Do This Against Your Better Judgement

Monday, 14 December 2020
Wollongong, Australia
By Greg Canavan

[8 min read]

  • Turning into Turkey
  • Only an inflation breakout will bring out a secular bear
  • How a bull market unfolds
  • QE only just started in Australia
  • Hold tactical cash

Today’s Insider essay is a long one.

But I think it’s very important for you to think about as we head into 2021. It’s an essay I wrote last week for subscribers of Crisis & Opportunity. So let’s get into it.


It’s been a rubbish year.

Despite that, it’s still gone by pretty quickly. The older you get, the faster it goes I suppose, whether you’re having fun or not.

With this being the last investment issue for the year, I wanted to write less of a retrospective and more of a prospective piece. What’s been has been. As investors, it’s more important to focus on what’s coming.

What’s coming, to put it simply, is more of the same. If 2020 has shown us anything, it’s that governments and the assorted technocrats and bureaucrats that surround them will not stop in their efforts to ‘make our world better’ or try to fix every problem that surfaces.

As the author of The Great Reset, and head of the World Economic Forum, Klaus Schwab, is a good example of this. He writes:

A new world could emerge, the contours of which it is incumbent on us to reimagine and redraw.

What pompous nonsense. It is incumbent upon them to stop interfering and let people live how they want to live, with minimal government interference. But that is not what is going to happen. 

These people will use the fear of COVID to exert even greater control. From a financial market perspective, this means an even greater role for central banks and more and more government spending.

Insanely, they are trying to eliminate risk from markets. We know that is impossible. As the great Hyman Minsky once said, stability creates instability.

But these people are sociopaths. They ignore history and plough on with their own agenda regardless. 

This realisation has made me think about risk a lot lately. Where is the greatest risk as we head into 2021?

The answer may surprise you.

While there will no doubt be a lot of volatility to contend with in the stock market, you’re going to get left behind if you don’t participate.

If you’re holding lots of cash or waiting for markets to ‘get cheaper’, in my view, you’re going to be waiting a long time. And you’re potentially going to ‘lose’ a lot of money while you wait.

I want to be really clear here though.

I’m not all of a sudden telling you that the world is going to be a much better place in the years to come. It’s not. It’s going to be a world where deflationary pressures continue. This sluggish growth will keep central banks and governments in the game. Constantly meddling. Constantly trying to fix what they have irreparably broken.

As long as economies don’t slow too quickly, company earnings will hold up and stock markets around the world are unlikely to plunge.

And if they do, guess what will happen?

Exactly…they will meddle.

Turning into Turkey

All the while they will trash and abuse the value of your money, the denominator of all assets.

Let me give you an example.

Have a look at the Istanbul Stock Exchange. It’s at all-time highs after enjoying a long-term bull market. What a run!

Source: Optuma

[Click to open in a new window]

But wait…

Looks can be deceiving. Here’s the same exchange over the same time frame denominated in US dollars. Changing the denominator has transformed a secular bull market into a secular bear market.

Source: Optuma

[Click to open in a new window]

Clearly, Turkish investors are buying stocks to escape currency depreciation.

The point to note here is that the Turkish economy is hardly robust, there is a dictator at the helm, and the country has plenty of social problems. Yet the market (in the local currency) is on fire.

I’m not suggesting the Aussie economy, or currency, is at risk of going down Turkey’s path. We have a lot of problems, but we’re not Turkey.

This is just an extreme example to show you how a stock market can be a hedge against economic turmoil and government control.

The real losers in Turkey are those with lira sitting in the bank.

Don’t suffer the same long-term fate.

There will be winners and losers in 2021 and beyond. In my view, the losers will be those holding too much cash.

So don’t mistake holding cash for safety. Sure, hold small amounts for tactical purposes (to take advantage of sell-offs), but don’t sit there waiting for markets to fall to single-digit price-earnings ratios. It’s not going to happen.

Let me rephrase that. It will only happen if we get a consumer price inflation break out and government bonds yields soar into double digits.

Only an inflation breakout will bring out a secular bear

The old-timers talk about the Dow being on a PE of 5 at the bottom of the market in the early ‘80s. The other side of that coin is long-term Treasury bonds yielded around 15%! Today, they’re less than 1%!

Imagine a risk-free rate of 15%. Add 5% risk premium and you’re starting with a 20% discount rate to value stocks. Put another way, a stock with a 20% earnings yield trades on a PE of 5 times! (1/0.2).

So if you’re waiting for stocks to get that cheap again, you’re waiting for inflation to run rampant.

Given the path we’re on, I don’t doubt that rising consumer price inflation is in our future. I just think it will take a few more ‘crises’ to get there. Each crisis will give governments more power to meddle with your money. The end result will be an inflationary collapse.

But in my view, that’s a few years away, at least.

In the mean time, I think the world turns into a version of Turkey. But instead of denominating the value of, say, the S&P 500 in another fiat currency to get an idea of its real performance, you can denominate it in gold. That will show you the real destructive impact of government and central banking policies.

Obviously that means gold should be an indispensable part of your long-term portfolio. And as you know, I’ve been telling you to accumulate during this correction.

But it also means you should look to add shares of quality companies during corrections or when they are momentarily out of favour. In the scenario I see unfolding in the years ahead, capital will flow into these stocks to escape cash.

If you don’t take this warning seriously, as I said, you’re going to get left behind. You’ll be like the boiling frog, enjoying the warm, comforting embrace of the cash, only realising it’s killing you when it’s too late.

How a bull market unfolds

How are prices going to keep moving higher, I hear you ask?

It’s simple. It will happen via investors using a lower and lower discount rate to value stocks.

This year, as you know, I’ve been using a discount rate of 8% to find bargains in the market. But I’m already starting to notice many stocks trading on an implied rate of 6–7%.

If I’m right about the market ‘turning Turkey’, in a few years’ time, I wouldn’t be surprised to see stocks trade on an implicit discount rate of 3–4%.

How does that compare to where things are now?

Well, one way to judge market value is via the PE multiple. Inverting this multiple gives you the earnings yield, which we can use as a proxy for the discount rate. But keep in mind this is a simplistic method to use as a guide only. It’s not completely accurate.

Let’s have a look at the Aussie market…

As at 1 December, the ASX 200 traded on a forward PE of 18.6 times. That suggests an earnings yield/discount rate of around 5.4%. (1/18.6).

This is higher than the long-term average. But it reflects the fact that corporate Australia is still in an earnings recession. Companies are expected to grow earnings strongly in FY22 and FY23. So the above average PE reflects this expected growth.

So on FY23 forecasts, for example, the PE might only be around 15 times, which is around the historical average, and implies an earnings yield/discount rate of 6.6%. And given government bond yields (the risk free rate) are around 1%, it suggests the market is indeed good value.

Also, keep in mind investors’ mindsets are only just starting to shift from bearish to bullish. True, there’s been a lot of speculative activity at the smaller end of the market; it’s been bullish there for a while.

But I’m talking about the broader market. As sentiment swings to the bull side, and earnings increase, the implied discount rate will continue to fall. Over the next few years I think that could push stock prices higher than many people expect.

Again, don’t suffer from a failure of imagination and think this can’t happen.

Have a look at this long-term chart of the ASX 200. Since peaking in 2007, the capital value of Aussie stocks has gone nowhere. It broke through the old highs at the start of this year…but it was a false break and stocks got slammed due to the virus.

It might take the better part of next year for the market to build a foundation and enough energy to break through this barrier again. But when it does, I don’t think you’ll see stocks sell-off again. They’ll just keep going higher.

Source: Optuma

[Click to open in a new window]

Again. Turkey…

Where else do you put your money when central banks and governments are trashing it?

QE only just started in Australia

Speaking of central banks, the Reserve Bank of Australia joined the global quantitative easing party in October when it started buying government bonds for the first time.

Other central banks have been doing this for years. The US Federal Reserve started in November 2008 and continued until October 2014. Over this time frame, the S&P 500 soared around 165% (see chart below).

Now, as you know, I don’t believe QE = money printing. But it does encourage risk-taking behaviour because people actually believe it is money printing. It also adds liquidity to the financial system, which, thanks to bullish sentiment, flows through asset prices and pushes prices higher. It’s a cheap central bank conjuring trick, but it seems to work!

Source: Optuma

[Click to open in a new window]

When QE ended in October 2014 — six years after it started — the market continued pushing higher as the economy was in a decent state. But the were underlying problems. For example, the oil price collapsed in 2014 and China’s economy got into trouble in 2015.

The point is, QE will have unintended consequences. But, along with ongoing fiscal deficits, it will push investors into the stock market because there is, to use a cliché, no other alternative.

That’s not to say there won’t be lots of volatility and scary drawdowns to manage. These corrections will test your conviction (and mine too).

But go back and look at the chart of the Istanbul exchange again. There were a number of sharp drawdowns in its move to record highs.

But that’s just the reality of stock market investing. It always has been and always will be.

With QE only just getting started in Australia, it’s worth considering another argument for stocks, and not being left behind in cash. That is, the Aussie market is relatively cheap.

The chart below shows the ASX 200 relative to the S&P 500. The data goes back to 1992. As you can see, the ASX 200 is as cheap as it’s ever been.

Source: Optuma

[Click to open in a new window]

Nothing is certain, but the odds favour this chart moving in favour of the Aussie market in the years ahead. It’s just another reason to be bullish on Aussie stocks over cash.

Hold tactical cash

As mentioned earlier, I’m not saying you shouldn’t hold any cash. But I would do so for tactical purposes. Build it up during strong rallies and deploy it during sell-offs. Easier said than done, I know. But this is how you should be thinking.

In my view, the market is now extended in the short term. So you should probably consider taking some profits or reducing some positions that have rallied strongly, with a view to building cash to deploy during the next correction.

But remember, over the long term, your cash is trash.

Continue below for Murray Dawes’ ‘Week Ahead’ update. Today, Murray explains why his technical model is saying gold may have a lot further to fall.


[WATCH] Gold Looking Shaky

By Murray Dawes


[Click on the picture to see where Murray sees gold heading next and to also learn about a key aspect of his theory — the key bar.]

The technical set up in gold is pointing to the possibility of further downside.

It is a great example of the types of set ups I look for with a false break of a major level taking place.

After a strong rally over the last couple of years gold has finally met stiff selling pressure. The rise in US bond yields and the lowering of market stress due to the COVID vaccine being distributed won’t help gold’s cause either.

The false break of the 2011 high is a major event and despite the fact gold may end up heading a lot higher at some point, there is the risk the correction in gold could last longer and fall further than most expect.

In today’s ‘Week Ahead’ update I give you a detailed explanation of the current situation for gold and show you where gold could be headed based on my technical analysis model.

I also give you an early Christmas present by describing what key bars are and how I use them to find key points of support and resistance as a trend develops.


Murray Dawes Signature

Murray Dawes,
Editor, Pivot Trader