A Note to Our ‘Really’ Smart Readers

  • Where the super money is going
  • Trouble ahead?
  • A bad omen
  • We’ll pass, thanks

It’s a roaring bull market, don’t you know.

Stocks are up because…of the prospect of more interest rate rises from the US Federal Reserve.

We don’t know what to think.

One day, an interest rate rise is bad news. The next day it’s good news.

No wonder investors are so confused. And if you’re after some advice on how to avoid confusion, we’ll be honest: you’ve come to the wrong place.

We’ve about as much idea as you have. We may even have less of an idea if you happen to be one of our really smart readers.

Regardless, we’ll give you our take on the current whim of the market shortly. But first…

[Note: If you’re one of our really smart readers and you’d like to meet other really smart readers, make sure you come to the 2016 Port Phillip Publishing investment conference. Alliance members, and those who joined the priority invite list can register now. Check your inbox for the invite. If you’re on neither of those lists, don’t worry, your chance will come on Saturday, when we make tickets available to all 40,000-plus of our paying subscribers.]


Overnight, the Dow Jones Industrial Average gained 213.12 points, or 1.22%.

The S&P 500 index closed higher by 28.02 points, or 1.37%.

In Europe, the Euro Stoxx 50 index gained 77.19 points, or 2.63%. Meanwhile, the FTSE 100 added 1.35%, and the German DAX closed up by 2.18%.

In Asian markets, the Nikkei 225 index is up 273.24 points, or 1.66%. China’s CSI 300 index is 0.35% higher.

In Australia, the S&P/ASX 200 index is up 89.73 points, or 1.69%.

On the commodities markets, West Texas Intermediate crude oil is trading at US$49.23 per barrel. Gold is trading for US$1,228 per ounce.

The Aussie dollar is worth 72.01 US cents.

Where the super money is going

The stock market may be roaring, but according to the latest numbers from the Australian Prudential Regulatory Authority (APRA), fewer investors are benefiting from it.

In our view, that’s a good thing. But save that thought for a moment. We’ll come back to it. First, the facts.

As Bloomberg reports:

Equities are falling out of favour with Australian retirement funds, which managed A$2 trillion as at March 31, the world’s fourth-largest pension pool. Their total allocation to equities slipped to the lowest in more than two years at the end of March, making up 48.5 percent of assets, down from half three months earlier. Australia’s benchmark S&P/ASX 200 Index declined 14 percent in the year to March 31, while the MSCI World Index slipped 5.3 percent in the period.

Bloomberg offers the accompanying chart:

chart image

Source: Bloomberg
Click to enlarge

You may be able to make out that the gold bars on the chart are in decline. Stocks accounted for around 53% of super fund assets in March 2014. Today, stocks account for 48.5% of super fund assets.

Over the past year, the S&P/ASX 200 index is down 6.7%.

That in itself will explain why the allocation of money in stocks is less than it was. And even with a continual flow of cash into super funds, under the Superannuation Guarantee, that hasn’t been enough to offset the decline in stock investments.

But of equal interest is the increased allocation to non-stock investments. The following chart from APRA shows how each type of fund typically allocates funds:

chart image

Source: APRA
Click to enlarge

From our perspective, the most troubling aspect isn’t the exposure to equities — which, in fairness is only slightly more than our recommended maximum exposure of 40% — it’s that all funds have a relatively small exposure to cash.

According to APRA, superannuation funds have just ’12.7 per cent [of assets] in cash.

That means, on average, Australian retirement savers only have $12.70 of every $100 invested in what we would call a ‘safe’ investment.

Almost half of their retirement savings are in stocks, which are susceptible to big losses during a market crash. Meanwhile, 21% of assets are in fixed interest (government and corporate bonds), and 13.8% of assets are in infrastructure and property investments.

Many see those as safe investments too. We wouldn’t be so sure about that. For a start, remember that, while fixed interest investments are an investment for the buyer, they are debt to the seller.

If the Australian or world economy turns south, it could affect revenue and profits for many companies, and that could affect those companies’ ability to repay their debts.

It’s not so different for infrastructure and property investments. Most infrastructure and property developments aren’t possible without the developer needing to raise tens or hundreds of millions of dollars…sometimes billions of dollars.

You saw what happened during the 2008 crash. The huge debt levels caught up with them. And so did the practice of revaluing assets higher, and then borrowing against the revalued assets in order to pay a distribution (dividend).

That whole model collapsed in spectacular fashion in 2008. Junior investment banking firm Babcock & Brown was the biggest casualty (not to mention all the investors).

But where the infrastructure funds once were, now the superannuation funds reside.

As we look into the past, we cast our eye over APRA’s 2005 report on superannuation funds. While the word ‘infrastructure’ appears 52 times in the current report, in the 2005 report…it appears not once.

Today, superannuation funds have $63.2 billion invested in infrastructure. In 2005, ‘other assets’ accounted for just $11.6 billion.

And property investments, which today total $120.8 billion of superannuation investments (not including self-managed super property investments), totalled just $33.6 billion in 2005.

What does any of this mean?

Well, on the one hand it’s pleasing to see that on average Australians have less than 50% of their retirement savings in stocks.

That’s good. Stocks are risky.

But on the other hand, it’s scary to think that all bar the 12.7% of assets held in cash, the remainder is in assets that aren’t necessarily safer than stocks.

That’s especially so when those assets are property, infrastructure, and fixed interest. All of which are either debt instruments themselves, or require major debt financing in order to operate.

All that may be fine in a world of low interest rates, where money is cheap and debts are de rigueur.

But what if money doesn’t stay cheap? What if money becomes more expensive…even a little more expensive? What happens then?

We have a rough idea. And for investors with 87.8% of their retirement savings in stocks and debt-related investments, we’re afraid the outcome won’t be very good.

Trouble ahead?

Is this a sign of things to come? Bloomberg reports:

Wesfarmers Ltd. flagged as much as A$2.15 billion in writedowns for its struggling Target department store chain and coal assets in Australia’s Queensland state.

The Perth-based company expects a pretax impairment of A$1.1 billion to A$1.3 billion for Target in its full-year results, it said in a statement Wednesday. Wesfarmers also expects a pretax impairment of A$600 million to A$850 million for its Curragh coal business.

The news itself isn’t directly related to Wesfarmers Ltd’s [ASX:WES] debt position. But it’s worth noting a couple of things. As at the end of the last financial year, Wesfarmers had…

  • $14.7 billion of ‘goodwill’ on the books
  • Short term debt of $1.9 billion
  • Long term debt of $4.6 billion

Right now, Wesfarmers’ 6.25% March 2019 bond is priced at a level to yield investors 3.04%. In other words, if Wesfarmers needed to raise debt in the market today, it would likely be able to price its bonds around that level.

But that’s today. In a bear market ‘goodwill’ soon vanishes, as the premium paid for an acquisition above the true market value vanishes too. That typically leads to further writedowns and further reported losses.

In that instance, how willing would bond investors be to receive a yield of just 3.04%? Especially if interest rates in general are on the up?

A bad omen

That’s right folks. As we said at the top, the market is soaring on the prospect of more rate rises by the US Federal Reserve. Again, from Bloomberg:

Asian stocks rebounded from a seven-week low, joining a rally in U.S. and European shares as a surge in U.S. home sales fuelled speculation the world’s largest economy can withstand higher interest rates.


If anyone should have learned anything at all from the past 10 years, it’s that we shouldn’t use home buying patterns as a reason to believe borrowers can cope with higher interest rates.

We’re fairly certain that 100% of US subprime borrowers prior to 2008 believed they could ‘withstand higher interest rates.

Either that, or they believed they could easily sell their home and pay off the debt anyway.

Turns out (as you’re well aware) that’s not quite how things turned out. So, if a surge in home sales is the main reason for the global stock rally, we’re quite happy to retain our limited exposure to stocks, and our big exposure to cash and gold.

We’ll pass, thanks

One more from Bloomberg:

Bayer AG, whose $62 billion takeover bid was rejected earlier by Monsanto Co., said it’s confident it can overcome the seed company’s concerns about the regulatory and financing risks related to a deal that would create the world’s largest supplier of seeds and crop chemicals.

[Double sigh]

The market certainly liked the news. Not only did the Monsanto Co [NYSE:MON] stock price rise to US$109.20, close to the US$122 bid price, but the Bayer AG [XET:BAYN] stock price gained too.

It seems in this market, everyone’s a winner — even the company that plans to raise debt to the value of 60% of its market capitalisation.

It looks like it’s drinks all round to this market, and the bulls are buying.

As tempting as it may be, we’ll stay teetotal!