Recent market volatility – is the market crashing? Are we on the way to another GFC?

Welcome to SWW …on a Monday … because we have been receiving a LOT of questions about what’s happening with this so-called “market crash”, why has the share market dropped so much, should we sell to cash to avoid massive losses?

Here’s the back story
The Australian share market has wiped out all its gains from the last 12 months

1. Some say we have entered a technical “correction”, plus
2. Following a massive sell-off on Wall Street overnight
3. It has fallen by more than 10% since its peak in late-August until October
4. There were days last week when it was dropping 2+% in a day

Why are markets tumbling?

• What America does, we follow, and so does the rest of the world
• The local market’s substantial decline comes after the Dow Jones index fell more than 600 points – this wiped out all its gains since January – 10 months’ worth
• New York’s benchmark S&P 500 index – down 3%, Nasdaq (tech heavy) – down 4.5%
• Australia is still faring better than some others when it comes to one-day losses; Tokyo’s Nikkei (-3.4%), Seoul’s Kospi (-2.5%) and Shanghai’s composite index (2.6%)

Why is this occurring?

• There’s a number of reasons, but a lot possibly comes back to investors taking profits ahead of upcoming uncertainty
• US Share market in 2 years rose 40% until the declines over the past few weeks
• Uncertainty is a major factor on share markets; People get worried, they sell their investments… so the market goes down
  • If you aren’t certain about what tomorrow holds, how can your plan and act today for it?
  • Certainty and confidence in the share market are the key drivers of consistent growth
    • Markets with too much confidence turn into bubbles
    • This will always exist in the share market; Consistence in confidence leads to overconfidence, overconfidence then leads to bubbles … but then profit taking sets in
    • Profit taking = Selling

Factors affecting sentiment and uncertainty; there are actually many things, but let’s focus on the major 4

1. US Midterms – Elections – Anyone heard of the blue wave coming? It is where the house and senate is voted on
   • Among the 33 Class 1 Senate seats upfor regular election in 2018 are 23 currently held by Democrats, two by independents who caucus with the Senate Democrats, and eight by Republicans
   • Republicans – 51 currently – All polls show Wyoming, Utah, Texas, Tennessee, North Dekota, Nebraska, Mississippi are all safe Republican – 8 seats up for re-election
   • 6 are up for tossups – In independent states
   • Democrats – 47
     • 19 seats are safe
   • There is an assumption – Republicans remain 51- Dems at 49 – but they’re still not in power. Media is saying the “blue wave” everywhere… but I don’t see it
   • Economic advisor Larry Kudlow this week blamed the spectre of Democrat wins for falling market prices.
   • Even if this is true, if it was the only reason for the market price fall, it is a great time to buy!
2. Raising rates – The Fed are very quickly raising rates
   • President Trump slammed Fed boss Jerome Powell, saying he threatened growth and appeared to “enjoy” hiking interest rates. – “Every time we do something great, he raises the interest rates,”
   • How does raising interest rates affect markets?
     • Shares; Free cashflows of shares is used and in the equation the risk free is the denominator
     • Analysts use the risk-free rate when they determine the intrinsic value of a stock. And the rates on Treasury securities are used as the risk-free rate.

A lower risk-free rate typically translates into a higher intrinsic value.

• Bonds and Bond pricing; Rates rise, bond prices fall, and it’s worse the longer the duration
• Rate rises can hurt the valuations of both asset classes

3. Decline of Tech – disappointing quarterly earnings from some major American companies
   • Tech stock declines drove much of the repricing
   • 6 of the top 10 are tech stocks
4. Geo-political
   • Tariffs and trade wars
   • Geopolitical tensions with oil producer Saudi Arabia for the killing of journalist Jamal Khashoggi
   • EU – Low growth and Italy’s conflict with the European Union regarding budget spending
     • This could be a big one, not enough time here but will do an episode on the EU and economic breakup in a future ep

We have been talking about America – Why cover it, we are in Australia?

• This does matter for us, not for fundamentals but ‘monkey see, monkey do’
• Crowd behaviour – Share markets around the world are highly correlated.
• Similar factors and similar human behaviour

What will cause Australia stocks to be volatile?

Similar things – overarching factors mentioned before, specifically to us though:

• Political uncertainty is a big one; almost one Prime Minister every year for the last 7 years
  • It’s hard to invest if you aren’t sure what is going on. As policies are likely to change so too does individual behaviour
    • Example; You learn that the cost of bananas is likely to triple in price in two weeks’ time…most people rush out and buy bananas.
    • When an outcome is likely from a political change, people change their behaviours prior to it even occurring

What will cause Australia to have slow growth in the long term?

1. Regulation – Stifles growth and competition by increasing barrier to entry – reduces incentive
2. Taxation – Detracts from the reward – again, reduces incentive

Examples: You can have growth with one and not the other

• Taxation – America after war: High taxes but low regulation, average 70-90% tax rate. There was, however, high growth.
• They did import a lot of gold and were one of the only developed countries not destroyed in the war
• Singapore had regulation but low taxes and no welfare – so, it has good growth.

When you have both high taxation and high regulation, GDP growth slows;

• GPD growth is important as it is highly correlated with share market growth
• Corporate Finance / Finance at Uni – joined the Investment Banking Challenge and we had to value a merger into the future. The initial growth would be large, but once the business mature. The growth assumption is almost on par with GPD growth of the overall economy.

Our History of GDP growth

• Used to be more volatile, but consistently higher in number
• As regulation increases our growth narrows down to 2-3% p.a. over time

What would it take for a market collapse?

• Housing crash – Either from lack of demand in property plus interest rates going up a lot
  • The housing market may decline a bit, but not like in the U.S.
• Fiscal Cliff – Government debt defaulting, banks defaulting
  • Anything that destroys the nature of financial markets
  • The Share market is related to financial markets – And also the foundation of every other company operating
    • A lot of companies need loans and credit to operate and they get that from the banks
    • If the banks shut down, so do a lot of other companies if they are overleveraged and can’t operate on revenues alone

Should you be worried?

• If the money is invested for a home deposit – maybe
• If the money is for the long term – not really
• This is part of the general market cycle
• What’s your end goal for your investment?

Ways to hedge against a collapse

1. If you’re ok with something that carries a bit more risk: VIX, ended near 22% higher, to its highest since the turmoil during February’s sell-off when markets started to perform. Not great over the longer term in a stable country.
2. Gold – I’ll cover this in another episode next week
3. Hold – Throughout the markets’ history, there have been collapses…ask yourself, are the markets still around?
   • Not only are they around, most are a few percentage points off their high points
   • What it would take to have a total market collapse – to get a 0% on all shares – Every company in Australia would need to go out of business. If that occurs we have more than our investment value to worry about.
   • That is why it is important to be well diversified – if you only have 1, 2 or 3 companies in your portfolio the chances of 100% loss is much greater
   • DCA in to the market – Take advantage of the downturns, but isn’t as risky as putting all into the market at the same time
     • Example: If you have $10k to invest, put $4k in now and wait, if it goes down put another $4k in
   • It may go up and it may go down – but at least you didn’t lose on $10k – nobody has a crystal ball

In the next episode I’ll give you another side to the Trump Economy and why the US economy is has done really well until now.

As always, if you have any questions hit me up at the contact page