Let’s begin today’s Markets and Money by closing the loop on the NAB story we wrote about yesterday. NAB stock fell by 5.22% when investors realised the company’s $2 billion placement to institutional investors at $21.50 was an 8.8% discount the closing price of the shares before NAB went into a trading halt.
Lesson? There’s always an unseen or unforseen consequence to any action. In this case, the good news for NAB is that it’s rebuilding its balance sheet with equity capital. That’s a good alternative when the global cost of capital is going up (mostly because government bond auctions are hoovering up so much private capital).
The bad news is that existing shareholders took a hit on their shares when NAB discounted the offering to the current share price. It probably had to do this to incentivise buyers. But that was the hidden cost, and it was born by existing shareholders. And in any event, we’re still not convinced that capital raised to buffer against further loan losses is the kind of event a shareholder would be bullish about.
Did you know there are already entrepreneurs who plan to build the infrastructure to recharge electric cars in Australia? Maybe it’s wacky. Maybe it’s ahead of its time. Maybe it’s creative destruction at work!
Yesterday’s Age reports that, “Shai Agassi is the charismatic entrepreneur, electric-car evangelist and founder of Better Place, a US-based company that plans to roll out the infrastructure necessary to recharge electric cars at home, at work and at battery-swap roadside stations.
“Speaking in Melbourne, he said Australia could become the modern equivalent of oil-rich Saudi Arabia if it quickly switched to manufacturing electric vehicles and lithium batteries. ‘A billion electric car batteries will need to be made – that is the biggest industrial opportunity in the world today,’ he said while giving the inaugural Deakins 2009 Eco-Innovation lecture. ‘Australia can pick whether to be an exporter of iron ore, phosphate and lithium, or of kilometres [in the form of batteries].'”
An exporter of kilometres? Hmm. It does sound wacky. But having recently written on an Aussie lithium producer in Diggers and Drillers, we’d agree with Agassi that a lot of electric car batteries are going to be built in China and Japan in the next twenty years. And they’re going to need a lot of lithium carbonate.
By the way, if you’re going to recharge an electric car battery, you’re going to need electricity to do it. Ziggy Switkowski says the wind and solar industry is a “cottage industry” that cannot meet the energy requirements of an industrial economy like Australia’s. “There is no other alternative but to go nuclear,” he says.
To be fair, Switkowski (like everyone) is talking his own book. He’s the head of the Australian Nuclear Science and Technology Organisation. His job is to talk up nuclear. But we think he raises a fair point that hasn’t really been debated in earnest in Australia: will renewable sources deliver the Australian economy the energy it needs to grow or do you need nuclear energy in the mix too?
Here’s a shocker: there is no inflation in Australia because men’s underwear is cheap.
We somehow missed that story in the papers earlier in the week. But sure enough, Thursday’s Age reports that, “Sharp falls in the prices of men’s underwear, fruit, vegetables, milk and bank charges helped offset big rises in the prices of women’s underwear, hospital services, real estate and petrol.”
The data, courtesy of the Australian Bureau of Statistics-suggest that if you wear jocks, eat apples and drink milk, your cost of living is going down, even if you get sick, buy property, drive a car, and sometimes wear women’s underwear. That’s probably good news for somebody out there. But is the cost of living in Australia really doing down?
Not if you ask the RBA! The Reserve Bank of Australia publishes regular inflation data. That data includes the “trimmed mean” measure of inflation. This measure (defined below) excludes volatile changes in certain consumer prices to “smooth out” the noise in the data set. The ABS also publishes this data, which you can find here on page 27 (analytical series 10).
What both data sets show is that underlying inflation in Australia is up about 3.6% in the last twelve months. That’s outside the RBA’s comfort zone of annual inflation/systematic erosion of your savings and purchasing power of between 2-3%. So are the statistics lying?
Well, we wouldn’t go so far as to suggest that government statistics may be deliberately understating the rate of inflation. That could never happen. But it does show you that statistics can often be abused to contradict common sense.
Common sense tells you the cost of living is going up, despite the really great deals you can get on men’s underwear. This is why there’s such a large difference between the headline rate of inflation-which measures consumer price growth across around 70 different categories-and underlying core inflation-which measures price growth in core consumer purchases and weights them accordingly.
It does have the feel of statistical hocus pocus about it sometimes. RBA man Tony Richards explained the methodology here in 2006. The key part of his speech was this: “[Trimmed means} ‘trimmed’ means in the sense that they are the mean or average price change for the CPI basket after taking away, or ‘trimming’, the more extreme price changes in any period.”
He added that, “Trimmed mean measures exclude – or more correctly down-weight – the impact of items based on whether or not they appear to be outliers in the period in question. These measures represent an attempt to estimate the central part of the distribution of price changes, and provide a measure of inflation that is not excessively affected by large price changes – either increases or decreases – in individual items.”
It’s a little weird to measure inflation by excluding the things that are actually changing in price. You’d think that would be important. But the RBA is trying to weigh which price increase matter more: underwear or petrol. It’s probably best to keep it simple and say that when money and credit growth increase and bank reserves grow, the money supply growth (inflation) leads to rising prices.
We move on to superannuation and a pretty significant discussion of a change in corporate cash flows and how investors value them. Some financial planners and folks in the super industry have written in this week saying that we’re being unfair to the industry by claiming the interests of planners and funs are not aligned with the interest of investors.
Suit yourself. We never said there weren’t honest financial planners there. And by definition, not all actively managed funds are average. Some are better! Some are worse!
The point that’s worth debating is whether there is a bias in the funds industry toward putting Aussie investors in common stocks no matter what’s going on in the market-and especially into products that financial planners get paid commissions on, whether they suit the needs, goals, and risk tolerance of their clients.
This probably sounds stupid. The purpose of the funds management industry IS to put people into common stocks. But we think this reveals the divergence of interests between investors and the funds industry. There are certain times in financial markets where you need to ask yourself if you should be buying what they are selling-or at least remember that they are always selling.
This thought was prompted by a study quoted in yesterday’s Australian Financial Review that shows the average balanced retirement fund was down by 13% in the year ended in June. It was the worst annual performance on record, according to research house Chant West. That performance is pictured below.
The upside-according to the data-is that over the last fifteen years, the median annualised return for growth funds was 6.9%. It peaked around 13% early 2000 and late 2007 before declining to around four percent each time. Chant reckons annual CPI increased by 4.2% over the same period. So all up, even after the shocker of last year, the investor who got into super fifteen years ago is still beating inflation and in the black.
This, of course, argues for buying and holding stocks and allocating the bulk of your assets (despite your age) to growth or balanced growth. That puts 40-60% of your assets in growth stocks. And THAT is the figure we think super investors should be asking themselves about.
If it’s a bear market in stocks as an asset class, then being that heavily weighted in common stocks for your crucial capital-accumulating/income-producing years is going to be a big mistake. Remember that upwards of 90% of your total return in any investment comes from being in the right asset class, not single stock selection.
The question of how you allocate your assets in super, then, is what we’re banging on about. Kris Sayce is banging on about it too. And in fact, he’s banging on about it so much we’ve decided to publish a new newsletter on the subject of superannuation, income generation, and controlling your risk. Look for an announcement on that in your inbox later today!
For now, we just think it’s a question you should be actively asking. Whether or not you actively manage your investments is up to you. But even in the equity market, we think it’s well worth examining the old saw that you should just buy and hold over time because stocks go up in the long run it’s too hard to time the market.
We have our resident Frenchman and technical analyst Gabriel Andre hard at work beta testing a system based on technical variables and charting. The goal of the system is to see if you can increase your returns in Blue Chip stocks by selling when they break technical support and buying back when the indicators suggest.
Granted, this is not the sort of thing for everyone. But in its latest monthly update, the ASX indicated that while volatility (as measured by the VIX) died down in June on the S&P 500, it stayed elevated in Australia. The average share market swing was 1.2% in the month.
That kind of volatility comes when there’s uncertainty. And that kind of uncertainty comes when there’s a changing in the structure of how large export commodities are priced (iron ore) and when investors aren’t sure how strong demand for Aussie resources will be in the next few years. Throw in lingering doubts over how well-capitalised the banking sector is and how much capital the country may have to import and you have a scenario where market volatility could remain much higher for a lot longer.
Or, if you want to put super returns and share market volatility in perspective, you could argue that volatility is going to remain high in stocks because there’s a huge debate over whether the historic equity premium in stocks is collapsing.
The equity premium is the extra return from stocks compared to bonds or cash that investors are willing to pay for. They take on a bit more risk. But in exchange for that they get extra return, the equity premium.
The argument for a collapse in the equity premium is made by some folks we quoted a few weeks back regarding the historic importance of dividends to the total return of your stock portfolio. The book is called Triumph of the Optimists by Elroy Dimson, Paul Marsh and Mike Staunton. And in it, the authors argue that over the last 100 years, corporate cash flows have grown faster in the last fifty years than in the previous fifty years.
As a result of the visible and tantalisingly large corporate cash flows, investors have been happy to bid up stocks (the rising equity premium) in order to capture a piece of those future cash flows. Hence rising P/E ratios (especially during the tech boom) and falling average dividend yields for stocks.
But if the authors are right and corporate cash flows revert to trend in the next fifty years, then investors are already paying too much for earnings that won’t materialise. Presto. Change-o. You can expect a falling equity premium as corporate cash flows revert to the mean growth rate.
And why would corporate cash flows revert to the growth rate they had in the first half of the 20th century? Why the credit depression of course! That is, you could argue (quite successfully we think) that the increase in corporate cash flows over the second half of the twentieth century was largely influenced by the growth in global money supply.
Low interest rates and money and credit growth (first in the Western world and lately in China) generated a ton of economic activity. Some of it was legitimate, as the global population grew in size and per capita wealth. It made led first to huge profit margins for American manufacturers. But later, it led to the migration of productive capacity to Asia and a structural decline in Western wages.
What’s more, some of the economic activity generated in the modern world of fiat money-particularly in inflationary periods-was of a lot more dubious value. It wasted capital in the sense that it did not produce incoming producing assets for the future that investors could own or capitalise.
But ALL the economic activity generated by money and credit growth found its way into higher corporate cash flows, at least for a pretty long period. Investors then bid up the value of those cash flows, resulting in the equity premium blowing out relative to bonds and cash.
If all that is changing now, it is a very big change and has serious consequences for your wealth-management and retirement plans. One obvious question is if the equity premium returns to trend, does that favour cash or bonds? Will investors prefer those assets more as they prefer stock less?
Our answer is a definite maybe! For many reasons, we would not shift into bonds, especially government bonds. We reckon either inflation or devaluation will eat way your capital there. On the other hand, you know what we think about gold!
But regarding stocks, we reckon switched-on investors will begin demanding stocks that do pay dividends over and above the interest rate on government bonds. Of course for a company to do that its cash flow has to be predictable and growing and not overly-leveraged or capital intensive. Finding those companies is what Kris is up to in his new letter.
But it’s also possible that outside the stock market you may simply see the formation a tangible asset premium or a “commodities premium.” As cash flows dry up for heavily leveraged business models in the financial economy, they will begin flowing for producers of tangible assets that play a part in the industrial growth of the developing world. Investors who can value those cash flows and time their entry into the stocks-accounting for volatility in commodity prices-may do very well.
That’s the idea anyway. And if that idea is correct, it means you may be able to profit in the coming years from a share portfolio made up of companies with growing cash flows from the resource-intensive growth of China. While cash-flows shrink at Macquarie, they may increase at Rio, BHP, and a whole universe of smaller Aussie miners.
But this is such an theoretical discussion-and so far removed from the cliché of buy and hold investing in your super-that we’d expect to see a great deal of volatility in shares as this debate progresses. The volatility is really a result of people not knowing what the future holds, and valuing the present value of future cash flows very differently.
And it could last awhile. The bull market in stocks lasted twenty years. The bear market has already lasted eight. It could last another ten-especially if the authorities actively prevent the liquidation of bad debts and write offs in bank collateral. It will be a long, drawn-out, Zombie-like, Japanese demise. And it means regular volatility on share markets.
We found some support for this observation here. It was a study published in the Journal of Financial Research in 2004 called, “Analysing stock market volatility using extreme-day measures.” The study’s author Jack Wilson says that the study finds argues that:
Volatility is higher during bear markets. The intuition is that periods of increased uncertainty influence the market in two ways. First, equity value declines reflect higher risk associated with increased uncertainty. Second, increased uncertainty is associated with increased volatility as the market receives information. Veronsi (1999) provides a model that explains how rational investors react to news more quickly in times of greater uncertainty, which increases stock price volatility. Our evidence supports this view.
We’d argue that rational investors are a figment of the scientist’s imagination. But it does make sense that in periods of increased uncertainty – and a historic change in the equity premium would definitely produce a lot of uncertainty – investors are going to behave in a highly unpredictable way.
At the very least, this suggests that more active management of your investments and your asset allocation is a good idea. We probably could have just wrote that and left it and that. But most people are reluctant to get more involved in managing their own money. It could cost them in the coming years.
On the other hand, it doesn’t take much to improve your results if you have someone doing your thinking and researching alongside you-someone who’s interests are aligned with yours. And that’s why we have Kris on the case!
for Markets and Money