It Didn’t Last…

  • What if share prices don’t go up?
  • Not as much growth as you think

The impact of Warren Buffett’s ownership of Apple Inc [NASDAQ:AAPL] stock lasted all of one day.

Yesterday the Dow Jones Industrial Average gained 1%, thanks to Buffett owning Apple. Today, the Dow Jones Industrial Average fell 1%, despite Buffett owning Apple.

The US stock rally appears to have petered out. The enthusiasm for rising interest rates (or is it falling interest rates?) has waned.

Now the reality has set in: the markets are stuffed.

Happy investing!

Markets

Overnight, the Dow Jones Industrial Average fell 180.73 points, or 1.02%.

The S&P 500 index fell 19.45 points, or 0.94%.

In Europe, the Euro Stoxx 50 dropped 13.3 points, or 0.45%.

Meanwhile, the FTSE 100 index gained 0.27%, and Germany’s DAX lost 0.63%.

In Asian markets, the Nikkei 225 index is up 100.75 points, or 0.61%. China’s CSI 300 index is down 1.32%.

In Australia, the S&P/ASX 200 index is down 22.77 points, or 0.42%.

On the commodities markets, West Texas Intermediate crude oil is trading for US$48.47 per barrel. Gold is trading for US$1,276 per ounce.

The Aussie dollar is worth 72.82 cents.

What if share prices don’t go up?

The blue-chip Aussie index, the S&P/ASX 200, has rallied hard since early April. It’s up almost 10% since 8 April.

However, an odd pattern appears to have developed. On a good number of days, stock prices have plummeted either at the open or in early trade, only to bounce sharply. The result is an overall up day, or a tiny down day.

To us, that’s an exhibit of odd behaviour. It suggests the market is schizophrenic.

In the morning, it’s the embodiment of bearishness, with investors unable to sell fast enough. By the afternoon, it’s nothing but the proverbial ‘blue sky’ as investors scramble to buy stocks for fear of missing out on the great stock bull run.

Of course, this isn’t new. In the book The Intelligent Investor famed investor (and Warren Buffett’s mentor), Benjamin Graham, describes the allegorical character he calls ‘Mr Market’.

At any given point in time, Mr Market either behaves as a manic depressive, willing to accept or pay only the lowest prices possible for a stock, while at others Mr Market behaves like an over-enthusiastic maniac, willing to pay or receive only the highest prices possible.

What can explain it?

It’s usually dangerous to pin any market move on one thing. But what the heck, we enjoy a bit of danger.

Our bet is program trading is playing a big part. If the market falls by a certain amount, it triggers automated buy orders, either in the futures market, stock market, or both.

Hence, the big rebound in stock prices.

In that case, you could naturally think program trading creates a kind of ‘floor’ under stock prices, ensuring they won’t fall any further.

It’s fine to think that, because for periods that can be true.

But, like with many things, it’s only true until it isn’t.

Leverage is like a double-edged sword, in that it can improve your returns, but increase your losses too.

In a similar way, program trading can create nice stock market rebounds…or accentuate a fall when the program trading turns the opposite way.

That’s the big risk today. Program trading will typically operate according to certain parameters. If the market behaves as it usually does — trading within certain ranges, or ‘standard deviations’ — the program trading systems can work well.

But as you’ve seen with apparently greater frequency in recent years, when the market moves outside of a certain range, all heck can break loose.

That’s the danger in today’s market. Investors are certain that if stocks or other asset prices fall, the government or central banks will do something to prevent asset prices falling further.

That’s why central banks are printing money.

It’s why governments are being encouraged to offer ‘fiscal support’ to economies — which usually means going further into debt.

And it’s why program trading systems are set to buy stocks on the dips. Why not? Buy while stocks are cheap, before the central bank bailout arrives.

However, the assumption is that another central bank or government bailout will do enough to prevent or halt a market collapse.

We have our doubts. Remember, debt levels around the world are at a record high. A McKinsey & Co report last year showed that debt had increased by US$57 trillion since 2007.

That’s during a period of so-called debt-deleveraging — a term you rarely hear these days, since the release of that McKinsey report.

For more perspective, debt levels by the middle of 2014 were 128% above the year 2000 level.

As the law of large numbers tells you, the bigger something grows, the harder it is for it to continue growing at the same rate.

In news that will likely displease investors, a more recent report from McKinsey & Co (gee, these guys aren’t much fun) advises that investors should expect lower investment returns in the future.

According to the report, over the past 30 years, US and European equities have averaged 7.9% per annum returns. Turning to the Rule of 72, it means you can theoretically double your money every 9.1 years.

That’s a nice bit of compounding over the long term.

But that’s the past. And past returns aren’t much good to you when it comes to thinking about your future returns — especially if the forecast for future returns is much less than in the past.

According to McKinsey, the best case growth scenario for US and European equities is 6.5% and 6% respectively.

That’s not a shameful return by any stretch. Although, it does increase the time required to double your returns from 9.1 years to 11 and 12 years respectively.

But, that’s the best case. In this investment world, we’ve seen that the best case doesn’t always happen. McKinsey gives a slow growth scenario too.

In that instance, US and European equities are forecast to grow at rates of 4% and 4.5% respectively. In that scenario, the period to double your returns increases to 18 years and 16 years respectively.

Again, not shameful, not as good as in the past either. Besides, what if McKinsey is wrong, and growth for equities is even lower?

What if equities only grow at a 2% or 3% annual rate? Well, in that instance, you’re looking at 36 years at worst, or 24 years at best to double your money.

Given the apparent slip in worldwide economic growth, falling wage rates, and the onset of inflation, is it really so crazy to think that stocks will only average a 2–3% gain over the next 10 years?

Not so long ago, it would have seemed crazy. Today, not so much.

[Reader’s voice: Hey grumpy, and what if McKinsey is wrong and growth is even higher? Silence huh!]

Despite our increasingly bearish stance on stocks, we still believe it makes sense to own stocks, especially if they are good and strong dividend payers, and they’re somewhat resistant to a potential downturn.

But we also recommend investors hold a significant amount of cash and other assets in their portfolios too. If we’re right about a major stock correction, we’re happy to take a bit of a hit with the stocks we own, but we want to own cash to be able to buy more stocks when the price is right.

Not as much growth as you think

Talking about growth, we stumbled across an old research report today. Written in 1985, it estimates economic growth in Britain during the Industrial Revolution.

Arguably, the Industrial Revolution was one of the most important periods in human history. The British economy began a transformation from an agrarian economy to an industrialised economy.

The result? Huge economic growth, right? Apparently not. We reveal more in a special note that went out to those who joined the Priority list for our 2016 investment conference.

It’s still not too late to get on the list. You can do so here. Joining the list commits you to nothing. You simply get to be among the first to get your hands on tickets for the conference when we make them available this coming Saturday.

To join the Priority list, go here.

Cheers,

Kris