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Investing: Don’t forget about the cycle

Another fast start to the year in financial markets. Following a disappointing end to 2018, equity markets rallied during January, with the MSCI World finishing the month up 7.7% (in USD terms).

Thursday, February 21st 2019, 3:54PM

by Pathfinder Asset Management

Karl Geal-Otter

With all this volatility it’s hard to really know where we stand in the cycle and what this year and the future could hold. The beginning of 2018 also had a euphoric start but, this feeling was quickly stubbed out in the following two months. So, we could be forgiven for treading cautiously in markets today.

Invest with cycles in mind

If you read any of Howard Marks’ (co-founder of Oaktree Capital) books or memos you begin to realise one of the most important things to know as an investor is never forget about the inevitability of cycles.

“Economies and world affairs rise and fall in cycles. So does corporate performance. The reactions of market participants to these developments also fluctuate cyclically. Thus price swings usually overstate the swings in fundamentals… So prices sometimes represent high multiples of peak prospects (as they did with technology stocks in the ‘90s), and sometimes low multiples of trough prospects. Ignoring cycles and extrapolating trends is one of the most dangerous things an investor can do. People often act as if companies that are doing well will do well forever, and investments that are outperforming will outperform forever, and vice versa. Instead, it’s the opposite that’s more likely to be true.” The most important thing, 2003

Even though the art of investing revolves around making decisions about the future, it is very difficult to accurately and consistently predict. So, as an alternative, we must evaluate where we are in the current cycle to have any chance of understand the possibilities that lay ahead.

So where do we stand in the current cycle?

Using traditional methods of evaluating the cycle we could look at price to earnings ratios (PE ratio), in other words, how much does it cost to buy $1 of corporate earnings. Using the S&P 500 as a barometer, the average PE ratio for the last 50 years is 16.7x. During late 2017, equity managers began complaining that the market was “overvalued” and that investment opportunities were sparse. It was hard to argue with them when the PE ratio was 30% above the 50-year average.

But this didn’t necessarily mean we were heading towards a downturn or a significant change in the cycle. We weren’t seeing the obvious signs of an investment bubble. During the dot-com bubble in 2001, for example, PE ratios of the tech sector were almost 200% above their average. Active managers also held plenty of dry powder during late 2017, which indicates there wasn’t a “buy at all cost” mania, typical of a bubble. For a recent example of this behaviour – think Bitcoin.

After the sell down in Q4 2018, the S&P 500 PE ratio is 17.9x, suddenly its quite hard for equity managers to say the market is overvalued. In fact, its only 7% above the long-term average.

Was December 2018 a bull market Blip?

Did we instead just have a little reset, or have the fundamentals changed? There is soft speak of an earnings recession, analysts are predicting a decline in US corporate earnings for Q1 2019 (-2.2%) but growth is expected to continue in the following two quarters by 1.0% and 2.4%, respectively (FactSet). A deep earnings recession does seem a little farfetched; the decrease in US corporate tax rates should provide stimulus, share buybacks were at a record high during 2018, trade war concerns are beginning to wane, and the US government shutdown is over (for now). Brexit is the front runner for economic disruption, but this will likely be contained within the UK and Europe.

So where does this leave us in terms of the cycle? Has the pendulum begun to turn back? Will the next flux be to the upside or downside? Today we are 12 months on from when people were seriously questioning how much longer we could go up for. Last year was a blip in the bull market. Fundamental valuations are now closer to historic levels and the cycle no longer feels stretched out.

Yes, we are further down the track, earnings and economic growth are slower than the last two years, but there is no obvious catalyst to spark change in the pendulum swing. In the past these catalysts have included low growth, high inflation and interest rates, excess debt and the use of leverage.

Markets have proven over the past 4 months why equities are considered a risky asset and volatility will likely remain higher moving forward when compared to the historically low level during 2016 and 2017. Volatility shouldn’t be feared, instead it should be seen as an opportunity. The bull market blip has provided this opportunity to buy into the bull market at more attractive levels.


Karl Geal-Otter is an investment analyst at Pathfinder Asset Management, a boutique responsible investment fund manager. This commentary is not personalised investment advice - seek investment advice from an Authorised Financial Adviser before making investment decisions.

Pathfinder is an independent boutique fund manager based in Auckland. We value transparency, social responsibility and aligning interests with our investors. We are also advocates of reducing the complexity of investment products for NZ investors.

Tags: investment Pathfinder Asset Management

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