Autumn Update
This quarterly edition from Snowgum Financial Services provides you with an nine minute summary of matters to do with the investing, economics and markets.
Key data
Inflation holds at 1.8%
Cash rate remains 1.5%
Australian economic growth is at 2.3%
G7 GDP growth rate is at 2.0%
China GDP growth rate is at 6.4%
Savings ratio has continued to trend lower to 2.5% - Australian’s have been living beyond their means
Australian unemployment rate is low at 5.0%
Budget highlights
This is a budget with little substance. Not overly different from previous budgets and a likelihood that it may never see the light of day with a change in government. Albeit, the labour party is in principle supporting much of the tax proposals.
Taxation
Middle income earners will see an immediate benefit from the budget with, in some instances, a doubling of the non-refundable Low and Middle Income Tax Offset (LMITO) for the 2018-19, 2019-20, 2020-21 and 2021-22 financial years. Some families will be up to $2,160 better off this financial year.
Other tax proposals are for the more distant future, so we are less certain of them becoming a reality. Things like;
Raising the top threshold of the 19% tax bracket from $41,000 to $45,000 in July 2022
Reducing the 32.5% tax bracket to 30% from July 2024
Superannuation
Voluntary contributions (both concessional and non-concessional) for those aged 65 and 66 are now allowed, without the need to satisfy the work test. A good opportunity for those retired at this age with some passive income to tax-effectively contribute.
For more detailed analysis of budget highlights, please see this summary provided by Challenger.
Economic introspection
A fascinating economic theme has recently grown in prominence connecting two, somewhat opposing, key tenants of our understanding of investment markets.
Investment market understanding has been guided by two competing ideas;
1. Efficient market theorem; and
2. Behavioural economics
Fama and French published their thesis in the early 1960’s, and ‘efficient market theorem’ became fundamental to understanding investment markets. The theory suggests that stocks and markets reflect up-to-date information and adjust, nearly instantly, to changes in that information. That is, markets are efficient at accurately pricing an asset, particularly over the medium and longer term.
For the most part, efficient market theory holds true; except when it doesn’t, and markets do strange things (like Tulip mania of 1637 or the Dot-Com bubble of 2000).
Partially in response to shortcomings of efficient market theory, the field of behavioural economics emerged. Richard Thaler, building upon the foundation of Kahneman & Tversky, explored how human emotional biases lead to irrationality.
Thaler is credited for humanising economics. Much of the preceding economic theory was based on the premise that economic agents were perfectly rational, when we know humans (economist call these agents) aren’t always rational.
Behavioural economics explores behavioural traits, like human specific emotional biases, which can lead to market or stock price inefficiencies or movements that appear to have no logical basis.
The challenge for the intelligent investor is differentiating between an efficiently priced and inefficiently priced investment or market. Unfortunately, it is not as simple as identifying irrational behaviour as, should the basis of that irrationality remain uncorrelated, markets will remain efficient.
To differentiate between inefficient and efficient market/investment(s), an investor must understand the conditions that cause inefficiencies. The Wisdom of Crowds elegantly outlines the conditions where efficient markets prevail and under what conditions behavioural economic theories might triumph.
The wisdom of crowds
Although recently in vogue, the wisdom of crowds is not a new idea. It was first described by Charles Darwin’s cousin, Francis Galton in 1907.
Francis Galton was at a county fair watching the public participate in a competition guessing the weight of an Ox. He observed that individual guesses were not particularly accurate, but curiously, the mean (average) weight of all the crowd’s guesses was spot on.
A more recent experiment, done by finance professor Jack Treynor, held a jelly-bean guessing competition in a lecture. The jar held 850 beans and the lecture class’ mean estimate was 871. Only one of the fifty-six people in the class made a better guess.
This phenomenon of crowds being ‘smarter’ than individuals is a key contributor to efficient market theory prevailing, particularly in highly tradable assets and markets.
The ‘wisdom of crowd’s’ phenomenon would appear to support the efficient market theorem. Yet, there are notable examples of crowds lacking wisdom entirely, some for extended periods of time (and we are not taking a swipe at the American voting public either).
The Dot-Com boom is a recent example of a breakdown in crowd wisdom. Some initial investors were attracted to dot-com stocks based on internet hype. As more buyers entered the market, asset prices rose. Rising asset prices validated views of internet hype and attracted more investors. Each newer investor displayed a herding bias, following the crowd with a “fear of missing-out”.
As dot-com stock prices rose, some investors chose to exit based on their differing views and understanding of the internet. When a crowd has enough diversity of view-points, the natural increase and participation of sellers with differing views would ordinarily restore market efficiency. However, if the flow of new investors, believing the internet hype, exceed the number of investors exiting, asset prices will continue to rise.
As asset prices rose further, the pool of investors who did not believe in the internet hype diminished. At some point, the only investors remaining invested are those who believe the internet hype. When this arises, there is a complete break-down of crowd diversity in thinking.
Once diversity within a crowd disappears, the crowd loses its wisdom. The wisdom of crowds’ theory should really be called The wisdom of sufficiently diverse crowds… not quite as catchy.
‘Group think’ is incredibly dangerous for investors. Herding biases (i.e. the fear of missing out) or recency biases which place too much emphasis on recent information all serve to homogenise the viewpoints of market participants.
Although the triggers for a breakdown of diversity can be varied, once a break-down of diversity is observed, the intelligent investor should question the rationality of an asset price, prior to making an investment.
A recent example of an investment market without diversity is the crypto-currency market place. Things like Bitcoin are usually only traded by “true-believers” in the crypto-currency revolution. All participants in the Bitcoin market are in some manner convinced that their specific crypto-currency is transformative, or at the very least, mirroring someone else’s belief. There is limited diversity of thinking and concerns on the efficiency of that market place are well founded.
Two years ago, a growing proportion of people in Melbourne and Sydney were convinced that residential property was a fantastic investment. Melbourne and Sydney urbanites spoke incessantly to their peers about property, further reducing the diversity of views. A strong recency bias and herding tendency emerged. Towards the end of the boom, we saw diversity diminish further with owner occupiers displaced by property investors/speculators. Fortunately, for many the family home isn’t an investment asset but a lifestyle necessity not readily tradable, mitigating a complete breakdown in diversity.
As property prices climbed, participants with more diverse views elected to sell property and fewer diverse (by thinking) investors continued to participate in the demand for property. As this trend unwinds, we have seen the recency bias that caused much of the pricing growth reverse. There is now a growing pool of property owners who no longer believe property is an investment panacea, restoring balance to the marketplace.
Ensuring you invest in a sufficiently diverse (by thinking) market place makes you a smarter and more successful investor.
Investment update
Domestic economy
Stockland CEO Mark Steiner stated the following;
“Credit is the lifeblood of the Australian economy, and policymakers and financial institutions must ensure responsible access to credit for first home buyers, owner occupiers and investors – who contribute to the supply of rental properties – to help ensure the resilience of our housing market."
The domestic economy remains overly dependent on credit. Australia has the 4th highest private debt to income ratio in the world (at around 200%) and the highest in the world on debt servicing as a percentage of income (around 20%). Morgan Stanley is predicting lower property prices and heightened economic risks. Consumers have to date supported consumption by reducing their savings rate down from 5.8% in 2016 to 2.5% of income in 2019. There is virtually no capacity to support consumption growth through further reductions in savings.
Investors with heavy exposures to bank shares and property assets have essentially layered their risk exposure to the residential property market and would be well advised to diversify their wealth.
The Australian economy shrank on a GDP per capita basis in the second half of 2018. It may be bad news to the Sustainable Australia Party (with their anti-immigration agenda), but immigration is keeping Australia out of economic trouble.
The recent budget further cut investment in research and development, hamstringing the possibility that a productivity boost will pick up the slack.
Internationally
With potential consumption weakness arising domestically and commodity prices having already surprised on the upside, further weakness in the AUD is possible. Speculating on currency movements is a quick way to get egg on your face, but still preferable to Senator Anning’s approach.
International exposure provides downside protection during weaker economic conditions. As global weakness typically leads to lower commodity prices, the AUD (which is heavily exposed to commodity prices) tends to reduce in value. This reduction in the value of the AUD during economic weakness, provides a tail-wind in the AUD value of international holdings.
Our preferred manner of accessing international markets is via active positions. Central banks continue to attempt to normalise their record low interest rates. Tightening monetary policy (interest rates going up) will negatively impact equity market sentiment, so passive exposures offer no downside protection against sentiment movements.
The best source of long-term capital protection remains investing in reasonably priced and well-run businesses.
Fixed interest
Early this year the Federal Reserve softened their stance on raising interest rates. This essentially bought forward a years’ worth of fixed interest returns. Expect a benign outlook as the lower yield expectations have already been priced in by the market. Risks are now more likely on the downside should economic data surprise on the upside.
As we have stated for the last few years, floating rate positions, whether in bonds or corporate debt markets (where there is a liquid secondary market) are the best places to be in a low interest rate world. Cash is a reasonable place to hold capital for the short/medium term, whilst awaiting further opportunities.
Good reads/views from the last quarter
Stanford professor discusses how to avoid assholes
Howard Marks memo to clients – Growing the pie
Berkshire annual report – pages 5 to pages 15
How to think about currency – Hamish Douglass interview (15:10)