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Paper Profits

January was extremely strong for the Australian market, which confused most people as it just kept on going. Later in January, anxiety swept through the equity, bond and commodities markets on uncertainty about the scope of the economic impact of the coronavirus in China, as airlines suspended flights to and from the country and businesses shut down their operations there.

Global markets were not as strong, but benefited from a lower $A.

Oil prices have been hit particularly hard, closing at the lowest level since early August. A measure of equity market swings called the CBOE Volatility Index recorded its biggest January jump on record, a sign of the jitters in markets.

Investors reached for traditionally safer assets like government bonds and gold. Demand for bonds pushed the yield on the 10-year U.S. government bond to 1.521%, nearing 2016’s record low, while gold prices hovered near the highest level in almost seven years.

International shares continued their strong run in the first 6 months of the 2020 financial year, while the Australian share market remained solid. This capped off a big 12 months (calendar year 2019), as falling interest rates pushed up prices across all asset classes. January 2020 has seen the Australian market jump out of the blocks – it is already well up on 31 December levels at the time of preparing this review.

Technically, a paper profit is an unrealised capital gain on an investment and only becomes an actual profit once the investment is sold. The term is often used when there are concerns that current prices are overvalued and that some of the paper profits will disappear, or do not reflect the true valuation. There is that feeling at present.

An investment can go up in price if the earnings it generates increase (profits, rent) or the amount people pay for a given set of earnings expectations increases, i.e. increase in PE ratio, reduction in property capitalisation rate.

These have very different implications. Earnings growth that generates growth in valuation increases wealth immediately.

Microsoft is a great company and while it had a PE of low to mid 20’s, it has recently jumped over 30 times earnings. Still it is well short of the eye watering 44 times earnings CSL is trading on (price for CSL is at record levels, but it is more to do with the record multiple of earnings i.e. PE ratio, than the increase in profits. Even companies showing minimal growth, but with reliable dividends such as Woolworths and Telstra are currently trading at concerningly high multiples. We all know residential property prices are going up again.

It is all about lower interest rates. That is what has been behind everything. All else is a sideshow. As long as there are no imminent fears, the lack of alternatives is pushing people into riskier assets.

However, value is getting harder to find. Australian asset prices from property to shares have very stretched valuations. Even overseas, where quality companies had remained at reasonable multiples (price growth was driven by actual earnings growth), things are starting to look a little toppy in terms of price, if earnings do not continue to grow.

A higher multiple can be justified by higher earnings expectations, but earnings growth, especially in Australia is far from robust. At the same time if we exclude banks and miners, the Australian market is now the most expensive equity market in the world.

Increases in prices not backed by earnings growth, can only occur if the multiple of earnings increases. When asset prices increase without an expectation of earnings increases you are stealing returns from the future.

If you pay more for something, your return must be lower in the future than if you pay less. That is a simple fact. High multiples are simply paying more for something. It makes prices go up now, but leads to lower future return expectations.

Interest rates and multiples oscillate (they move up and down in a range) in an inverse direction. So, as rates fall, multiples rise and vice versa. This has boosted returns for a decade, but as interest rates cannot go much lower, multiples cannot expand much more and what has been a very positive impact on capital returns, can only be neutral over the medium term if rates stay low. The impact will be negative when rates eventually rise. In the longer term, you must assume rates will go up, although we cannot see how they can lift rates in Australia without destroying the housing market.

The main point is that from here on you will need earnings or rental growth, as multiples have been pushed to the limits. In the short-term, price rises can attract buyers, but without something radical occurring that completely changes the outlook, it is logical to expected lower returns going forward when multiples are stretched and earnings growth is low.

That is why we are taking a wider view of investment options and looking to add some investments that generate returns through a niche strategy or specific opportunity. We remain cautious on Australia, which is lumbered with massive household debt, low earnings growth and high multiples.

We also tend to take some profit in these situations and are reluctant to buy. You cannot time markets, but you can make make sound value-based decisions, to reduce risk and give yourself the best chance of success.

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