confirm nor deny it. You may recall that a couple of nights back I admitted being baffled by the construction slowdown here in WA. It… Read more »
Jimbo
Guest

“Property as a tangible, solid refuge. Low yield in the short term, but, in Australia, relatively safe; very tax friendly.” — Biker

HaHaHaHa

Australian property safe? Really?

Seems Forbes, The Economist and one of the worlds largest hedge fund managers disagree with you there biker. But hey, I’m sure you know best. wink, wink ;)

http://blogs.forbes.com/greatspeculations/2010/07/26/aussie-housing-bubble-gets-popped-with-chinese-credit-crash/

Biker
Guest
“HaHaHaHa Australian property safe? Really?” When very, very ordinary Aussies all around us have become multi-millionaires through property investment, I have to reflect that your derision is just happy ignorance, Jimbo. Moreover, your willingness to pay off someone else’s property is one of the happy fortnightly events which make it all possible. Please don’t misunderstand our situation: a.) We are _happy- that you’re renting; b.) You are happy that we’re ‘subsidising’ your rent; c.) We are happy that the government kindly assists us to help you; d.) You are happy that the government kindly assists us to help you. It’s… Read more »
Ned S
Guest

Yeh, when I’m having REALLY challenging financial thoughts, I console myself with the fact that I’ve got some property – And doubt I’ll lose more than 70% – On it – Although my other investments could get whacked!!! ? :) :) :)

Ned S
Guest
“About 6.4 million of those enrolled to vote on August 21 are older than 50 …almost half of all potential voters” – That’s one hell of a lump Biker. I remember reading some stuff a back that went along the lines of The day is going to come when media outlets that want to sell their stuff are going to have to start saying re RBA rate rises ‘Retirees granted an interest rate increase’, rather than ‘Homeowners spared an interest rates increase’. I’m not at all sure that is how it will work in practice. But it’s worth bearing mind… Read more »
Don
Guest

I also console myself to the fact that when my place is paid off in Melbourne I will have somewhere to bolt when the terrible crash comes. I am even planning a “Dr Evil” type cellar lair, along with a stash of gold and silver coins I can recline on, like Scrooge McDuck in his vault, whilst listening to the chaos wafting down from above. It’s not much but it is a plan :)

Stillgotshoeson
Guest
Comment by Biker on 4 August 2010: “HaHaHaHa Australian property safe? Really?” When very, very ordinary Aussies all around us have become multi-millionaires through property investment, I have to reflect that your derision is just happy ignorance, Jimbo. So all these people have become multi-millinaires yet you still think that property is not overpriced nor in a bubble? Gold has gone up… Will correct at some point… it will reach it’s apex then correct… Equities went up reached an apex an corrected.. Yet property has no apex and will rise forever.. WOW maybe us bears are actually wrong and property… Read more »
Bearamundi
Guest

Feel for the Biker shoes!! When he’s washed-up after the correction, unable to console himself with the spoiled, dependent and hence fearful spawn he’s raised up; standing by the side of the road asking you to spot him $20 so he can fill him the strada…well, drive on

Biker
Guest
Can see you’re starting to figure out how it works, Shoes. Some additional points you may wish to consider: 1.) property rises and falls; 2.) these fluctuations generally result in falling interest rates; 3.) interest is the main cost faced by property investors. Take Keen’s thesis that interest would fall to 0%. That’s a major Lotto win for people like us. Didn’t happen, of course, but just the _fear_ he created nearly halved our main cost. I’ve no idea what might happen to gold or shares. We became ‘comfortable’ through property. Super helped, of course. If gold goes to $5K… Read more »
Biker
Guest

Dependent offspring?!~

Best laugh yet. :)

Stillgotshoeson
Guest

Comment by Biker on 5 August 2010:

If gold goes to $5K per oz, as you’ve predicted,

You have mistaken me with some one else here… I have not said/predicted 5k/Oz Gold

Biker
Guest

Don’t worry, Shoes… . If the gold price falls, governments will rush in to support it. Stimulus programs will be supported by both parties.

In Maslow’s hierarchy, gold is up there with food, water, shelter and warmth.

;)

Biker
Guest

Damn. Left silver out of the list.
Checked Maslow. Yep… it’s there… right after gold.

Bearamundi
Guest

At least you’re focused Biker, on property…hang-on, maybe too focused…(sound of Aspergers alert ringing)

Biker
Guest

Console yourself with that hope, Bear. Each fortnight as you’re about to burst into tears of depression over your lot in life, just count your blessings, among them your excellent judgement.

Your diagnosis is, of course, correct. It’s up there with your call re workers in fluoro vests all living in poverty. Classic!~

bearamundi
Guest

My apologies if I am correct. I was just making fun of your tremendous skill/focus in being able to make money on property. My hope is that you are as happy as you sound.
I’m just having a laugh, but not at your or anyone’s expense I would hope. I guess you are the same way too. Life can be so boring otherwise don’t you think?

Biker
Guest
“I was just making fun of your tremendous skill/focus in being able to make money on property.” It doesn’t take much intellect. Nor is focus reliably correlated with Aspergers, although the reverse is often true. I confess I read your posts with a little sadness. Some of your views are a little aberrant. That’s not unusual here, on a site which, necessarily, focusses continually on worst-case-scenarios. You could develop a plan based on a hope of WCSs and hunches. Many here have. Optimism, hard work and flexibility are more likely to relieve the boredom of waiting, year-after-year, for a property… Read more »
Biker
Guest
Don: “I am even planning a “Dr Evil” type cellar lair, along with a stash of gold and silver coins I can recline on, like Scrooge McDuck in his vault, whilst listening to the chaos wafting down from above.” :) You definitely need to hire the DVD “The Road”, Don. (You may need to rewrite your checklist, after seeing it!) Aussie producers have attempted a variant, “Last Ride” to try to cash in on the theme. It doesn’t really work… very similar to the Yanks’ attempt to ride the wave of the Mad Max series, with “Steel Dawn”. Flop!~ Interestingly,… Read more »
Ned S
Guest

The problem with gold and silver for us boomers is that as we age we’ll forget whereabouts in the house we put it. Although some kind soul might still be prepared to tell us where our house is? :)

Biker
Guest

ROFLMAO(KBL)!~

Someone will just yank my leash if I’m lost, Ned!~ ;)

Bearamundi
Guest
Hey Biker, that’s the way. No harm intended, and none taken. For my part you can be a bit serious and distort my posts but what else do we expect? It is just a couple of typed lines with no other contributing factors to inform judgement. Re property crash, I don’t think I am waiting. Allow me to digress for a moment. I regard myself as a generally happy man because I can answer 3 questions: 1. What do I want? 2. Where can I get get it? 3. How can I let myself have it? This is my focus… Read more »
Biker
Guest

“1. What do I want?
2. Where can I get get it?
3. How can I let myself have it?”

Ever consider:

1. What do _we_ (really) need?
Read Maslow for help, here.

2. After those critical issues,
what else is _really_ important?
Read health and family, here.

3. While we’re getting what _we_
really need, can we help others
get those things, too?

Some of you will have interesting responses to that third question.
Ask yourself, before rejecting that premise, if precious metals really serve that end better than property does… . :)

Biker
Guest

Sorry, your questions aren’t brilliant, son. They’re all about _self_.
Now google ‘autism’… .

Bearamundi
Guest

Well I tried Biker. This cat ain’t that and I’m sorry you don’t get it or want to because they cut through the nonsense perfectly. On your side, one of my mates teases me sometimes about autism/savant/mensa and I haven’t had the guts to ask him if he’s serious. I will.

Chris in IT
Guest

3 is interesting. I once heard an anti trader speech that suggest that unless you can ‘serve’ others you are doing unsustainable. Clearly, just providing market depth (which is all a trader really offers) is not a terribly large amount of value…

Ned S
Guest

It’s one of my criticisms of the US – They move money around the world and consume stuff. It mightn’t be a bad idea if they went back to working for a living?

One of the comments on a recent link by Ross went along the lines that it’s only a matter of time until the computer trading algorithms pinch the last dollar off the ma ‘n pa types. With the prediction being that at that point the algorithms will turn on each other!!! :)

Biker Pete
Guest
Well, it’s true that algorithms are evolutionary these days, Ned…. ie., they Darwinistically seek out and eliminate weaker players, thus preserving only the strongest in the field. In my considerably-biased view, this is where tangible assets represent some security, as opposed to paper-based assets. Evolutionary algorithms, in the wrong hands, may too easily manipulate the outcomes in favour of those whom these programs select and ‘reward’ as ‘strong’; without any ethical consideration for the rights of individuals… or the common good. We’re right to express caution. This field is fast becoming the new panacea: eliminate any minor players, or uncertain… Read more »
Bearamundi
Guest

Phew, he is only joking about autism. Biker, I’m a pretty smart guy and can come across to others as high functioning. I’m just clear about what I value and what is important to me and don’t get caught in tangents. How about you though? Don’t you think you lack social grace at times?

Biker Pete
Guest

I’m not sure we should ignore the counsel of friends, Bear.

Me? Just a soakwell digger. When I feel I’m lacking social graces, I take a shower.

Don
Guest

“You definitely need to hire the DVD “The Road”, Don.”

Not a big fan of movies with cannibals Biker. Not really to my taste if you know what I mean :)

As far as the future goes I am not a pessimistic person, I think the future will be difficult but will work out all in all and not be too bad. Yes, there will be ups and downs and some things will happen that will test anyone’s faith in our species but we will make it somehow. There is always hope and if that fails…..come Mr Bigglesworth, to the lair!

Don
Guest

Robert Burns said it best I think:

“O wad some Power the giftie gie us. To see oursels as ithers see us!”

Biker
Guest

So true, Don.

Others tend to look down on me at times, when I’m hard at work.

“I…can come across to others as high functioning.”

When I’m deep in a soakwell, I’m perceived by others as low functioning…

On the matter of cellars as refuge, another Scottish poet, Knopfler, noted:

“Daddy is he a goodie or a baddie
Daddy can I have a .44?
Once upon a time there were cannibals
Now there are no cannibals any more…”

bearamundi
Guest
A soakwell digger with a social theory? This is uncommon. How many Australians have the latter or have even done Psych 101? Not too many I’m afraid and that is precisely why we elect sociopath after sociopath in this country. Just watch Biker, when you get up tomorrow morning. The three questions are operating in you as a fact, not just a theory. You’ll get your plate of muesli and then a coffee and hopefully enjoy both tremendously. All these questions do is make it crystal clear. Now if you want to care for others, that is your business; but… Read more »
Biker
Guest

Psych 101? :)

Biker
Guest

You’ve made a new man of me, son.

Hallelujah! I’m born again… cleverer, like you!

bearamundi
Guest

Dang! Got me again. Very funny….

Ned S
Guest

Teaching ditch diggers to read ‘n write – Bit progressive for mine. Though I can see potential benefits in teaching Financial Advisors to dig ditches? :)

Ned S
Guest
A bloke once said to me that you shouldn’t invest in something if you don’t understand it – So I made a bit of an effort to understand stocks – Hot money, Pump ‘n dump, Flash crashes, Margin calls, Front running, Insider trading – And theoretically one should try to give a bit of thought to what’s going on in the economy (as opposed to what government is saying) – And in individual businesses (as opposed to what their CEO is saying). So I’m currently inclining to the view that a bloke wouldn’t invest in these things if he did… Read more »
bearamundi
Guest

This ain’t exactly Hallelujah stuff, it ain’t meant to be a display of cleverness I hope, its FREEDOM once you perceive it as what is happening. Everything else is a form of frustration. “Show me the money!!”

Biker
Guest
Here’s the money. I said: “When I’m deep in a soakwell, I’m perceived by others as low functioning…”* Quite delightfully, you reaffirmed my worth as a self-actualised BEing. Your friend may have noted your tendency to miss low-level humour, Bear. One thing on which we agree: this _is_ b-o-r-i-n-g. While I appreciate your attempts to lift my game; MENSAte me to a higher life form; and educate me in finance, your efforts are probably wasted. We became very, _very_ comfortable buying, building, renting and selling property. Nevertheless, after the GPC, when I’m standing at the side of the road begging… Read more »
bearamundi
Guest

Oh, and I thought you were just colluding/excluding again. No intention to alter you one bit prickly Biker, that would be too frustrating. Sorry if I get a bit driven from time to time. “boring”-there you go now, you have the perfect excuse to carry on being the grumpy snob we’re used to, and let yourself have it _comfortably_

Biker
Guest
Reread your stuff to see who’s prickly, MENSA Boy!~ :) Like me to _paraphrase_ it for you, son? Go back thru’ your stuff to extract the poisonous little gems studded throughout your posts. My conclusions? 1.) Someone once assessed this autistic fool as ‘high-functioning’. It’s _always_ a major mistake to state this to his face. OK, your mum told you what the psych said. Her fault, then; 2.) Fool then figures he’s MENSA-material; 3.) Fool repeatedly proves he’s not, online; 4.) If you have to TELL others you’re high-functioning, it’s highly-unlikely you are the genius mum _thinks_ you are. (Check… Read more »
John
Guest

You’ve got him on the ropes, bearonmundi.

BORE the old b*stard to death!

bearamundi
Guest

Now that’s funny!! Aussie humour is such a tangible asset!!

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