Olivers Insights

A tougher, more volatile year for shares..

Our view is that this year will see more constrained returns from shares with increased volatility – including the likelihood of a 10-15% correction along the way – than we saw in 2012 and 2013. Shares are no longer dirt cheap, they are more dependent on earnings for gains, the prospect of Fed rate hikes are starting to loom and as usual there are numerous other “worries” that could give us that volatility: China, Ukraine, etc. And of course, the seasonal pattern in shares often sees corrections occur around mid-year.

..but the trend is likely to remain up

However, it’s too early in the economic and investment cycle to expect a new bear market or crash. A typical cyclical bull market goes through three phases.

• Phase 1 is driven by an unwinding of very cheap valuations helped by easy monetary conditions as smart investors start to snap up undervalued shares as investor sentiment moves from pessimism to scepticism.

• Phase 2 is driven by strengthening profits. This is the part of the cycle where optimism starts to creep in.

• Phase 3 sees euphoria with investors backing their bullishness by pushing cash flows into shares to extremes. The combination of tightening monetary conditions, overvaluation and investor euphoria then sets the scene for a new bear market.

At present we are likely in Phase 2. Some optimism regarding the economic outlook and share markets has returned but we don’t see the signs of euphoria that become evident in Phase 3 as precursors to a new bear market:

• Valuations aren’t dirt cheap, but they’re far from expensive. Price to earnings ratios are only at long term average levels of 14.4 times in Australia (average of 14.1 since 1992) and 15.1 in the US (average of 15.9). Some tech stocks have rich valuations, but the tech heavy Nasdaq trades on a price to earnings ratio that is one third of the tech boom peak and the broader US share market on 15x forward earnings is way below its tech boom peak of 24. So it’s hard to see a tech driven crash.

Source: Thomson Reuters; AMP Capital

The gap between earnings yields & bond yields, a proxy for the excess return shares offer, remains above pre GFC norms. This is reflected in our valuation indicators which show markets slightly cheap. See the next chart.

Source: Bloomberg, AMP Capital

• Global economic indicators have been gradually heading higher which should be supportive of earnings growth. This is indicated in business conditions PMIs (next chart).

Source: Bloomberg, AMP Capital

There are now more indicators pointing upwards in Australia and profits are now helping share market gains, as evident in the following chart that breaks down annual changes in the All Ords into that driven by profits and that due to changes in the ratio of share prices to earnings.

Source: Bloomberg, AMP Capital

• Inflation remains benign and monetary policy easy. Ample spare capacity has meant that global inflation remains low. As a result even though the Fed is slowing its quantitative easing program, interest rates will likely remain low for some time.

• Finally, there is no sign of the investor exuberance seen at major market tops. Short term measures of investor confidence in the US are around neutral levels. See next chart. The mountain of money that built up in bond funds in the US has yet to fully reverse. In Australia, investors still prefer bank deposits over shares and the share of cash in the super system is double pre GFC levels.

Source: Bloomberg, Sentimentrader, Investors Intelligence, AMP Capital

Of course there could be a left field shock – an escalation in Ukraine, a policy mistake in China or the Fed. But if you worry too much about such things you would never invest.

Is the Fed to blame?

One thing I find many of the perennial bears seem to have in common is a hatred of the Fed. They argue the Fed should have stood by and done nothing through the Global Financial Crisis – as advocated by whacky disciples of Austrian economics – to allow a full “cleansing” of the economy and that it is in some way causing the slow recovery seen over the last few years. There are several points worth noting on this.

First, just standing by and doing nothing through the GFC could have led to a re-run of the Great Depression which left an unmeasurable human toll and scared a generation, many of whom were innocent bystanders during the excesses of the 1920s. Allowing the same so called “cleansing” to happen needlessly again after the GFC would have been immoral and pointless.

Second, while the Fed’s actions have not led to a boom in the US it has at least bought time to allow the economy to heal – much like keeping a coma patient on life support. The slow recovery is not the Fed’s fault but rather the desire to reduce debt and caution seen post the GFC.

Third, while the Fed’s quantitative easing program has helped support the US share market the main driver has been a surge in US company profits to record levels. In other words the rise in US shares has not detached from reality but reflects fundamental improvement. See the next chart.

Source: Bloomberg, AMP Capital

Fourth, the Fed’s move to wind down or taper its quantitative easing program and talk of eventual rate hikes is a sign of success. In other words, extreme monetary easing has done its job and so can now start to be withdrawn. This is a good thing, not bad. And of course even when US interest rates do start going up next year it will be a long time before they reach levels that seriously threaten economic growth.

Finally, misinterpretations of Fed communications are inevitable and are not a sign that it does not know what it is doing. The Fed under Bernanke and Yellen have made it pretty clear what they are looking at and in this context their policy moves have made sense.

What about the demographic cliff?

Some have long tried to link demographic trends with share markets, but it is very messy. The basic thesis is that as the baby boomer wave moves through the population it will stop being a big positive for shares (as they either run-down savings or consume less depending on which demographic thesis you follow) and that this should start around 2009-10. This approach predicted a big rally through the 1990s and 2000s and got it completely right in the former but disastrously wrong last decade in relation to US shares. Given shares never got anywhere near the levels they were supposed to reach last decade (the biggest advocate of the demographic model had the Dow Jones going to 40,000 through the 2000s) it’s hard to see why they will now crash.

Concluding comments

While shares might see a brief 10-15% correction at some point this year, a new bear market is unlikely and as such returns should remain favourable through the year as a whole. The time to get really worried is when the topic of conversation with cabbies and at parties is about what a great investment shares are, but I have yet to find a cabbie talking about shares in recent years and at a party I attended last weekend the only person who mentioned shares told me he had just switched all his exposure to cash!

Dr Shane Oliver
Head of Investment Strategy and Chief Economist
AMP Capital

Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.

Great news for the economy

While it took a bit longer than usual, the housing sector has responded just as it should to lower rates:

• lower interest rates led to improved housing affordability;

• which has led to increased home buyer demand (housing finance is up 23% year on year and new home sales are up 40% from their September 2012 low);

• which in turn has led to higher house prices;

• which has signalled to home builders to build new homes – with building approvals now about as high as they ever get pointing to a construction boom on the way; and

Source: Bloomberg, AMP Capital

• rising house prices, which boost wealth, and stronger housing construction are positive for retail sales.

This is all good news as a stronger housing sector is critical if the economy is to rebalance away from mining investment.

But is it turning into bubble trouble?

While a housing recovery is necessary to rebalance the economy, a concern is whether it’s becoming another bubble. The home buyer market has started the year strongly with auction clearances high and house prices surging. According to RP Data capital city house prices are up 10.6% over the year to March with Sydney home prices up 15.6%.

Source: Australian Property Monitors, AMP Capital

Property prices are on the rise again in other comparable countries, eg the US and UK. The trouble is that Australian house prices are turning up from a high level.

Source: Case-Shiller, Nationwide, ABS, AMP Capital

Asset price bubbles normally see overvaluation, excessive credit growth and self-perpetuating exuberance. On these fronts the current readings for housing are mixed.

Australian housing is overvalued: Whilst real house price weakness through 2010 to 2012 saw this diminish the problem has returned again with a vengeance:

• Real house prices are 13% above their long term trend.

Source: ABS, REIA, Global Financial Data, AMP Capital Investors

• According to the 2014 Demographia Housing Affordability Survey the median multiple of house prices to household income in Australia is 5.5 times versus 3.4 in the US.

• The ratio of house prices to incomes in Australia is 21% above its long term average, leaving it toward the higher end of OECD countries. This contrasts with the US.

• On the basis of the ratio of house prices to rents adjusted for inflation relative to its long term average, Australian housing is 27% overvalued.

So Australian house prices meet the overvaluation criteria for a bubble. Other criteria are less clear though.

Credit growth is a long way from bubble territory: over the year to February housing related credit grew 5.8%. This is up from recent lows, with 7.6% growth in credit for investors leading the charge. But it is pretty tame compared to 2003-04 when housing related credit growth was running at 20% plus and 30% for investors. Related to this we have yet to see much deterioration in bank lending standards.

Similarly, the self-perpetuating exuberance that accompanies bubbles seems mostly absent at present:

• House price strength is not broad based. Whereas prices in Sydney (+15.6% year on year) and Melbourne (+11.6% year on year) are very strong in every other capital city they are up 5% or less;

• Related to this there has been only one year of strong gains, whereas the surge into 2003 ran for seven years;

• Australian’s don’t seem to be using their houses as ATMs at present (ie where mortgages are drawn down to fund consumer purchases and holidays). Rather they still seem very focused on paying down debt.

• We have yet to see property spruikers out in a big way.

• There is little sign of buyers rushing in for fear of missing out.

• The cooking shows are still out rating the home related shows on TV!

For these reasons I don’t think it’s a bubble yet. However, the acceleration in price gains means the risks are rising.

What’s to blame for high house prices?

Whenever house prices take off and affordability deteriorates there is a tendency to look for scapegoats. A decade ago it was high immigration and negative gearing. Now it looks to be foreign buyers (from China), self-managed super funds and as always negative gearing. However, none explain the relative strength in Australian house prices:

• Foreign and SMSF buying is no doubt playing a role in some areas but looks to be relatively small overall. Chinese interest in Sydney seems to be concentrated away from first home buyer suburbs.

• Such simplistic explanations ignore the fact that when interest rates go down, Australian’s borrow to buy houses and prices go up. We don’t need to resort to foreigners to find a reason why house prices have gone up!

• Negative gearing has been around for a long time. It was removed in the 1980s but was reinstated as it was clear its removal worsened the supply of dwellings. Restricting it for property would also distort the investment market as it would still be available for other investments.

Rather the fundamental problem is a lack of supply. Vacancy rates remain low and there has been a cumulative construction shortfall since 2001 of more than 200,000 dwellings. The reality is that until we make it easier for builders and developers to bring dwellings to market – and hopefully decentralise our population in the longer term – the issue of poor affordability will remain.

Implications for monetary policy

As things currently stand the risks to financial stability flowing from the surge in house prices are more than balanced by sub trend economic growth, falling mining investment and risks to Chinese economic growth. As such it remains appropriate for the RBA to keep interest rates on hold at 2.5% for now. However, our expectation is that the RBA is likely to step up its jawboning of the home buyer market by warning buyers not to take on too much debt and not to expect ever rising prices, ahead of a move to higher interest rates probably starting around September/October once economic growth has started to pick up.

While talk of so-called macro prudential controls, such as limits on loan to valuation ratios for mortgages may hot up, the RBA would probably prefer to avoid such retrograde approaches (they didn’t work in the days pre-deregulation) in favour of jawboning and an eventual rate hike.

Against this backdrop we expect further gains in house prices but at a slowing rate over the remainder of the year, particularly once interest rates start to rise again.

Longer term, the overvaluation of Australian housing will likely see real house prices stuck in a 10% range around the broadly flat trend that has been evident since 2010. This is consistent with the 10-20 year pattern of alternating long term bull and bear phases seen in real Australian house prices since the 1920s. See the fourth chart in this note.

Housing as an investment

Over long periods of time, residential property adjusted for costs has provided a similar return for investors as Australian shares. Since the 1920s housing has returned 11.1% pa compared to 11.5% pa from shares. Both have been well above the returns from bonds and cash.

Source: ABS, REIA, Global Financial Data, AMP Capital Investors

They also offer complimentary characteristics: shares are highly liquid and easy to diversify but more volatile whereas residential property is illiquid but less volatile and shares and property tend to be lowly correlated to each other. As a result of their similar returns and complimentary characteristics there is a case for investors to have both in their portfolios over the long term. At present though, housing looks somewhat less attractive as an investment being overvalued on several measures and offering lower (cash flow) yields. The gross rental yield on housing is around 3.3%, compared to yields of 6.5% on unlisted commercial property, 5.7% for listed property (or A-REITs) and 5.8% for Australian shares (with franking credits). So for an investor, these other assets continue to represent better value.

Concluding comments

The recovery in the housing sector is playing a key role in helping to rebalance the Australian economy. However, while the house price recovery does not appear to have entered bubble territory yet, the risks are rising. The RBA’s first line of attack is likely to be more intensive jawboning, warning home buyers not get too giddy in their house price expectations and not to take on too much debt. Later this year though this is likely to be followed up by a couple of interest rate hikes, all of which will likely see house price gains slow.

Dr Shane Oliver
Head of Investment Strategy and Chief Economist
AMP Capital

Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.

Myth #1: Rising unemployment means growth can’t recover

Whenever there is a downturn this argument pops up. But if it were true then economies would never recover from recessions or slowdowns. But they do. Rather, the boost to household spending power from lower mortgage rates and any tax cuts or stimulus payments during recessions eventually offsets the fear of unemployment for those still employed. As a result they start to spend more which gets the economy going again. In fact, it is normal for unemployment to keep rising during the initial phases of an economic recovery as businesses are slow to start employing again fearing the recovery won’t last. Since share markets lead economic recoveries, the peak in unemployment usually comes after shares bottom. In Australia, the average lag from a bottom in shares following a bear market associated with a recession to a peak in unemployment has been twelve and a half months.

Based on All Ords. Source: Bloomberg, Thomson Financial, AMP Capital

Hence the current cycle where the share market has gone up despite rising unemployment and headline news of job layoffs is not unusual.

Myth #2: Business won’t invest when capacity utilisation is low

This one is a bit like the unemployment myth. The problem is that it ignores the fact that capacity utilisation is low in a recession simply because spending is weak. So when demand turns up, profits rise and this drives higher business investment which then drives up capacity utilisation.

Myth #3: Corporate CEOs, being close to the ground, should provide a good guide to where the economy is going

Again this myth sounds like good common sense. However, senior business people are often overwhelmingly influenced by their own current sales but have no particular lead on the future. Until recently it seemed Australian building material CEOs saw no sign of a pick-up in housing construction even though it was getting underway. Now it’s widely accepted. This is not to say that CEO comments are of no value – but they should be seen as telling us where we are rather than where we are going.

Myth #4: The economic cycle is suspended

A common mistake investors make at business cycle extremes is to assume the business cycle won’t turn back the other way. After several years of good times it is common to hear talk of “a new paradigm of prosperity”. Similarly, during bad times it is common to hear talk of a “new normal of continued tough times”. But history tells us the business cycle will remain alive and well. There are no such things as new eras, new paradigms or new normals.

Myth #5: Crowd support indicates a sure thing

This “safety in numbers” concept has its origin in crowd psychology. Put simply, individual investors often feel safest investing in a particular asset when their neighbours and friends are doing so and the positive message is reinforced via media commentary. But it’s usually doomed to failure. The reason is that if everyone is bullish and has bought into the asset there is no one left to buy in the face of more good news, but plenty of people who can sell if some bad news comes along. Of course the opposite applies when everyone is bearish and has sold – it only takes a bit of good news to turn the market up. And as we have often seen at bear market bottoms this can be quite rapid as investors have to close out short (or underweight) positions in shares. The trick for smart investors is to be sceptical of crowds.

Myth #6: Recent returns are a guide to the future

This is a classic mistake investors make which is rooted in investor psychology. Reflecting difficulties in processing information and short memories, recent poor returns are assumed to continue and vice versa for strong returns. The problem with this is that when its combined with the “safety in numbers” myth it results in investors getting into an investment at the wrong time (when it is peaking) and getting out of it at the wrong time (when it is bottoming).

Myth #7: Strong economic/profit growth is good for stocks and vice versa

This is generally true over the long term and at various points in the economic cycle, but at cyclical extremes it is invariably very wrong. The big problem is that share markets are forward looking, so when economic data is really strong – measured by strong economic growth, low unemployment, etc – the market has already factored it in. In fact the share market may then fret about rising costs, rising inflation and rising short term interest rates. As an example, when global share markets peaked in October/November 2007 global economic growth and profit indicators looked good.

Of course the opposite occurs at market lows. For example, at the bottom of the global financial crisis (GFC) bear market in March 2009, economic indicators were very poor. Likewise at the bottom of the mini-bear market in September 2011 economic indicators were poor and there was a fear of a “double dip” back into global recession. But despite this “bad news” stocks turned up on both occasions, with better economic and profit news only coming along later to confirm the rally. History indicates time and again that the best gains in stocks are usually made when the economic news is poor and economic recovery is just beginning or not even evident, as stocks rebound from being undervalued and unloved.

Myth #8: Strong demand for a particular product or stock market sector should see stocks in the sector do well and vice versa

While this might work over the long term, it suffers from the same weakness as Myth #7. By the time demand for a product (eg, new residential homes) is really strong it should already be factored into the share prices for related stocks (eg, building material and home building stocks) and thus they might even start to start to anticipate a downturn.

Myth #9 Countries with stronger economic growth will see stronger equity market returns

In principle this should be true as stronger economic growth should drive stronger revenue growth for companies and hence faster profit growth. It’s the basic logic why emerging market shares should outperform developed market shares over time. But it’s not always the case for the simple reason that often companies in emerging countries may not be focussed on maximising profits but rather may be focussed on growing their market share or social objectives such as strong employment under the influence of their government.

Myth #10: Budget deficits drive higher bond yields

Its common sense that if the government is borrowing more (higher budget deficits) then this should push up interest rates (the cost of debt) and vice versa, but it often doesn’t turn out this way. Periods of rising budget deficits are usually associated with recession or weak economic growth and hence weak private sector borrowing, falling inflation and falling interest rates so that bond yields actually fall not rise. This was evident in both the US and Australia in the early 1990s recessions and evident through the GFC that saw rising budget deficits and yet falling bond yields.

Myth #11: Having a well diversified portfolio means that an investor can take on more risk

This mistake was clear through the GFC. A common strategy had been to build up more diverse portfolios of investments with greater exposure to alternative assets such as hedge funds, commodities, direct property, credit, infrastructure, timber, etc, that are supposedly lowly correlated to shares and to each other. Yes, there is a case for such alternatives, but last decade this generally led to a reduced exposure to truly defensive asset classes like government bonds. So in effect, investors actually began taking on more risk helped by the “comfort” provided by greater diversification. But unfortunately the GFC exposed the danger in allowing such an approach to drive an increased exposure to risky assets overall. Apart from government bonds and cash, virtually all assets felt the blow torch of the global financial crisis, as supposedly low correlations amongst them disappeared.

Myth #12: Tax should be the key driver of investment decisions

For many, the motivation to reduce tax is a key investment driver. But there is no point negatively gearing into an investment to get a tax refund if it always makes a loss.

Myth #13: Experts can tell you where the market is going

I have to be careful with this one! But the reality is that no one has a perfect crystal ball. And sometimes they are badly flawed. It is well known that when the consensus of experts’ forecasts for key economic or investment indicators are compared to actual outcomes they are often out by a wide margin. Forecasts for economic and investment indicators are useful, but need to be treated with care. And usually the grander the call – eg prognostications of “new eras of permanent prosperity” or calls for “great crashes ahead” – the greater the need for scepticism as such strong calls are invariably wrong.

Like everyone, market forecasters suffer from numerous psychological biases and precise point forecasts are conditional upon information available when the forecast is made but need adjustment as new facts come to light. If forecasting the investment markets was so easy then everyone would be rich and would have stopped doing it. The key value in investment experts’ analysis and forecasts is to get a handle on all the issues surrounding an investment market and to understand what the consensus is. Experts are also useful in placing current events in their historical context and this can provide valuable insights for investors in terms of the potential for the market going forward. This is far more useful than simple forecasts as to where the ASX 200 will be in a year’s time.

Conclusion

The myths cited here might appear logical and consistent with common sense but they all suffer often fatal flaws, which can lead investors into making poor decisions. As investment markets are invariably forward looking , common sense logic often needs to be turned on its head when it comes to investing.

Dr Shane Oliver
Head of Investment Strategy and Chief Economist
AMP Capital

Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.

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For twenty five years or so my core focus at work has been on the allocation of assets – shares, bonds, property, cash, Australian, global, etc – across multi asset portfolios. Some might say that’s a job that naturally flows from being an economist with a macro (ie big picture) focus. But my interest in asset allocation actually runs much deeper.

I was reminded of that by the news last month that Eugene Fama, Robert Shiller and Lars Peter Hansen had shared the 2013 Nobel Prize in Economics. For anyone interested in investing the contribution of Fama and Shiller to the understanding of investment markets is relevant, but this is particularly so for me as my PhD thesis, largely undertaken around the late 1980s, related in part to their insights.

Markets are effcient…

But first a bit of history on economic thought regarding the workings of investment markets. Economists prior to World War 2 had a somewhat ambiguous view of the role of speculators in investment markets. On the one hand seeing them as likely to smooth prices out over time (as to make money they have to buy low and sell high) thereby contributing to better functioning markets. But on the other hand the economic literature prior to World War 2 is strewn with references to occasional irrational markets with language like: manias, financial orgies, feverish speculation, frenzies, etc. In other words it was generally thought that financal markets occasionally go off the rails and by definition are not always right.

The well-known economist, John Maynard Keynes waxed lyrical on this, in fact arguing that speculators in investment markets are trading simply on the basis of “anticipating what the average opinion expects the average opinion to be” regarding where a security will go in price rather than what it is really worth based on prospective yields and that this causes instability. And he put his money where his mouth was, reportedly making a lot of money trading shares.

However, starting in the 1960s and 1970s, thanks in large part to the work of Eugene Fama, it became generally thought that asset markets are "efficient" in the sense that all publicly available information will be rationally reflected in prices for things like shares, bonds and currencies. As a result only new information will cause prices to change but since new information is unpredictable (otherwise it wouldn’t be ‘new’) and prices are always where they should be, asset price moves should be unpredictable or follow what became known as a random walk ¹. Initial tests of whether past share prices can predict future prices and whether new information is reflected in share prices provided support for the so called efficient market hypothesis (EMH) and so it became widely accepted. If investment markets are efficient this has a number of implications:

• No one can consistently beat the market – supporting the case for investing in passive share funds that track the index rather than trying to pick individual stocks.

• Starting point valuations don't matter. The same return is available from high or low levels for share prices as the market is always right. It follows from this that there will be a constant return differential on offer between assets to compensate for different risk levels. Eg, shares will always offer a higher return than bonds. This helped cement the concept of buy and hold or set and forget when it came to determining investment portfolios.

• If markets are always right, free markets are the best way to allocate resources in an economy.

The market efficiency notion was often made fun of by the joke about the economics professor and his student walking through a university: the student sees a dollar note on the ground and tells his professor, but the professor says no it can’t be there otherwise someone else would have already picked it up!

…markets aren't effcient

But starting in the early 1980s a group of economists – in particular led by Shiller, but also helped along by some work undertaken by Fama himself – began to seriously question the market efficiency notion.

• In particular Shiller (in 1981) found that the volatility of share markets was far greater than can be justified by the rational expectations of future dividends.

• Various studies, including one co-authored by Fama (in 1988) found that while share price changes are positively (but not significantly) correlated at time horizons out to a year or so, over long time horizons – over 3 to 5 years or more – they are negatively correlated (and significantly so). In other words if shares perform poorly over one five year period they are likely to perform well over the next. This suggested that share markets are mean reverting with years of below average returns followed by years of above average returns. The next chart, showing rolling five year changes in Australia share prices, illustrates this to some degree.

Source: ASX, Bloomberg, AMP Capital

• Various other studies found that share market valuation measures provide a guide to future returns.

• Finally, various anomalies in share markets – such as seasonal patterns like the January effect which sees above average returns from November through May – also called into question the efficient market hypothesis.

At its core, most of the early tests of the EMH focussed on whether publicly available information is quickly reflected in asset prices, whereas the tests by Shiller and others asked whether it was “rationally” reflected and the answer was no: share prices move more than is justified, they move in cycles over years and are affected by starting point valuations.

The final nail in the coffin of the EMH was the October 1987 share crash – changes in the long-term outlook for profits & interest rates cannot explain the 30% swing in US shares and the 50% swing in the value of Australian shares in late 1987. Likewise, changes in the outlook for IT stocks cannot justify the 80% swing in the tech heavy Nasdaq index early last decade. Problems with the efficient market hypothesis were all obvious long before the GFC came along!

Irrational man (and woman)

At the same time there was increasing evidence that individual decision making is not rational, but rather that individuals suffer from various lapses of logic. For example, they tend to: downplay uncertainty and project the current state of the world into the future; overweight recent spectacular or personal experiences; focus on occurrences that draw attention to themselves; be overconfident in their own abilities and suffer from wishful thinking. And these lapses tend to be magnified at times by crowd psychology.

The combination of lapses of logic by individuals in making investment decisions and the reinforcing effect played by crowd psychology go a long way to explaining why speculative surges in asset prices develop (usually after some good news) and how they feed on themselves (as individuals project recent price gains into the future, exercise “wishful thinking” and receive positive feedback via the media). Of course the whole process goes into reverse once buying is exhausted, often triggered by contrary news to that which drove the rise initially.

Now of course some argued that it doesn’t matter whether all individuals are rational (economists know they aren’t really!) but if enough are then a share market will behave as if everyone is. In other words: if lots of Warren Buffetts buy when everyone is panicking and sell when everyone is greedy this will push share prices to where they should be despite an irrational bunch of investors. But it is clear that while there are rational investors like Buffett, there are barriers to their ability to buy low and sell high in sufficient volume to keep share prices at fundamentally justified levels:

• First, there simply may not be enough rational investors to battle against a constant stream of new investors with little knowledge of cyclical swings in markets.

• Second, given the size of the irrational crowd, to paraphrase Keynes “markets can remain irrational for longer than sensible investors can remain solvent”.

• Thirdly, competitive pressures may make it hard for institutional investors to have long term investment horizons making it harder for them to trade against the market if they believe it will take a long time to pay off.

• Finally, the true value for assets can never be known with certainty so at extremes there is always an element of doubt causing even the Buffetts to hold their punches.

So where does all this leave us?

There are several observations. First some see the EMH as an example of how economists have their heads in the sand, only to see them eventually wake up to reality that occasionally investment markets go off the rails. But in order to understand how markets work it’s useful to get an idea of how they should work first, and then work from there. Which is in essence why Fama's work has been so valuable and recognised as such in the Nobel Prize.

Second, if investment markets get it wrong should we really trust them to play the key role in allocating resources in the economy. The short answer is yes. I would much rather trust a market than a soviet style bureaucrat to allocate capital throughout the economy. The proof is in the pudding – market driven economies performed much better than socialist economies last century which explains the demise of the latter. Related to this, speculative manias arguably play a role in the innovation that drives economic prosperity. Snuffing out the 1920s boom based on electricity and mass production or the 1990s IT boom prematurely could have starved a lot of great ideas of capital and slowed the long term rise in living standards that we are all benefitting from.

Third, some markets do behave efficiently for much of the time. For example the US share market is so overanalysed that it is very hard for individual stock pickers to consistently beat the market. In such markets it makes sense to just use passive index funds, futures or ETFs to gain exposure.

Finally, and perhaps most importantly, the insights of Robert Shiller and others over the last thirty years demonstrating that markets are excessively volatile and tend to follow mean reverting cycles highlight that asset allocation should be adjusted dynamically over time. Using a process that is increasingly referred to as ‘dynamic asset allocation’ (or DAA) this involves increasing the allocation to assets when they are undervalued and out of fashion with investors and reducing the allocation to them when they are overvalued and very popular with investors. This essentially means overweighting assets around the time their potential return is greatest and vice versa. It’s perhaps the best way to take advantage of the insights of Robert Shiller and others.

Dr Shane Oliver
Head of Investment Strategy & Chief Economist
AMP Capital

¹Now of course someone with inside information will have an advantage – but that's why it’s banned.

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It seems that every 6 -12 months the China perma bears roll out their worries again. At the core of such concerns are a bunch of structural issues: that China’s investment driven growth model is unsustainable, that its housing sector is overheated, that it has lost competitiveness and most significantly that it has taken on too much debt. However, much of these worries have been overdone. This note looks at why starting with the cyclical outlook.

Growth cycle stabilising

There is no doubt that the slowdown in China’s growth rate since 2010, when it peaked at 12%, to around 7.5% recently has caused consternation and unnerved investors. The uncertainty was made worse earlier this year by a patch of softer economic data, a mini liquidity crunch around June when the People’s Bank of China appeared to be trying to slow lending through the less regulated non-bank or “shadow banking” system and speculation that the new Chinese leadership of President Xi Jingpin and Premier Li Keqiang would tolerate much weaker economic growth.

However, since then concerns about China’s cyclical economic outlook have settled. First, Chinese leaders have repeatedly stated that the floor to acceptable growth is around 7 to 7.5%. For example Premier Li recently indicated that 7.5% was the lower limit based on an estimate that 7.2% growth is necessary to create 10 million new jobs each year which is what’s roughly required to cope with the migration of around 18 million people each year to urban areas.

Second, the liquidity crunch has eased with money market lending rates settling back around 3%, although there has been a recent spike to around 4% in an effort to mop up liquidity associated with capital inflows. They remain well below 13% peak seen in June.

Third, and perhaps most importantly Chinese GDP growth has picked up to 7.8% year on year in the September quarter. Consistent with this economic activity indicators have stabilised and perked up. October data showed:

• an improvement in business conditions PMIs with the manufacturing PMI in a relatively stable range since early last year, consistent with a stabilisation in GDP growth;

Source: Bloomberg, AMP Capital

• annual growth in industrial production running around 10.3% up from a low of 8.9% in June;

• retail sales growing 13.3% from a January low of 12.3%;

• electricity production up 8.4% versus 6.4% a year earlier;

• while growth in fixed asset investment slowed to 19.3% year on year, this is part of a rebalancing. More interestingly the slowdown was accounted for by slower investment by state owned enterprises with private firm investment stable at around 22% growth;

Source: Thomson Reuters, AMP Capital

• export growth appears to be trending up and import growth is solid at around 7.5%;

• while inflation has increased to 3.2% year on year this is due to an acceleration in food prices. Non-food inflation is stable around 1.6% and producer prices are still falling;

• finally, while money supply growth has remained solid at 14.3% year on year, growth in overall credit has slowed to a still strong 19.5% year on year from a peak in April of 22% and 37% growth in 2009 as the Chinese authorities reign in credit growth that has been occurring outside the banking system, ie “shadow banking”. But this looks to be a controlled slowing rather than a collapse.

The overall impression is that growth has stabilised and improved a touch with no sign of a hard landing and inflation remains benign. With monetary and fiscal policy remaining growth supportive, exports set to benefit from stronger global growth and Premier Li targeting a 7 to 7.5% floor for growth we expect growth to run around this level next year.

Debt is a worry, but nothing to panic about

The biggest concern is that a rapid build-up in debt starting in 2008 has led a domestic debt bubble. However, there are several points to note. First, China’s aggregate debt level is not high by global standards. See the next table.

* Includes local govt debt of 30% of GDP. Source: IMF, BCA, AMP Capital

Second, the rapid rise in China’s debt level is partly a result of a very high savings rate and those savings largely being recycled via the banking system rather than via the share market which means savings are simply recycled into debt. Third, reflecting its very high savings rate (around 50%) China is the world’s largest creditor nation with the world’s largest foreign exchange reserves. The risk of a typical emerging market crisis where foreign investors lose confidence is low as China is not relying on foreign capital.

Finally, there is no denying that the rapid increase in China’s debt is a worry if it continues and as rapid increases run the risk of poor asset quality. However, the authorities recognise this with a clear focus on slowing the “shadow banking” system and the new leadership indicating there is little scope for more monetary and fiscal stimulus and that the emphasis will be on economic reform to boost growth. While the Communiqué from the 3rd Plenum was long on clichés around “deepening” and “perfecting” and short on detail it is clear the focus will be on reforms to allow market forces to play a more decisive role in the economy. While details will take time to be released and the reform process will be gradual its likely this will focus on deregulating financial markets and removing bureaucracy amongst other things.

What about the "housing bubble"?

Talk about a housing bubble in China has hotted up once more as house prices have picked up again. And reports of "ghost cities" continue to circulate. The reality is far more complex with an undersupply of affordable housing, low home ownership and low levels of household gearing where average deposits are around 40% of values and 20% of buyers pay in cash. Household debt is low at 30% of GDP versus 85% in the US and 100% in Australia. And with household income growing around 10% a year it’s hard to argue there is a bubble when property prices rose just 2% in 2011, were flat in 2012 and look like rising 10% or so this year. While there are oversupply conditions in some cities and bubble like conditions in some others, overall it seems the Chinese property market is a long way from a bubble.

The investment overhang, or is it?

Talk of the need to rebalance growth in China away from investment to consumption has been around for a while. Over time it will happen. But it will be a very slow process. First, despite the strong growth rate of investment in China, its annual level of capital investment per person is low compared to developed countries. See the next chart.

Source: BCA Research

Second, China’s urban share of the population at 50% is up from 20% in 1980, but if Korea is a guide its likely on its way to 80% over the next 30 years. This means an extra 400 million people moving into cities. To achieve this will require massive investment in housing and urban infrastructure.

Finally, China has been able to grow so strongly because it hasn’t experienced the inflation and balance of payments crises experienced periodically by many underinvesting emerging countries like India, Indonesia and Brazil.

In short claims that China is overinvested and investment needs to fall sharply relative to consumption are misplaced.

Has China lost competitiveness?

With Chinese wages rising rapidly, concern about a loss of competitiveness is quite common. However, there is little evidence this is a major problem. First rapid productivity gains are offsetting labour cost increases. Second, Chinese exporters have been moving up the value chain to higher value adding exports like electronic machinery. Finally, Chinese export are continuing to gain share, rising from around 4% of total global exports in 2000, to 8.5% in 2008 to 12% now suggesting little sign of a loss of competitiveness.

The Chinese share market

Chinese shares are cheap with a price to historic earnings ratio of 11 times and a price to forward earnings ratio of 8.5 times. This makes it one of the cheapest share markets globally and is suggestive of good returns in the years ahead as it becomes clear Chinese growth remains solid.

Source: Thomson Reuters, AMP Capital

Concluding comments

China is unlikely to return to the 10% plus growth of last decade. But growth does seem to be stabilising around a still strong 7.5% pace and many of the common concerns regarding China are overdone.

Dr Shane Oliver
Head of Investment Strategy and Chief Economist
AMP Capital

Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.

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The collapse in short term interest rates and associated fall in long term bond yields has seen investors seek out decent investment yield in assets as diverse as corporate debt, property, infrastructure and shares. And more recently this has broadened into a general search for higher returns as confidence in the economic outlook has improved.

When assets are in strong demand their price goes up and their investment yield (or the cash flow the investment provides relative to its price) falls. This is certainly evident over the last two years. The chart below shows the yield available on various assets today versus what they offered 2 years ago. Bond yields have increased slightly after earlier sharp falls. But the yield on all other assets have fallen, although – corporate bond yields excepted – not quite as much as the plunge in term deposit rates.

Source: Bloomberg, REIA, RBA, AMP Capital

But what's driving this chase for yield? Has it gone too far? If it has further to go what warning signals should we watch? And what does it all mean for investors?

Drivers of the chase for yield

The search for yield, and more recently higher returns generally, is being driven by a range of factors:

• Low interest rates have pushed bank deposit rates down and bond yields are very low, all of which is encouraging investors into higher yielding alternatives;

• Reduced fear of an economic meltdown has helped investors feel comfortable taking on more risk. Initially, fresh memories of share market falls saw this concentrated on assets providing high yields as this provided a degree of certainty that returns would be positive. Assets such as property, infrastructure or high income shares like bank shares in Australia all benefitted.

• However, as past sharp share market falls recede in time and are replaced by ongoing news of rising markets – and as indicators such as business conditions PMIs have started to signal stronger global growth – investors have started to focus more on shares for capital growth.

Source: Bloomberg, AMP Capital

• Finally, interest in yield is receiving a longer term push from the aging population. This started last decade as the first baby boomers moved into their pre-retirement phase and is intensifying now as they are starting to retire. This is driving demand for investments paying decent income in the form of dividends, rent, interest payments, etc.

Demographic influences likely have a long way to go. However, the first three drivers noted above are a normal cyclical phenomenon. In other words in the early stages of an economic recovery it’s quite normal to see investors start to take on more risk by moving out of bank deposits as interest rates get lower and lower and the economic outlook brightens. Initially this focuses on investments providing a high yield given the certainty of return this provides but eventually investor interest moves on to growth oriented investments. In other words what we are seeing is nothing new. It’s just more pronounced this time around because interest rates are lower than normal and GFC related share market falls have been deeper.

Moving out of bank deposits & taking on more risk is exactly what central banks like the Fed and the RBA want investors to do, because by taking on more risk this helps make capital available for investment in factories and buildings. And the rise in value of risky assets like shares and property helps boost wealth and hence spending. So nothing new here.

It should also be recognised that part of the rebound in asset prices reflects a return to normality as the risk of economic catastrophe gets unwound. This has seen the price to earnings multiple of shares return to more normal levels.

The danger, of course, comes when it all goes too far.

Has it gone too far?

The typical investment cycle eventually sees the chase for yield and surge in asset prices pushed too far as rising levels of debt and overvalued asset prices leave investment markets vulnerable when central banks adopt tight monetary policy to head off inflationary pressures or other imbalances in the economy. Right now we are a long way from that point.

• First, while Australian house prices are bit extreme, asset prices generally are not. The yield available on Australian investment grade debt still offers a spread over that available on cash and term deposits. Share market price to earnings multiples have increased significantly over the last two years but only to around their long term average for Australian shares (see chart below) or to still below long term averages in the case of global shares.

Source: Thomson Reuters, AMP Capital

The gap between the distribution yield on Australian real estate investment trusts remains above the negative levels reached in 2007, ie before the GFC. Unlisted nonresidential property yields also remain relatively high such that commercial property continues to offer an attractive prospective return premium over bonds. In fact it is substantially higher than in the early 1990s & in 1997 after which property values fell sharply. See next chart.

Source: Bloomberg, AMP Capital

• Second, we are a long way from the sort of debt surge that was occurring prior to the 2008 global financial crisis. Credit growth remains very weak globally and in Australia suggesting little risk of another debt blow-up at present.

Source: Bloomberg, US Federal Reserve, AMP Capital

• Finally, while global growth is improving and the US Federal Reserve may soon start to slow its monetary stimulus program – possibly starting next month – a shift to tight monetary conditions looks to be a long way off. Inflation in the US, Europe and Australia remains low at just 1.2%, 0.7% and 2.2% respectively. Moreover, spare capacity as measured by output gaps (or the difference between actual and potential GDP) remains significant suggesting little inflationary pressure ahead. As indicated in the next chart, the output gap in the US is a long way from where it was in 2007, just before the GFC. So interest rate hikes are still a fair way off. In fact rate cuts are still possible in Europe.

Source: Bloomberg, AMP Capital

In other words the chase for yield and returns has not pushed asset values to an extreme. It looks fine as long as interest rates remain relatively low and investment markets don’t become too overvalued or geared. At this stage we still look to be a long way from that, suggesting the chase for better yields and higher returns still has further to run.

What to watch?

The previous section basically highlighted the three key groups of indicators to watch for signs that the chase for yield and higher returns has gone too far:

• Valuation indicators such as price to earnings multiples for shares, yield spreads for bonds and the return premium property offers over bonds;

• The rate of growth in private sector credit or debt.

• Indicators of inflationary pressure and hence future interest rate hikes.

So far so good, but they are all worth keeping an eye on.

What does it all mean for investors?

There are two key implications for investors.

First, while the yields and return potential across most assets have fallen following recent strong rallies, there are a range of assets providing more attractive income flows than available on cash and bank term deposits. These include corporate debt, real estate investment trusts, shares and unlisted non-residential property.

Second, with yield related investments having performed so strongly over the last year or two and bond yields likely to gradually trend up, there is a case for those who can take on a bit more risk to consider a higher exposure to parts of the share market that have underperformed and yet will benefit as global and Australian growth picks up, eg, resources shares.

Dr Shane Oliver
Head of Investment Strategy and Chief Economist
AMP Capital

Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.