If you’re buying a bull, buy a young bull
The investment markets have been buoyant for around three decades now. Most investors have seen consistent increases in equity and property prices and decreases in interest rates (at least until just recently). Long gone are the days when home mortgage rates were 17.5 per cent.
These Goldilocks investment markets have persisted for so long that most downturns could be simply characterised as “phew, that was a bad dream – now back to the races” and a popular and successful investment strategy has been “buy the dip”. If I’m right, maybe one should rather “sell the rallies”.
An oft-used mantra is that “markets have never failed to surpass their previous peak”. That’s true, of course, but just look how long it took for the Dow Jones Index to return to its 1929 peak. The best part of 30 years! And the past 35 years isn’t a good guide for the future and basing one’s investment strategy on this period gives rise to considerable risk – the most obvious one being that interest rates might rise and equity prices fall for a prolonged period. My reasons for recommending caution are as follows:
- Equity prices are historically high and bond yield are historically low and mean reversion would suggest some reversal of the past 35 years.
- The past 15 years has been influenced by quantitative easing (“QE”) where central banks kept interest rates at artificially low emergency levels. Low rates have led to an asset price bubble where interest-rate sensitive assets were taken to extraordinary heights and risk was mispriced. This is now unwinding.
- Low price volatility and high returns has led to mean-variance optimisation favouring growth assets with little consideration for fundamental analysis and a general complacency that no matter what happens it will all be fixed by central banks, if for no other reason, some institutions are ‘too big to fail’, so called moral hazard.
This complacency is further evidenced by the high level of growth assets in MySuper products and in the design of retirement products. At Australian Catholic Super we implemented an award-winning retirement product called RetireSmart, essentially a set-and-forget strategy that rebalances a member’s pension account between a bucket of cash and a bucket of growth assets. Products like these are, unsurprisingly, called bucket strategies and there are other versions around. What was interesting to me was that RetireSmart had implicit in its modelling that two years of cash was sufficient to deal with any market dislocation, implying that downturns were just a short-term blip.
But I just wonder whether this golden age of investing is coming to an end and whether the bull market in growth assets is getting a bit long in the tooth (or, more correctly, short in the gums). A portfolio that is essentially shares and cash has little chance of navigating anything but a short sharp downturn.
After all, a wise man once said, “if you’re going to buy a bull, buy a young bull!”. In other words, if asset prices are cyclical then maybe now is the time to be moving out of growth assets. Even a strategy as simple as ‘buy low, sell high’ which underpins most rebalancing would suggest switching out of equities into just about anything else, hence my previous article recommending that now is the time to be looking at diversifying strategies.
Let us have a look at one component of the Australian economy, namely consumer spending. Retail spending is a very large part of the Australian economy and has been buoyed by falling interest rates lifting household disposable incomes and by rising asset prices.
Rising asset prices have led to increased consumer spending because households see their assets rise each year and feel more confident in spending. This is called “The Wealth Effect”. Sometimes it is more than just consumer confidence leading to higher spending. Sometimes households even borrow more against their increased equity, thus using their homes like an ATM to pay for holidays, renovations and the like. My best guess is that the outlook for the Australian economy is less than positive. Here are my reasons:
- The likelihood of a global recession, which is so high that a US recession is the base case for many if not most economists.
- Property price declines (remember, property prices do not need to fall to dampen confidence they just need to stop rising).
- Rising interest rates (notwithstanding that this may be exacerbated by some fixed rate mortgages switching to a higher variable rate).
If one takes all of these factors together, the outlook for consumer spending is likely to be poor and accordingly I think that because consumer spending is such a large part of our GDP that employment and other activities will be negatively affected. Given that equity markets are historically good leading indicators of an economic downturn I am suggesting that equity markets are too highly priced for what the future holds.
I hope that I’m wrong! After all, I have been accused in the past of ‘predicting 13 of the past two recessions’. So, what can any investor do given my prediction?
If an investor has a very long-term investment horizon (like my 32 year old daughter who has at least 28 years before her super savings are available to her) then one might as well buy equities, ride the volatility and know that in any downturn she can accumulate good assets at reduced prices. All good for funds with young demographics like Rest, Australian Super and HostPlus to maintain a high growth default strategy.
However, for investors like me (60 years old, large account balance and shorter investment horizon) I need a lower-risk strategy than my daughter. Notwithstanding that the life tables suggest I might live into my 80s, I believe that older, higher-balance members need a more diversified investment strategy – yet another argument in favour of a lifecycle default super strategy or some form of age-based default.
When the next downturn comes, I certainly do not want to be holding the traditional 70/30 portfolio that most super funds have. Of course, I sympathise with those funds that are coerced by Your Future Your Super (YFYS) to hold a small number of asset classes with less diversity and less alpha to offset any potential downturns.
For example, the risk-controlled strategy that I put in place at Australian Catholic Super had around a third of the downside risk of most balanced MySuper strategies. This was borne out over Covid in 2020 when median funds lost over nine per cent and our older investors lost less than three per cent.
I wonder if older members or their advisers will see the danger and change course before it is too late? I wonder if the government will acknowledge the risk and change its YFYS benchmarks such that super funds have a potential way forward in a market downturn? On the other hand, maybe funds are so focused on peer relative returns that they will be happy with low or negative returns if other funds are doing the same.