Friday, November 20, 2009


What goes down, must come up?

During the long-lived "global financial crisis" bear market of last year I read many comments from disgruntled investors saying they would never again risk a penny in the stockmarket. I even read serious articles suggesting that this "crash" was the death knell of the capitalist system! But history shows that stockmarkets rise and fall, and sometimes very dramatically. Cycles in the market are natural, and in fact, inevitable. The trick is to respond to those cycles - not to try to avoid them.

All Ordinaries index 2005 - 2009
Any chart of a stock market index, or indeed of an individual stock, will show up and down trends. And smaller up and down cycles within those longer underlying trends. Where do these cycles come from? They reflect the fact that market prices are largely determined by human emotions. Principally the two warring emotions of fear and greed.

Up trends are perpetuated by investors wanting to capitalise on the rising market prices - we might say they are driven by greed. Investors are willing to pay more for a share they see as a good investment, and so prices continue to rise.

But eventually there comes a point where the majority of investors think the share price has gone too high and become overpriced, so they start selling to crystallise their profits.

To make sure their stock is sold, they are willing to lower their asking price, and the market value of the shares starts to fall - a down trend has begun.

The down trend is perpetuated by investors continually asking less for the shares to get rid of them before the price falls too low - in other words, fear now has the upper hand over greed.

Prices keep falling until eventually the pendulum has swung too far the other way - now the majority of investors see the shares as underpriced and the selling frenzy ends. Investors now see the the stock as a bargain and start buying... the buying pressure starts the price climbing... a new up trend begins...

... and the whole cycles goes on and on.

Many investors just don't seem to get this. When the market is falling for an extended time, as it did throughout last year, they act as though the sky is falling.

Did they really think the extraordinary bull market that preceded the so-called "meltdown" could continue indefinitely?

The reality is that it's no more possible to have bull markets without bear markets than it is to have buyers without sellers - one is a necessary precondition for the other.

Some people can see this clearly. Even during the height (actually that should be "depths" :-) ) of the bear market a year ago, this story in the Australian correctly pointed out to a shell-shocked reading public that historically, the market always recovers:

Climbing back after bear markets end

James Dunn October 15, 2008

THE journey of Australian investors since October, from hubris to nemesis, has probably changed the way a generation thinks about shares.

The spectacular pyre of $400 billion in stock market value has come as a particular shock to those who had only been share investors since 2003. In the five years to the end of 2007, the Australian market gave investors an average return of 21.2 per cent.

Counting dividends, the market appreciated by 160 per cent in five years. It was the best five-year period ever recorded on the Australian market.

Now the market is down 37 per cent from its peak on November 1, 2007. That means it must gain 58 per cent to get back into clear water.

Shell-shocked investors are asking, how will it do that? The first thing investors should look at is that the Australian market has never failed, following a slump, to regain and exceed its previous high point.

That's the best thing that can be said about bear markets, says Shane Oliver, head of investment strategy and chief economist at AMP Capital -- that they end. Since 1960, he says, bear markets in US and Australian shares have lasted an average of 15 months, with an average top-to-bottom fall of 32 per cent in the case of US and 34 per cent in the case of Australian shares.

The climb from the pits of despair to a fresh high for the index can be measured in years, but it eventually gets there. That's why, since 1900, Australian shares have delivered a total return (capital growth plus dividends) of 12.4 per cent a year on average, according to Oliver. David Reid, managing director of research firm Andex Charts, has produced numbers that show quite starkly why the market's relative cheapness makes it an attractive long-term investment -- because it usually is.

Andex Charts has calculated the returns made by investments in the main accumulation index (share price growth plus dividends) of the Australian share market, made at every month-end since January 1, 1950, and held for 10 years. In the period to August 31, 2008, there have been 585 10-year investment periods -- and not one had made a loss.

The lowest 10-year return was 2.9 per cent a year (for the 10 years ended September 30, 1974), while the best return was 28.7 per cent a year (for the 10 years ended September 30, 1987. The median 10-year return comes in at 13.3 per cent a year.

The most recent completed 10-year return -- for the decade to August 31, 2008 -- is 12 per cent a year. This is despite a 13.1 per cent fall in the last 12 months of that period. Reid says the index would need to have fallen by 66 per cent in September to produce a negative 10-year return.

The lesson in these numbers is that if you are certain that you can give a share market investment (that is, in the accumulation index) time, you can be confident that it will make money for you.

A financial planner would get into trouble for describing the share market as capital guaranteed but, statistically, the accumulation index is, if you hold it for 10 years.

Brian Parker, investment strategist at MLC Investment Management, says at the heart of the long-term performance of equities is a simple engine: profitable companies generating earnings and their retained earnings compounding, and as a result those companies growing in value over time.

"That's what the share market boils down to -- profitable companies reinvesting for growth. The share market at any point in time is just a snapshot of a large collection of businesses. Over time, the value of businesses tends to grow as population grows and technology improves and the economy grows, and the market is generally prepared to pay higher price-earnings (PE) multiples for companies that can demonstrate this growth."

But the short-term performance of equities is driven by market sentiment, says Parker: the constant battle between greed and fear. When one of those prevails as totally as fear does at the present, fundamental valuation goes out the window.

"Market cycles of greed and fear and excessive optimism and excessive pessimism can greatly inflate or deflate the kind of market multiples that people are prepared to pay for businesses. Over the long term, the market should reflect the true value of businesses, but we've always known that in booms and slumps, the PEs over-shoot -- as they're doing at the moment. The Australian market's PE is down to 10 times earnings -- that's the cheapest it's been in 24 years. But no one is looking at the fundamentals -- they're simply dumping stocks."

Parker says the long-term attributes of shares are why equities are given the biggest role in superannuation portfolios -- because it's the most reliable generator of long-term wealth.

"Superannuation is our longest-term asset, whether we like to acknowledge it or not. That's why super portfolios in accumulation phase are 60-70 per cent held in shares.

"If you're in the business of building wealth over the long term, what builds that wealth? In a free-market economy, ultimately it's the businesses that make stuff and sell it for a profit that build the wealth. If you want to build long-term wealth, you're going to have to get on that train."

It's important not to become emotional when investing, and to remember that even those who stayed fully invested in the market during the "crash of '87" not only recovered all the funds they lost, but benefited from the subsequent bull market - while those that panicked and sold out missed out on the recovery.

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