Platinum's "Illusions of Comfort" by Marc Lerner

Platinum’s “Illusions of Comfort”

Marc Lerner

At Valor Private Wealth, we take great interest in Kerr Neilson’s view as he has a wonderful track record at Platinum. We are happy to hold an allocation of our client’s money with his funds and in his business. In August 2012, Platinum wrote a report which in the face of Australia’s rising sharemarket, should be at the forefront of investor's minds.

The report charts the last two decades of booming economic growth in ‘the lucky country’ and the economic trends that have accompanied it. Rather than being used as an opportunity to reform government policy, this period has instead been used, largely, to increase the size of the government, particularly in the area of regulations. The report predicts it is likely this will end in “breaking-point” regulatory reform when the good times end, similarly to what happened in the early 1980s after the disastrous inflation of the 70s.

The report recounts how the boom in China led to a mining boom in Australia, which spread through the economy and into areas like housing through an overblown and subsidised financial sector. The good times will end, it predicts, when China slows down heavily, leading to a fall in commodity prices and a consequent rise in real wages (wages relative to the price of the output being sold). This will lead to rising unemployment, as those businesses still remaining afloat cut back on labour in the face of rising real costs. Whilst interest rates can, and likely will, be cut down further as a measure to stimulate the economy, this will not help with the structural problems of misallocated assets that the boom has resulted in. The report speculates that BHP’s recent announcement of $100 billion in investments over the next 8 years (more than it has had in capital expenditure in the last 20) could well prove to be a ‘peak bubble’ signal.

Overall, the report provides an interesting discussion of Australia’s recent economic past and the mistakes that have been made in it, as well as future challenges we will likely encounter. In the meantime, of course, the great Australian bull market will continue, with dividend yields being the main – if not only - motivation for buying shares relative to staying in cash. 

Mainstream views on China

It is a mainstream view now that China has to slow. The Australian government and Australian investors are the last to accept this fairly obvious coming slowdown.

China has to slow fixed asset investment at some stage...

Great article here from Andy Xie. The big China slowdown in fixed asset investment has to come at some stage. The question is whether they take their medicine now or get quite sick in the next few years...

Either way, those holding onto the hope that China can keep growing forever at their current growth rates, I think Andy sums it up quite well:

China's FAI is so vast that sustaining rapid growth would surely bankrupt the country soon. FAI has tripled in five years to the current level of 70 percent of GDP in nominal value. If it triples again, the amount would become bigger than the economy of the United States. There wouldn't be enough money in the whole world to fund it.

This is why I feel comfortable about not holding any of the Australian Miners.

How much this affects the Aussie banks is a less certain, however I would guess that West Australian, Northern Territory and other mining dependent property areas will have a reasonable amount of de-leveraging of their properties. Add this to a weak Victorian market and an already decimated Queensland market and the mainstay of the banks, that is property assets, is not looking overly promising. At the current elevated prices for the banks, I think there is significantly more risk than shareholders are factoring in.  

Is Australia getting carried away with this rally?

It is a very rough indicator, but the Australian share market forward Price Earnings (PE) ratio is currently trading at 17.78 (According to Commsec).

The Dow Jones is currently trading at 12.5 forward PE and the S&P500 is trading at 13.78 (According to the WSJ).

I certainly don't see paying a roughly 30% premium for the Australian market at present as overly rational.

Unfortunately these numbers rely on analysts throwing numbers at a dartboard to predict the earnings of companies in the next 12 months. This suedo science is not very accurate, however I would guess it is slightly more accurate for larger more stable companies such as Coke and Proctor and Gamble, than for a volatile company such as a miner.

Perhaps Australia should be called the optimistic country rather than the lucky country? As a cautious investor, I would be very worried paying nearly 18 times earnings for a group of predominantly cyclical stocks (mostly miners and banks) which are much closer to the top of their cycles than the bottom and likely to have some headwinds in the next few years.

Well Constructed Argument on Housing...

A very good article by macro business about Australia's housing market is here.

I sleep very well at night knowing that I do not hold assets which are 10 times geared betting that our housing market will get substantially better from here (aka Aussie Banks).

In the short term, I am guessing that there will be more suckers being caught up in this fad of rushing to yield and the prices might go a bit higher. If you are a trader, you are going to have a fantastic time riding this fad. But like all fads, they don't last. In the end, the true valuations of the stocks will revert them back to where they really should be long term. (this might take a few years though, it all depends on interest rates and China) The secret to investing is not riding the tops of the bubbles like the dot com, the leveraged property trust bubble or the mining boom, it is actually about attempting to avoid these bubbles because when they pop, your losses on the downside can be crippling.

For those of you who like to ride the tops of bubbles (all the brokers who get paid for convincing people to buy and sell). Enjoy. I prefer to buy wonderful businesses when they on sale and detest owning highly geared businesses when they are at the top's of their cycles and trading up to 5 times the price of than their global peers. (Aka Aussie Banks).

If I am wrong and we are going to make our property bubble worse, then I will likely eat my words for a few years, but if we grow our household debt at above GDP and income growth for the forseeable future (as projected in the Commonwealth bank analysts projections), then we will succeed in having one hell of a housing bubble. I think growing household debt above income or GDP growth from here is an extremely dangerous paradigm. For the banks to be worth their lofty multiples, the need to grow at rates that would put household debt to 130% to 140% of GDP. This would be about double the current US household debt to GDP ratio. We currently have the biggest housing bubble in Australia's history, but if the banks are to grow at the rates their earnings multiples imply, we would have the biggest housing bubble in the history of the world. With China likely to have a hiccup soon, that is something I dont think is likely.

Dividend blindness

For those of you who like to simplify life and believe that having a high dividend yield is the single metric to help you sleep at night with your portfolio, please read this article. Bank of America had a 6% yield and then went on to fall 95% from this level.

In 2007, numerous US banks were talking about the housing market recovering soon and how fantastic their dividend yields of 6% were. Does that sound familiar? Most of them crashed. 

Whilst it is not definite that we will have an exact replica of the American housing crisis, the article above should highlight the media beat up over dividends and ignoring the risks when investing in these highly volatile businesses. The Australian banks do have better capital ratios than many of the US banks before their downturn, but Australia has much higher house prices. (As seen below thanks to Steve Keen)

The Australian banks are approximately 10 times geared. This means they have about 10% equity and 90% debt. Add this to derivative portfolios that are twice the size of the Australian economy for each bank and you have extraordinary complex and risky businesses.

Most mums and dads will just compare the dividend rate to cash and see that it is a few percentage points higher and rush in.

The majority of Australians who live off dividends for retirement in my opinion do not have enough to truly retire. True retirement is having enough money to live off lower risk assets such as government bonds and cash. Those that are needing their dividends from risky assets to live off for their basic needs do not have enough to truly retire. There are very few people who ever make it to this comfortable level.

There were numerous unfortunate news stories during the GFC of people telling their woes of losing their retirement income because their portfolio had dropped so much. These people were living off their risky share investments rather than living off their cash. This sort of market crash will happen again and again over the next century and beyond and those that are fully invested and living off their risky shares will again be burnt.

True retirement is having enough cash to live off for 10 years based on your minimum retirement amount, then invest the rest.

At market peaks, you may need more than this.

Your minimum retirement amount is based on your basic living needs before luxury expenses such as holidays etc.

If you need 40k to live off for your basic needs and if you expect cash returns to average 3% over the next decade then you need $341,208.  This is a very simple present value calculation. This money should be quarantined away and not touched unless there is a market crash. You then live off your cash and dont sell your investments below their true value.

If you are a forced seller of assets during a downturn when you are drawing income, you can destroy capital at a rate that you can never recover from.

In 1929, the market dropped 87% to its lows in 1933. If you were fully invested at this point in time and living off the dividends, you could have been wiped out in a few years.

It took 22 years for the market to recover from its 1929 highs. 1967 took approximately 15 years. 2000 took approximately 13 years. If you are investing in stocks, you must expect far more volatility than many people understand.

For those heavily invested in highly geared entities such as banks, the US banking story of the last 5 years proves that these events are possible. A number of US and european banks no longer exist or are trading at 90% of their pre crisis value. Prepare for the worst, hope for the best.

This method for preparing your retirement assets for the worst market scenario is not only prudent, it is crucial to ensure you have sufficient assets to ride through the wild market fluctuations.

I honestly hope that Australia does not have a downturn in the next few years because there would be a great deal of pain for many retirees. Our share market is unbalanced in its banking and mining dominance. Our super funds have one of the highest exposures to shares in the world and mums and dads have extreme over exposures to banks and miners because that is the dominant force in the media.

Unfortunately this hope is dependent on Australia continuing to ride China's debt fueled boom. I prefer to be a realist rather than a pure optimist and I still expect this story to play out at some stage over the next few years, and it may not be pretty when it does.

Im Back...

After getting married and enjoying a wonderful honeymoon in the Maldives and the Great Ocean Road, I'm back to business.

A lot has happened in a few weeks. The share markets have run off on a bullish rant with little news to drive the returns. A 1% increase in CBA's net profit for the last 6 months has let to a 35% increase in their share price. Is this logical? Perhaps if you are dividend lemming.

Aussie banks are a leveraged play on our housing market. If you believe house prices are going to boom from their very elevated levels then go ahead and invest, but if you are more prudent and believe that Australian house prices are somewhat overvalued then be very cautious. I once again return you to Steve Keens debt deflation blog and this all telling chart:

The banks are not safe investments!!!! The vast majority of banks around the world lost 80% or more during the last downturn and a good number went broke. Australia is just yet to have its downturn, but it is not a small probability that we have a sizeable correction. I strongly caution those who are piling their retirement assets into these shares to think about the downside before you invest too much of your capital.

As Graham always said, in the short term, the stock market is a voting machine and in the long term the stock market is a weighing machine.

A well renowned broker recently said to ignore the downside risks and dive into the share market. When brokers are speaking like this, it is time to be more cautious.

Our expectation for Australia having less than exciting times ahead has not changed, it has just been delayed by another enormous stimulus program in China. The sub prime issues of the US being mimicked by the frivolity of the current Chinese wealth management products. Whilst it is impossible to predict what percentage of these products will turn sour, the rate of their growth often gives an inkling into the rate of their downfall. With debt to gdp growing at a staggering 30-40% in the last 12 months, the slowdown in investment when it comes will be more severe.

The Chinese "building empty fixed assets" story is unlikely to end well when it finally turns, those that are piling into Aussie equities in the hope that they get a few extra percentage points of yield could have disappointment in the years ahead.

"Be fearful when others are greedy and greedy when others are fearful" (Warren Buffett). This becomes more apt the higher the market runs on very little earnings growth.