Rudi's View | Jan 25 2012
FNArena has a legacy stretching many years of operating ahead of the curve when analysing financial markets, the Australian share market in particular. Last year we guided investors towards industrials with sustainable dividends when virtually nobody else was on our side. Our commitment for 2012 is to continue to build on all the good things we achieved in the past.
By Rudi Filapek-Vandyck, Editor FNArena
In hindsight, one of the better analyses I wrote in years past dates from mid-2008, when I calculated how four years of above average investment returns followed by a sharp sell-off in the first half of 2008 had affected the long term average return for the Australian share market. As it turned out, my calculations suggested four years of 20%-plus returns still hadn't been compensated for, suggesting more sell-offs were needed.
At the time I wrote "I hope I am wrong in this conclusion". It turned out I was correct. A few weeks later global equities commenced another leg down, which (finally) pushed the longer term performance for the share market below averages experienced over past decades.
As many an experienced statistician will ensure us, in the absence of irreversible, structural changes in trends or fundamentals, many things tend to revert to the mean, given enough time. This principle becomes especially important when making predictions about the future of financial assets. As such I was curious what the calculations would look like more than 3.5 years after my previous assessment.
The principle of reversion to the mean is more engrained in our financial thinking than we probably realise. A few positively biased market commentators have pointed out in recent weeks the Australian share market very seldom experiences a negative performance two years in a row, with history showing no precedents for doing it in three consecutive years. While this is true, where these commentators' suggestion is wrong is that Australian shares did not experience a negative year in 2010. Including dividends the end result for that year was a small positive 2%.
Regardless, history contains far more years of positive than negative performances, so equities are more likely to post a gain each year, irrespective of what happened the previous year. And it would appear, especially in turbulent times such as the thirties and the seventies, that big swings either way are more likely to be followed by a swing in the opposite direction. On this basis, a bit spurious I know, we might draw the conclusion the odds for 2012 are skewed towards a positive net result by year-end.
It is not difficult to see how this motivates investors to start each year again with positive expectations. History shows this is more often correct than not. This also provides the most logical explanation for the so-called January effect. I don't believe there's any predictive value in how equity markets start the new year, and experiences in recent years have shown exactly that. What is a fact is most calendar years take off on a positive note. Combine this with the fact that more years end with a positive result and it is but inevitable there will always be a high correlation between the two.
I think investors are better off focusing on when December and/or January don't deliver a positive result, as happened in 2008. Since this doesn't apply this year, let's move on to more interesting statistics.
While equity market results for individual years can vary significantly, as we've all experienced over the past four years, it remains remarkable that calculations over longer periods show average returns combining capital gains plus dividends have a tendency to oscillate around 9-10%. Sometimes the market experiences a period of positive excess, for example between January 2001 and December 2007 the average performance in Australia had climbed to 14.9%, well above 9-10%. By December 2008, however, the average when measured from January 2001 had fallen to 8.25%.
Things get a lot more interesting when we update our calculations for the following three years (until December 2011). The years 2009-2011 delivered us respectively a big bounce (+35%), a year of hardly any change (net), and a double digit negative performance in 2011. The impact on our longer term calculations appears to be positive in the short term, but negative farther out. The average performance for the Australian share market has fallen to 8.45% for the eleven years since 2001 (down from 10.3% for 2001-2010), but if we start in 1991 the average still stands at 11.50%. If we take 1985 as our starting point, the average still runs at 12.85%.
Note: 8.45% is well below 9-10% (positive short term), while 11.50% and 12.85% are both well above (negative longer term).
To complete the picture: over the past ten years (2002-2011) the average return calculates as 8.29%, confirming the short term bias is possibly to the upside.
Post GFC/Lehman Bros collapse, many market strategists have argued that from now on average returns for equities will be lower, closer to 8% per annum than the 9-10% experienced pre-2008. The above calculations going back to either the mid-eighties or early nineties seem to support such predictions as consistently lower returns in the years ahead (on average) will push the long term performance for Australian equities eventually below 10% again. In the short term, however, we are back where we were at the start of 2009, suggesting a positive bias for 2012.
Note that reversions to the mean can be long drawn out processes and the timing can only be accurately established in hindsight. The excesses between 2004-2007 were quickly offset in 2008, but none of the above guarantees that 2012 will compensate for disappointments in 2010 and 2011. What it does suggest, in my opinion, is the odds of a genuinely positive outbreak increase the longer the share market remains inside its trading range. Which is why I would argue that if 2012 turns out another year of disappointing range trading, the odds turn very much in favour of a big rally in 2013.
Another way of illustrating all of the above is by mapping out the periods of strength and weakness for Australian equities since the beginning of the century. As shown on the chart below, nothing moves perpetually in the same direction and one possible observation to make is that equities now appear in another uptrend since bottoming in September last year. Tempering this view is the observation that small moves like the one we experienced since September (8%) have been witnessed before, and they do not necessarily mean a change in overall trend is upon us (US equities have surged close to 20% since then, suggesting a positive scenario).
There are other reversions that can be added in support of equities, such as the fact that bonds have outperformed equities over the past thirty years. Historically this is a rare occurrence and one that suggests a turning point in (relative) favour of equities is near. Another one is the fact that forward Price-Earnings (PE) ratios for equities are now so low that further downside appears limited, unless we go through a similar experience as in 2008 when earnings estimates fell off a cliff. Note this is widely regarded unlikely, even by bearish market experts.
Other reversions suggest there will remain plenty of headwinds in front of us, in particular for the all-important US share market, including US corporate profit margins at all-time highs and the inverse relationship between wages and corporate profits. The latter brings home the reminder that politicians and investors better watch what they desire as an improving labour market will eventually pull down profit margins for those companies doing the hiring.
Other reversions that deserve investor attention: the relative valuation gap between defensive stocks and cyclicals had stretched to extreme levels by September last year. No surprise thus which stocks have outperformed this January. Also, historically the relative performance between US equities and gold appears to develop through 20 years of relative outperformance for equities, followed by a ten year catch up for gold. This year will be the tenth year the gold/equities ratio has reversed in favour of gold.
These and other reversions, including for individual stocks, will receive more detailed attention in the following weeks.
(This story was originally written on Monday, 23rd January 2012. It was published in the form of an email to paying subscribers that day).
Note: our tests have revealed the chart included might not show up if the email was received via gmail. We are at a loss as to why this is the case. Apologies, but nothing we can do at this stage.
Note 2: paying subscribers receive two e-booklets written by myself. If you haven't received your e-booklets, send us an email at info@fnarena.com
