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Sweet spot helping bull market rampage

Since the beginning of 2013, the real S&P500, which is adjusted for inflation, has risen by almost 200% and apart from two bouts of volatility in 2015/2016 and at the end of 2018, it’s been smooth north easterly sailing especially since 2016.

Global stocks began a significant march higher in February 2016. At the time, the global economy looked bleak but major economic ‘blocs’ were about to accelerate (relatively speaking of course) thanks to a dovish Federal Reserve and a massive Chinese domestic economic reflation attempt.

Difficult markets for value investors

That we have been in a bull market for the last six years cannot be contested, and that’s a difficult thing for a value investor to want (or need) to admit. What’s challenging is not that we want lower prices to be able to buy more safely. What is challenging is holding on to what we have even when prices exceed the valuation estimates based on our most optimistic assumptions.

When we now take a balanced look at global market, we see conditions similar to those that existed in 2016. A manufacturing slowdown, as measured by the world industrial production excluding the US, is underway. And the US indicator for new manufacturing orders, published by the Federal Bank of Dallas, has fallen 30% cent from its 2018 highs.

But despite these simple measures, the market is focused ahead. With the US Federal Reserve easing and China again reflating, investors are looking past the gloom and are factoring in an improvement in conditions. At some point in the future, the market might even become fearful of inflation emerging but right now it’s a trade truce between China and the US and a calming of Brexit uncertainties that has captured investors’ imagination.

On top of all of that we have a Federal Reserve confronting a suite of structural factors that should keep rates low. Low rates don’t render asset prices immune to sell-offs but they are of course supportive for all asset including equities.

The structural factors that suggest interest rates could remain low for a very long time and therefore support already stretched asset prices, include demographics and debt among others.

The much-longer-term outlook

Over the next eight decades to 2100, Planet Earth is forecast to see its population growth slow almost to a halt. More importantly perhaps, the proportion of the global population over the age of 65 will rise from 10% today to over 20% by 2100. A doubling of the proportion of people over 65 will have a significant influence on global growth as well as on government budgets.

We have seen in Japan when more people retire, productive capacity and economic output decline. Coincidentally, government healthcare and pension liabilities rise. Individually, and in combination, lower economic output and greater debt has a depressing effect on interest rates.

If an ageing population and increasing debt is a negative influence on interest rates, then the world may be in for an extended period of low rates. And the US Federal Reserve is in no rush to turn hawkish or tighten policy. Despite a continuing decline in unemployment, real wage gains remain muted.

In China, the economy is picking itself up from the mat after its trade war with a Trump-led USA. Understandably, Chinese shares were hit hard and are arguably ‘under-owned’. They now trade at about 11 times current earnings. If Chinese stocks are included, emerging market equities are likewise trading at just 12 times current earnings.

The question is whether these earnings are bottom-of-the-cycle. If they are and earnings rebound, Chinese shares could be a bargain. We note reports that Chinese credit creation has accelerated, and manufacturing is also recovering. Industrial profits could also be at the low point of this cycle.

If global growth continues, the equity risk premium (ERP) should also decline. A decline in ERP while the risk-free rate remains subdued, will raise equity valuations even if earnings don’t recover. But earnings may indeed recover as well. Under these conditions, stock market performances could exceed those of the year just completed.

Have central banks created a ‘sweet spot’?

It could be argued that, much as we can now see was the case in 2016, global markets could be in a bit of a purple patch - a sweet spot, if you like – where aggregate profit growth is beginning to recover, while inflation remains low and central banks remain accommodative with no warnings about a change of tack.

If the current combination of factors remains unchanged, then with the exception of a black swan event, that by definition is unpredictable, there is a strong reason to expect a continuation of the bull market with higher prices and expanding price/earnings ratios in 2020.


Roger Montgomery is Chairman and Chief Investment Officer at Montgomery Investment Management. This article is for general information only and does not consider the circumstances of any individual.


January 19, 2020

You are so right Jeremy ... (fair) value is reassuring, but its not market value.

January 16, 2020

Roger, there is a degree of dividend chasing by retirees. Given very low interest rates this will continue. Aussie market is also benefiting from home country bias.

Warren Bird
January 16, 2020

Ah, Roger, you're almost converted! You've almost said that there ARE fundamental reasons for low interest rates and it's not just an artificial construct of central banks, that they're operating in an environment that needs them to be accommodating. You're not far from the kingdom now!

January 16, 2020

What does it really mean for markets when Mr Montgomery is optimistic??

January 16, 2020

The big question for value investors must be whether they can bring themselves to invest in growth stories with high PEs. Amazon lost money for its first 16 years, and no value investor would touch Tesla which has doubled in price in a few months. Value investors may well think the market will run further but it's not in the stocks they want to buy, it's in the ones they hate.

Cameron Reilly
January 28, 2020

There are still plenty of opportunities for value investors who know where to look. Some fund managers get high returns by sticking to value stocks. The problem with growth stocks is knowing what to pay for them. It's not about "hate". It's about having a science behind investing that makes sense.


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