Answering Your Questions

Monday, 11 May 2020
Melbourne, Australia
By Greg Canavan

Over the past few weeks you’ve sent in a number of questions about the markets. Today, I’ll answer some of those questions.

Firstly though, a quick comment on the market.

During the March panic, markets started to price in a pretty nasty economic outlook.

But now, particularly in the US, markets are pricing in…what? A rapid recovery?

Have a look at the leader in all this, the NASDAQ. After another rally on Friday, it is now UP 0.32% for the year.

The Insider

Source: Optuma

Unbelievable?

Maybe. But only if you think the market should conform to your beliefs.

The sooner you understand that the job of the market (in the short term, at least) is to inflict as much pain on as many people as possible, either monetarily, or psychologically, the better you’ll be able to roll with the punches.

My view, for what it’s worth, is that in the same way the market got too bearish in March, it is now moving back to overly bullish.

Sure, there are definite reasons to be bullish. The global economy is on its way to opening back up. But the short-lived slowdown has done an immense amount of damage. To think that we go back to normal within a few months is a low probability bet.

I’m tipping you’ll see profit-taking kick in pretty soon. My view is that you’ve seen the low, but the bull market isn’t about to resume anytime soon.

I’ll be back with more on this on Wednesday.

For more market analysis after your questions, don’t forget to read below for Pivot Trader Murray Dawes’ the ‘Week Ahead’ video. Murray will also show you how pivots keep him out of trouble.

***

The first question comes from Geoff. He asks about the ‘current rash of capital raisings and what they mean in the longer term’.

Large scale capital raisings (in size and in breadth) are often a sign of a market close to, if not at, a bottom. Most managers and boards are poor stewards of shareholder capital. They buy it back near the top and issue more near the low.

So from a short-term perspective, it’s often a positive sign that we’re in the midst of the storm. Longer term, there are two ways to look at things. From a positive perspective, companies that raise equity capital have stronger balance sheets (less debt relative to equity) and greater liquidity. They are therefore less likely to suffer distress.

But the flipside to this is that there are more shares on issue. This means metrics like earnings and dividends per share will suffer, as $1 of earnings are diluted by more shares being on issue.

If share issues are widespread, it can have an impact across the entire market. But in this case, the additional liquidity thrown at the market by central banks more than compensates for the increase in shares on issue. As a result, I don’t think the recent equity raisings will have a detrimental long-term impact.

The next question comes from Neil. He asks for my thoughts on how his kids, my kids and grandchildren will repay the huge amounts of debt we have just taken on. ‘I see death taxes coming back in, raising the GST 5% as a min, and changes to franking credits. What are your thoughts on this?

Put simply, I believe inflation will pay off the taxes. It won’t happen immediately. It could take years to play out. But rather than raise taxes and threaten an economic recovery, I believe the current government will go the other way. That is, it will reduce taxes on labour and capital, and cut regulation, to promote economic growth.

Then, the Reserve Bank will keep rates low, even after inflation picks up in the future. Real rates will remain negative for years, thus slowly reducing the nation’s real debt burden.

Which leads into the next question, from Adam:

Hi Greg,

I have been grappling with a concept – and would love to hear your thoughts.

Does a pro business/pro growth, (regulatory easing, faster approvals, less red tape etc) response to COVID related economic slow-down, risk increasing the speed of digital and robotic transformations? Which in turn may place greater pressure on un-employment (as we lose jobs that can be automated)? What could be the longer term economic consequences of this?

This is something we would have needed to deal with in the future anyway, but much more gradually, on an industry by industry or tech by tech basis

What could be the longer term economic consequences of accelerating this trend?

ASX:SOR’s automated security solution that Ryan talks of is a potential example of this.

It’s a great question, and could be a real problem in trying to create the inflation I spoke about above.

Of course, we have no idea whether the government will turn out to be pro-growth in terms of cutting regulations and red tape. But assuming the speed of digital and robotic transformation of the economy increases. What happens then?

Well, in general, it would be good for the economy as it would increase productivity and boost real GDP growth.

But it would also be deflationary, in that it should lead to lower costs. Productivity led deflation is good deflation. But our wise central banks don’t see it this way. Deflation is bad. Full stop. They will be perplexed by the lack of employment generated by a digital/robotic economy.

Interest rates will therefore stay low, no matter which way you look at it.

In theory, the long-term consequences of such a shift in the economy should be positive. But keep in mind digitisation has been around for a while now. If social media, Netflix and Amazon are the most prominent things to come from a digital economy so far, then I don’t want to get too excited about what the future might hold.

I received some good responses to my discussion of Buffett’s Berkshire Hathaway and valuation last week. Including this one, from Mark.

Mysterious calculations of Intrinsic Value, baffling brains all over the world.

Trying to apply these theories to this market will send you crazy.

Let’s keep it simple.

Fair point. And noted. I’ll keep it simple from now on. For those who are interested, I have a book coming out soon that has a chapter on valuation and how to calculate estimates of intrinsic value. So you can check it out there.

Speaking of simple, let’s hear from Mike…

Hi Greg

Always like your work. Re valuing a stock. PE (price-earnings) ratio doesn’t fully account for the debt a firm may hold. What do you think re EV/EBITDA ratio? I look for companies in the 4-6x range. Lower the better. 

Plus I only buy shares if I reckon the firm can grow earnings by at least 10%/annum. What measuring stick do you use?

I agree. The PE ratio has a number of limitations. However, I find it useful when used in combination with a company’s return on equity (ROE).

Usually, a company with a low PE (say, below 10) will also have really poor profitability. That is, its ROE will be low, say below 10%. Conversely, a high PE company (growth stock) will usually have strong profitability, measured by a high ROE (say above 20%).

I find that a combination of a below average PE and an above average ROE is a good indicator of value.

The EV/EBITDA ratio is also good, in that it accounts for a company’s debt levels. But if you limit yourself to a range of four–six, you could miss out on some stocks that have excellent growth potential.

As far as growth measuring sticks go, I don’t use any. I use valuation analysis and charts. That’s it.

There were a few more great questions, but I don’t want this letter to blow out. I’ll get to them next week. If you have a question, or want me (or one of the other editors) to cover a particular topic, send me an email to letters@portphillipinsider.com.au.

Oh, before I forget, there is one more thing.

We had a good number of emails from you saying you’re enjoying the conversations Woody is having with our editors. That’s great and we’ll keep them coming. Hopefully going forward we’ll be able to bring a few outside experts into the conversation at some point, too.

A couple of you (here’s looking at you Kerryn and Jan) also pointed out that Woody forgot to provide a link to the ‘two for one’ offer we’re making on Exponential Stock Investor and Secret Crypto Network in honour of the ‘Bitcoin Halvening’ event, which takes place sometime on Wednesday.

Apologies for that. To access that offer, simply click here.

And if you haven’t yet watched Friday’s zoom conference call with Woody, Sam, Ryan and Lachy, watch that here.

Catch you on Wednesday.

Cheers,
Greg


Trust the Model
By Murray Dawes

 

[Click on the picture above to watch Murray explain how his trading model keeps him out of trouble. He also gives a detailed analysis of the S&P 500 futures and shows you why he thinks the next leg up in this rally could be short-lived.]

What a difference a week makes. In last week’s update, I was starting to get fired up thinking we were getting closer to a sustained sell-off.

But prices found buying support within the daily uptrend and have gone up ever since.

We saw a daily buy pivot confirmed on Tuesday last week in the E-mini S&P 500 futures and my daily momentum indicators are still pointing up. That was enough information for me to back off from looking for shorting opportunities.

Having a model to guide your actions doesn’t mean you have a crystal ball that tells you what’s coming next. But it can stop you from making dumb decisions.

By having a clear set of rules to follow before you are allowed to trade, you will save yourself from making many trades that don’t work out.

Learning to trust a model is difficult. When you have a strong view one way or the other you will always come up with some excuse why you should trade.

When your model disagrees with your view it is tempting to override the model and go with your gut instinct.

When you have had multiple losses from ignoring the model, you finally get to a point where you start to trust the model.

The more we listen to what the market is telling us rather than filtering market information through our biased views, the closer we get to consistently profitable trading.

Right now, the model is telling me that the daily and weekly trend is up, but the monthly trend is down.

I have mapped out the areas above the market where I expect to see strong selling pressure and I am cheering this rally on hoping prices get up there.

Then I will need to see confirmation that the selling pressure is actually there.

Once all of those boxes are ticked, I will be allowed to trade with defined risk and targets set out prior to trade entry.

Markets are so volatile that you will always get to a point where you feel out of control if you don’t have a strict code of conduct. Having a model that you trust ensures that you are proactive rather than reactive to market volatility.

I was getting fired up at the start of last week and was actively looking for shorting opportunities as the week wore on. Thankfully, the model took over the reins and told me to cool my jets and wait for a better opportunity, which I reckon isn’t that far away.

I think the next spike higher will meet stiff selling pressure, so I’m watching things closely. The model will tell me when I’m allowed to act.

Regards,

Murray Dawes,
Editor, Pivot Trader