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Beware of experts on yesterday

Beware of experts on yesterday

by | Oct 9, 2020 | Financial Planning, Investments, Wealth Management

This article appeared in the Australian Financial Review.

The amazing events of 2020 have been a great reminder that no two share market cycles are the same. The word ‘unprecedented’ has come to be all but worn out, whether it’s to describe the worldwide sell off in February and March, or the rebound in April and May, or the level of government and central bank support doled out along the way.

One thing that doesn”t change, however, is there is no shortage of experts competing to use history as a guide to explain why things just don’t make sense right now or will all end badly. Whether it be warnigns that valuations are too high, share markets are too reliant on a handful of companies, or market signals are being confused by central banks and governments, smart investors need to be wary of what have been called “experts on an earlier version of the world.”

Of course, there are some rules of investing that will always apply, but you also need to allow that markets are a constantly shifting mix of factors. Like ingredients in a recipe, if they are mixed in different proportions, you’ve got a whole new dish on your hands. Some new factor can seem to come out of nowhere and exert such profound influence that it all but squashes the last big trend into insignificance.

Take, for example, the common warning that share markets are expensive based on current price to earnings (PE) ratios compared to long-term historical averages. The price you pay for a share divided by how much that share will earn next year gives you a basic measure of how expensive it is: the higher the number the higher the valuation.

Based on earnings forecasts for the next 12 months, global shares are trading on a PE of 21, versus a 32-year average of 16. Likewise, Australian shares are on 18 versus 14, and the US is 23 vs 16. Nobody likes paying too much for something, and it can take years to recover from overpaying for investments.

However, it’s long been accepted that low inflation is supportive of higher PE ratios, and right now, inflation is much, much lower than it has been over the last 38 years. In fact, inflation and interest rates peaked around 1980 and have been in decline ever since. So it makes perfect sense that PE ratios would be higher now than they were over that long-term average.

 One of the most commonly used techniques to value a company’s share is to do a discounted cash flow, or DCF, valuation. To do that you apply a ‘discount rate’, which is usually based on bond yields, against forecast earnings to see what they’re worth in today’s dollars. The lower your discount rate, the higher will be the present value of those future earnings and thus the higher the share’s valuation.

Right now, 10-year bond yields across the world are about the lowest they’ve ever been. So, again, it makes sense that valuations are higher today than they would have been at any time over the past 40 years.

What about those over-stretched US tech companies we keep hearing about? Again, the comparison needs to be kept in context. Once upon a time the market was dominated by companies whose costs went up in proportion with their sales. Industrial companies required bigger factories, supply chains and distribution networks to sell more widgets.

But now some technology-based businesses can expand their sales enormously without their costs increasing at all. That means the return on equity, which is a basic measure of profitability, for those businesses can be exponentially higher than their industrial counterparts, so it makes sense they will trade on vastly different metrics.

The problem here is an investor with a forty year career of investing in stocks with low PEs, because that’s what worked best for the previous 40 years, will understandably struggle to accept those high PEs are anything but an aberration from sensible valuations. Such an investor is almost undoubtedly an expert in an earlier version of the world.

They would never have bought Amazon shares five years ago when they were on a PE of 741, yet over that period the shares have risen more than six-fold and are still on a PE of 119. Evidently, when it comes to a company like this, a PE ratio is not the right valuation measure to use, and it’s ridiculous to argue the market has got it wrong for five years.

That doesn’t mean those investors won’t make money, it’s just that they’re unlikely to make as much money in today’s version of the world. With bond yields so low, an investment that offers apparently huge scope for growth with high profits becomes extremely attractive.

2020 will be remembered as an extraordinary year, with lessons for both the short and long term. The short-term lesson is just how difficult it is to second guess the market. No matter how certain we might be that something doesn’t make sense, Mr Market really doesn’t care what you think. The long-term lesson is that structural shifts in markets, like inflation and interest rates grinding lower and lower, can be hard to see while they’re happening, but the effects on markets can be profound.

While it’s smart to take on board the lessons from each cycle, we’ve seen time and time again it’s not so smart to presume history will simply repeat itself.

When is the right time to refinance your loan?

When is the right time to refinance your loan?

by | Oct 5, 2020 | Financial Planning, Investments, Wealth Management

A study by the Reserve Bank of Australia (RBA) earlier this year found the average home loan that is more than four years old is paying an interest rate 0.40% higher than what is currently available for new loans. This may not seem like a lot but on a $500,000 loan it means you are paying $2,000 of extra interest each year that you could probably avoid. During the current pandemic, clients have been looking at ways to reduce their expenses and refinancing activity has reached historical highs. Is now the right time for you to refinance?

Reducing your interest repayments may not be the only reason you could look to refinance. Depending on your personal circumstances, refinancing can also help you to:

  • Renovate your property – you can borrow extra funds to build an extra room, landscape the back yard or renovate your current kitchen.
  • Consolidate your debt – if you have a credit card, personal or car loan, you may be able to fold these into your home loan saving significantly on interest.
  • Releasing equity – you can borrow against the equity you have in your home to fund the deposit on an investment property or just to have extra funds if you need them.
  • Change to loan features that better suit your circumstances – this may include switching from an investment to owner occupied loan or moving to a loan which offers an offset account and credit card.

Refinancing requires you to complete a full application for the new loan. The lender will assess whether you can afford the loan based on your current circumstances, so if you have had a recent reduction of income, or increased expenses, it may affect whether the loan application is approved. Lenders have also adjusted their credit policies in light of the current pandemic and the rules that applied when you were first approved may have changed. You must also consider what has happened to the value of your property since you purchased it. If the value has fallen, it may mean that you are unable to borrow the same amount that you had previously. Conversely, if the value has risen it may present a great time to release equity.

Another factor to consider in refinancing your home loan is the costs associated with moving to another lender. Whilst you may save on repayments, the costs of discharging your current loan and the application fees for the new one may leave you worse off. This becomes more prevalent if you have a small balance or when you are on a fixed rate.

Depending on the change in funding costs of the borrower, it can be very expensive to break a fixed loan before maturity. When they mature, fixed loans will revert to variable which are often less competitive to others in the market. This is an excellent time to assess whether you can move to not only a lower rate, but a loan with the right features for you.

Lenders have recognised that the associated costs of refinancing may hinder your ability to change loans and regularly offer ‘cash back’ incentives of up to $4,000 to overcome this barrier. Whilst it certainly helps, it is important to do the analysis on each scenario. Often those lenders without a cash back offer, but a slightly lower rate, will save you far more over the medium to long term. This is where a mortgage broker can help assess your options.

I always suggest that clients review their loan every two to three years simply to ensure they have the most appropriate product available. Often it will not be the right time to change lenders, but doing the research gives you confidence that you are not overpaying.

Lessons from previous bear markets

Lessons from previous bear markets

by | Mar 27, 2020 | Investments, Markets and Economy

There’s an old saying that the stock market goes up by the stairs and down by the elevator, except this time it’s been more like jumping out the window. The ASX 200’s gut-wrenching 30% plunge from its late February peak was clocked up in a brutally quick 17 trading days and has left punch drunk investors wondering if things will ever get better and occasionally even wondering if they can continue to bear the pain. Let me assure you, things will get better, regrettably, however, nobody knows when.

Every investor needs to have a plan, or a strategy, that reflects their ability, willingness and need to take on risk. If share markets didn’t face the risk of falling, they would not offer long-term returns above cash. While bear markets will always test an investor’s resolve, hopefully some historical context will be helpful, not just in terms of how bad it can feel at the time, but the inevitability of recovery afterwards.

Notably, this hasn’t been the sharpest selloff we’ve ever had in Australia, that ignominious title goes to 1987, a near five month correction that saw the All Ordinaries almost halve and included Black Monday (which was actually a Tuesday when the tsunami of selling hit Australia) where shares dropped 26% in a single day.

Then there was the GFC, where the All Ordinaries fell 55% over an excruciating 14 months from its peak in November 2007 to its final bottom in early March of 2009.

All up, if you use the rule of thumb that a bear market is a fall of at least 20%, over the past 60 years Australian shares have experienced seven of them, including the current one. The average time it took to recover the losses was 53 months, though it’s varied between 15 in the mid-1990s to more than 10 years after the GFC (the length of the recovery period is highly influenced by how overvalued the market was going into the selloff). That means the average return over the recovery period has been better than 10% per annum, or almost 13% if you exclude the GFC as an outlier.

Lessons from previous bear markets_chart1

Again, for some context, in the US there have been 12 bear markets since 1965 with an average fall of 31%, and an average recovery period of 21 months (less than half Australia’s). That means once the bear market is finished the average returns over the recovery period have been more than 23% per annum.

The question everyone’s asking is when will the current correction stop, and the honest, but entirely frustrating, answer is nobody knows. The analysts at Heuristic Investment Systems have looked at the history of US share market corrections and concluded that mid-sized recessions have typically resulted in the market falling 25-30%, which is where we are now. Deeper recessions, like the GFC tend to see falls of 40-50%, so arguably the market’s pricing in a 60% chance of a deep recession.

Looked at another way, company earnings typically fall 15% in an average recession and the ‘forward price to earnings multiple’, that is the PE ratio the market trades on based on forecast earnings for the year ahead, can go down between two and seven points. From where the US market was immediately prior to this correction starting, a 15% cut in earnings and the PE dropping to 15 would take the S&P 500 to 2,250.

An alternative way to assess how share valuations stack up is the ‘equity risk premium’ (ERP), which measures the extra return shares are offering compared to a risk-free investment in bonds. Even after accounting for expected cuts in earnings forecasts, for the ERP to be as high as it was during the GFC and the European debt crisis would imply 2,600 on the S&P 500.

What those estimates tell you is the share market is already pricing in a serious economic slowdown. Even though there are some commentators arguing this slowdown could be worse than the GFC, we’ve had 10 years of slow but steady growth in between, so don’t expect the index to retreat all the way back to the same level. Plus, central banks and governments, having learned from the GFC, are coordinating their efforts to throw the kitchen sink at supporting economies.

For those that have not sold their shareholdings, there is arguably a lot of value in shares at current levels and to sell now would simply lock in a loss, and for those lucky enough to be holding cash, you have the kind of opportunity that comes along maybe once a decade to build a great, rest-of-your-life portfolio.

If you’re wondering when to invest, don’t for a minute think you’ll be able to pick the bottom, the odds on that are about the same as winning the lottery. And remember, the market will start to turn when the odds of recovery are 50.1%, as opposed to 49.9%, so if you wait for certainty, the market will have taken off well ahead of that point. You should also bear in mind, you don’t have to be all in or all out so you can hedge your bets: if you think there’s a 30% chance the market has bottomed, then you can invest 30% of your resources.

Are you reviewing your SMSF’s investment strategy?

Are you reviewing your SMSF’s investment strategy?

by | Jan 28, 2020 | Financial Planning, Investments, Wealth Management

As trustee of a SMSF, you have many obligations to ensure the smooth running of your fund. One such obligation, which is often overlooked, or inadequately prepared, is your fund’s investment strategy.

The Australian Tax Office (ATO) has issued letters to nearly 18,000 SMSF trustees as part of a campaign to ensure trustees are aware of their investment obligations.

The primary concern is ensuring that trustees have considered the diversification and liquidity of their assets when formulating and executing their fund’s investment strategy.

Importantly, it should be noted the ATO is not attempting to regulate and limit the control and freedom SMSF trustees have, but rather ensuring that if trustees wish to invest their assets in a certain way that they must clearly articulate their reasons for doing so.

An investment strategy should be considering the SMSF’s blueprint when dealing with the fund’s assets to ensure the fund’s investment objectives and the members’ goals are met. It provides the parameters to ensure you invest your money in accordance with that strategy. This is where the ATO has a primary function to ensure that trustees act in accordance with these obligations. Strategies can change, and there is no reason why you can’t change the way you invest. However, your investment strategy should be updated to reflect this.

An SMSF investment strategy must take into account the following items:

  • The risks involving in making, holding and realising the SMSFs investments, their expected return and cash flow requirements of your SMSF.
  • The diversification and composition of your SMSF investments.
  • The liquidity of your SMSF investments, having regard to expected cash flow requirements.
  • The SMSFs ability to pay your current and future liabilities, including benefits to the members.
  • Considering whether to hold insurance cover for each member of your SMSF.

An important requirement for you as trustee of your SMSF is to have an investment objective and a strategy to achieve that objective in place, before you start to make decisions about how you want to invest your SMSF’s money and change the investment objectives you have set for your SMSF at any time.

It’s not uncommon for SMSFs with lower member balances to find diversification a challenge as there is limited money to invest. Nonetheless, you are still required to demonstrate that you adequately understand and mitigate the associated investment risks.

If you find yourself in this position, it is important your investment strategy reflects these risks.

If you have invested in a large illiquid asset such as real property which may form the majority of your fund, it is timely to ensure your strategy reflects the concentration and liquidity risk associated with this investment.

For example, we met with a trustee who was running an account-based pension within his SMSF. His fund was fully invested in just the one asset being a commercial property. The challenge he faced each year was that the net rental income wasn’t sufficient to cover his minimum pension payments and the costs of running the fund. He relied on making annual contribution to his fund in order meet his pension obligations. This liquidity risk wasn’t adequately reflected in his investment strategy.

Where you have an investment strategy in place that deals with these risks and can provide the necessary evidence to support your investment decisions, no further action is expected.

Where your fund has not complied with its investment strategy requirements under superannuation law, you may be liable to administrative penalties being imposed by the ATO, as Regulator of the SMSF sector.

Your investment strategy does need to be reviewed at least once a year and this will be evidenced by your approved SMSF auditor. It is also important to review your strategy whenever the circumstances of any of your members change or as often as you feel it is necessary. The following practical tips will help you keep on top of your obligations:

  • Put your investment objective and strategy in writing
  • Set an investment objective that you can realistically achieve with the investments you are comfortable to invest in
  • There is no template for an investment objective and strategy, but make sure they reflect how you intent to invest your fund
  • The investments you actually make must be accommodated by the investment strategy you have set
  • Most importantly, document your actions and decisions, as well as your reasons, and keep them as a record in order to demonstrate that you have indeed satisfied your obligations as a trustee in this important area

How can we help?

If you need assistance with your fund’s investment strategy, please feel free to give us a call to arrange a time to meet so that we can discuss your particular requirements in more detail.