Hints on market psychology…
Everyone loves a bargain. You don’t have to look too far at the mad rush on boxing day sales in Sydney to find evidence.
Strangely, when it comes to investing, people hate bargains. I have never understood why anyone would take pleasure in over paying for something. When it comes to shopping for consumer items, everyone knows the price and the value. When it comes to investments, most only know the price.
The value of an investment is not an exact number and often has elements of more art than science. For a consumer item like milk, it is easy to work out what it is worth due to the feel of how expensive it is for your weekly budget. If milk was $10 a litre, you would avoid milk. If milk was 50c a litre, you would be making milkshakes.
Unfortunately, when people think about investments, they don’t have a weekly budget to limit their expenses. There is often a lack of reference for what is expensive and what is not.
At Valor, most of our clients are not financial experts, however I like to explain our thinking so that they understand our positions. This simplifies our thought processes. When it comes to working out how expensive an investment is, we look to compare the investment to the highest risk free rate available. Currently we use a five year fixed deposit as our reference. If you put less than $250,000 in a five year fixed deposit with an Aussie bank, you have absolute assurance that you will get your money back due to the government guarantee. At present you can get 5%. If you were to invest in an investment which is going to be riskier than this guaranteed 5% and earn less than 5%, then I suggest you give the local mental ward a call to have your brain checked. Unfortunately, professional investors invest with a less than 5% return on a regular basis. There are not enough mental wards for these speculators.
At Valor, we will not invest unless we believe that we have a risk adjusted return of greater than 9%. This 9% is not a fixed number. If the risk free rates rise, we will adjust our reference, however we will always have a significant margin of safety over the highest risk free rate available.
Currently there are very few assets that are likely to return greater than 9% and so we would prefer to hold cash to protect capital.
9% stated returns are not exact calculations.We look at individual companies, however we are wary of getting caught up in market group think. We use numerous clues to work out where the market psychology is positioned.
One of these clues is the market cap to GNP (Gross National Product). With the markets at approximately 115% of GNP, we are definitely not in the 50c a litre milk range, but closer to the $4 or $5 dollars a litre range.
Another tool is the number of stocks hitting 52 week lows and highs. We are far less confident about investing when the number of stocks hitting all time highs is multiples of the number touching their lows. At present, the list of lows is very short.
The number of clients requesting to invest more money is also a good indicator of market over confidence. Many of our clients are extremely intelligent people, however few of them have the correct temperament to be above average investors. A good majority of my clients are currently wishing to invest significantly more. This makes us more wary.
In Australia, the sense of entitlement that has grown over the last few decades due to a lack of financial pain is likely leading to a misallocation of capital and excess private debt. Whilst this is probably going to continue in the short term, we grow increasingly worried about the destabilising effects on our financial system that this may have in future years.
We may under-perform in the latter stages of this credit bubble in China and Australia as we avoid the excesses, however as I see my position to protect my clients wealth, we will likely avoid the fall out if it eventuates. I loathe to lose money and this animosity toward destroying wealth is leading us to avoid what others see as a “permanently high plateau” of prosperity.
In the meantime, our Google, Verizon and American Express holdings will continue to grow our clients wealth regardless of the frothy local conditions.
“You only know who has been swimming naked when the tide goes out” (Buffett). The tide appears to be closer to full tide than low tide.
Rather than being perma-bears, we will become giddy with excitement if “Mr Market” has more mood swings in the coming years. Until then we remain patient.