Deflationary funk and the returns on your investment portfolio

Investment Perspective – December 2015

“Neither the investing method nor the fundamentals of the business are right or wrong because the mood of the market is favourable or unfavourable toward the “stock”. That is because when you really think about it, “stocks” (shares) are all about the financials and the trading price, the share price… the cash up value. What matters more is the economics of the business” 

Peter Flannery

Although I wouldn’t lose too much sleep over it, currently “the Buffett indicator” which is based on economic expansion compared to share prices across the market shows, unsurprisingly, market prices are stretched.

The current reading for the US market on this ratio stands at 122%. That is not something that we don’t already know – right?

Oh, the highest reading was around the 2000 tech bubble with a reading of 150%.

Anyway, according to theory this ratio suggests that the (US) market will average pretty much 0.00% return over the next eight years, including dividends.

The optimistic return over the next eight years using the Buffett indicator suggests a potential return of 5% per annum over the next eight years.

The pessimistic view using the Buffett indicator offers a return of -7.8% each year over the next eight years (-7.8% x 8 years by -62.4% (negative) return!).

There are other measures too that we could use to highlight the important point that share prices are expensive. For example we could use the Shiller P/E ratio, which also indicates that the (US) market is over valued. Even the regular P/E ratio is 22, which suggests markets are well above the historical mean of 15.9.

So, what does this mean? What should we do?

There is some good news for us …

The above methodologies for valuing markets offer an across the markets approach to valuation. As you know, at WISEplanning I prefer to invest inside the markets rather than across the markets. We invest in business economics – we don’t play the markets.

This does not mean that the trading prices of the businesses in which we invest won’t be affected when there is a general pricing downturn. The individual businesses in which we invest and their prices may be affected more or less (than the overall market) – depending on market sentiment. After all, trading prices are all about market sentiment rather than the underlying fundamentals.

To be clear, some of the growth investments that we invest in (e.g. Starbucks, Expedia, LinkedIn and others) are highly priced all things considered. That is just where the market places them at the moment.

In the event of a serious economic shock or other negative sentiment, those prices stand to drop the most.

Luckily for us though, no matter how much those prices decline, it is highly likely that I will be recommending we either average down the original buying price if the purchase was recent, or topping up the original buy price if the purchase was further back in the past. That is because much of what goes on with the price, the global economy, investment markets, sharemarket indexes and the like, only has limited impact on the underlying economics of a business.

The deflationary funk will impact though

That is because economic activity and growth helps underpin the financial performance of businesses, particularly in the short term. Therefore it stands to reason that if that tail wind slows down then it might have some impact on the underlying economics of a business but not significant. The real impact would show clearly on profit and on the trading price, probably for longer than some might prefer.

Ultimately then, slower economic growth is a much slower tail wind than fast economic growth if you see what I mean? Looking ahead it may cause 12 month pricing on your investment portfolio (the cash up value, the return) to increase at a slower pace than has been the case in the past as market sentiment reflects those slower tail winds.

For example, Europe and Japan are battling deflation. Minimal economic growth there.

China is managing an economic slowdown. Still quite fast economic growth there but slowing. America is fighting hard against a significant debt load and sluggish economic growth. Collectively that is a significant slowdown in the tail wind of economic growth – deflationary funk.

Is it any wonder interest rates are around 4% or less in New Zealand for investors. We think we are hard done by. How would you feel if you lived in the UK or the US where interest rates are half that or lower!? Again, more deflationary funk.

Yes but what about …

Auckland property prices, aren’t they rising fast?

What about the share price of Starbucks, LinkedIn, Expedia and others, aren’t they rising well beyond bank rates too?

Well you know the answer to that … price and value are different things and at the moment Auckland property, the trading price of Starbucks and the trading price of Expedia all rise faster than underlying economic growth in the economies in which they are based for different reasons.

Although a bit of a blunt instrument, demand for those businesses’ shares is one simple reason (yes there is more to it) and the demand for property in Auckland is part of the reason that prices rise well above underlying economic growth.

Think about it … how long can Auckland property prices continue to rise at a pace of well over 10% each year when economic expansion around New Zealand is around 2%?

I know what you are going to say, but Auckland is an economy in of itself. No argument there. The reality though is that Auckland is not the global economy.

House prices are subject to certain variables that rely on a specific set of circumstances to make those prices rise at the current pace. Compound the pace of Auckland property price growth of the last 10 years over the next 30 years and how do those numbers look? Honestly, is that realistic?

Back to the good news …

Market sentiment does not control the underlying economics of a business.

The market can like a business (e.g. Starbucks) or hate a business (e.g. IBM) however the long-term impact of that market sentiment dissipates as time rolls by and the underlying economics of the business emerge.

As an aside by the way, did you know that Warren Buffett watched IBM for 50 years before buying its shares? I know, if you’re already 60 you’re probably not planning to watch something for 50 years before you buy it! Don’t worry, you won’t need to.

And so …

No one wants to hear that “deflationary funk” might negatively impact on returns for the foreseeable future. I believe it will be somewhat of a head wind moving forward from a pricing perspective, particularly in the short to medium term – what do you think? Well, I could always be wrong.

At the same time opportunity still exists. That is because the global economy simply does not stop when things become difficult. Price and value are not the same thing. The short term financials that everyone looks at including the trading price, the price earnings ratio, the latest profit or the market sentiment, do not determine the underlying economics of a business.

Sure, I will look at all of those financials and others too. However, I invest in the underlying business economics and continue to suggest that you do too.

I know this is not mainstream. I realise that this is not a concept or a methodology that others grasp or can even talk to.

If we want to protect our capital and achieve decent results over time in order to preserve our long term buying power then we must invest in productive assets.

If we are going to do that, then it should be done with those underlying fundamental economics as our guide – not the noise of the markets.

“Price is what you pay … value is what you get.“

Benjamin Graham