Roger Montgomery: Is this time different?

Perhaps the four most dangerous words in investing are ‘this time is different’.  While the circumstances, economic and financial conditions always change, the market’s reaction, and its ability to overestimate the short term, while underestimating the long term, never change.

I could regale you with the reasons for the market’s current malaise, pointing to the difference between the market’s expectations and the facts, and indeed, I will spend a short time ion those topics, however the vastly more important lesson will be the stable investment  framework you can employ to navigate whatever 2023 (and future years) throws at you.

We know the most valuable temperament for an investor is to patiently wait to be greedy when others are fearful, and patiently wait to be fearful when others are greedy.  

The issue however is avoiding infection when others are fearful, as they are at the time of writing.

As I write, equity markets are heading south.  Indeed, all the returns since November 2020 have been wiped out.   Perhaps controversially, this is a time for investors to rejoice rather than despair. Falling markets provide the chance to invest in quality businesses – often at knock-down prices. So, my suggestion, is to prepare for 2023 by making the market corrections your ally.  Remember, the lower the price you pay, the higher your return.

I have rarely seen sentiment this glum.  Amid worries about earnings growth, inflation and rising interest rates, Price to Earnings (PE) ratios, which are the pulse of stock market sentiment, are at levels seen only twice in the last two decades - during the Covid-19 sell-off, and prior to that, the Global Financial Crisis.  

In 2023 inflation is likely to remain the topic du jour. From time to time the market will be excited about inflation peaking or even the pace of decline.  That optimism however will be followed by periods of disappointment as investors again realise inflation is not falling to central bankers’ acceptable bands quickly enough.  The road to tolerable rates of inflation will be longer and rockier than typically impatient stock markets would like.  This is likely to produce volatility, and high-quality businesses will drop along with the garbage.  On those days it will be vital to take advantage of the despondency, because as sure as night follows day, the market will return to an enthusiastic disposition, eventually. In other words, investors should welcome these temporary periods of market malaise.  And temporary the current period of investor dejection will also be.

For the latter part of 2022 and for the first quarter of 2023 I am watching an important metric - the rate at which central banks shrink their balance sheets through the process of Quantitative Tapering.  While all eyes are currently focused on conventional monetary policy, and the speed and magnitude of interest rate increases, the outcome is largely known.  There is no ‘edge’ for investors in predicting rates will keep rising and remain higher for longer.  That scenario has already been articulated by central bankers.  

What is less understood, is the influence central banks have on equity markets through the tapering of their bond purchasing.  As central banks withdraw liquidity, the punchbowl, which fuelled the asset boom over the last two decades, is removed, and asset appreciation must unwind. For now, we can at least say the period of extraordinary prices being paid for profitless prosperity companies is over.

Moreover, while bear markets inevitably pause, history suggests they don’t end while Central Banks are still tightening. Keep this in mind.  An aggressive disposition is probably not warranted until rate rises have ended.  Markets will eventually boom again, and you must have already established your portfolio, but it is likely the market will need to be confident rate rises are done.  Currently, the simultaneous surge in two key assets – U.S. Dollars and U.S. Treasury Bonds – reflects a flight to safety.  Investors outside of equities are therefore, arguably, still fearful.  

The higher consequent volatility in bonds and currencies eventually finds its way to higher equity volatility. This in turn may lead to a second leg-down in the equity bear market.  

I don’t know how long it will last nor whether we even see lower prices caused by further compression in PE ratios, or declining earnings (the ‘E’ in PE) inspired by an economic recession, which is itself caused by vigorous central bank action to quell inflation.  

What I do know is two things; first, these periods deliver sometimes mouth-watering prices, and second, these periods don’t last.  The current bear market will be followed by a bull market.  If history is a guide, the bull market will produce new highs and great wealth for those who had the temperament to take advantage of the markets fear.

I remain of the view that inflation in the U.S. has peaked*. That’s a good thing, but it will take longer than the bulls expect to get inflation down to the Federal Reserve’s intended target of two per cent.

I believe early signs are confirming U.S. inflation has peaked . Store inventory levels are high, as are wholesale inventory levels. Days-to-deliver and backlog-of-orders have also peaked, suggesting the trend is in the right direction for the price of goods that had hitherto suffered from supply chain bottlenecks.

But the service sector makes up a large component of U.S. Core Inflation and salaries are, in turn, a large component of services prices. U.S. wage growth is at its highest level in decades suggesting the Fed is no-where near pausing rate increases. While the labour market remains tight, it’s simply premature for the market and investors to be excited about falling inflation.

The tight labour market will eventually resolve itself. First however, international flights need to be cheaper for workers to be able to afford to migrate, work, and alleviate the tightness so many companies are complaining about.

Therefore, when the market gets excited about inflation peaking, you should zip up your wallet and wait. The market will inevitably be disappointed again. And when the market slides on the disappointment, you should be sharpening your pencil ready to invest in the high-quality companies and funds you have had your eye on.

While the Fed raises rates there is risk the economy falters. Fed Chairman Jerome Powell warned the world to expect some pain. In any event, fiscal and monetary largesse has given way to restraint. This should dampen aggregate demand. And company earnings of course are a coincident with GDP, so as the economy slows you can expect the proportion of the companies reporting declining earnings to rise. Those companies should see more material share price falls. But they’re not the companies we are investing in.

We also know bull markets always follow bear markets. There will be a dawn. Remember Ben Graham’s urging to take advantage of Mr Market’s wallet rather than listen to his wisdom? You can read the Mr Market Allegory here when, in 2018, as the market then corrected, I wrote about making market corrections your ally.

The good news is that inflation is ever so gently easing. It is not contracting as fast as an impatient stock market would like, and there’s some concerns about the state of the economy, but that’s when opportunity abounds. And historically – at least since 1970 – when the economy is growing, even slightly, and disinflation is occurring (‘disinflation’ is consecutively lower rates of inflation) – growth stocks do well.

Be greedy when others are fearful and fearful when others are greedy, remember? It’s when sentiment is disappointed and glum that bargains abound.  And on that front, this time is not different.

*We care about U.S. inflation because that’s what drives the S&P500, which influences all other equity markets including our own S&P/ASX indices.

All prices and analysis at 30 September 2022.  This information was produced by Montgomery Investment Management Pty Limited (AFSL No. 354564). This material is intended to provide general advice only. It has been prepared without having regard to or taking into account any particular investor’s objectives, financial situation and/or needs. All investors should therefore consider the appropriateness of the advice, in light of their own objectives, financial situation and/or needs, before acting on the advice. This article does not reflect the views of WealthHub Securities Limited.