October has thus far been one of the worst months for equity investors in the past few years. Lots of people have asked me how to invest in these times, here are my thoughts.
The market is on a rollercoaster. The tech-heavy NASDAQ is heading towards another week of declines, the S&P 500 has had more down-days than up-days this month. The effect of the negative sentiment is even greater on the South African markets. The JSE All Share Index is down from a high of 61 684 points to a current low of 50 877 points. That is very close to bear market territory. Yet the base case seems to be that this is still a correction in a bull run, rather than the start of a bear market. Everybody points to the strength of the US economy, a feature that president Trump takes full credit for. I don’t agree. I would be very cautious. In the fund I manage, I have been selling equity in June and early September. I have never had this much cash.
There are a few reasons for my pessimistic view on the future short-term prospects of the share market. Many originate in the USA .
We have had almost a ten-year bull run since the end of the great recession of 2008. The recovery from the second most severe downturn in the last 100 years has been shallow, but because of that, it lasted very long. Companies now record record profits, mostly aided by un-natural low interest rates. Since Trump was elected president of America, the economic growth accelerated even more, topping 4% on an annualized basis. The unemployment rate is at a very low level,. The share price valuations reflected such optimism. Not since the dot.com bubble, when valuation of a business plan written on a napkin was worth U$100 million, has the Shiller’s P/E ratio reach such lofty levels.
The problem though is that the last spurt of growth was caused mainly by the Tax cuts imposed by Trump. I am not against the Tax cuts, but using it now leaves the president with one less tool should the economy slow down. You would want to have some powder dry, because open economies do have natural cycles.
Then come the tariffs. The first salvo was aimed at almost all aluminum and steel producers outside of the US, friend or foe. The problems are twofold. The first is that if the biggest consumer imposes tariffs, other big consumers of the metals need to follow suit or fear of getting the surplus glut dumped onto their market. The marginal cost of finished steel and aluminum are the transport and storage costs. The second issue with tariffs on steel and aluminum is that they are also mostly input costs for other goods such as cars or buildings. The knock-on effect on prices is far greater than tariffs on finished products. US producers would have also increased their prices to reach import parity and as such, almost everything – from cars to houses to beer cans get more expensive, and somebody will have to pay for it. Initially the producers would absorb some of the costs, lowering their profit margins. But eventually the consumer will need to pay more for their goods.
In an effort to “make the USA great again”, president Trump started a trade war with China. His reasons are debatable, but the economic impact is underestimated. Gone are the days where the Chinese only imports were cheap cloths and plastic goods. These days, much of the imports are sophisticated electric and mechanical machinery, often used in the production of other goods. Thus this supply chain is very difficult to replace overnight, let alone get American companies to take over the slack. Therefore, all that would happen is that in the short-term consumer prices will increase. And as anybody who has done economics 101, if prices increase, quantity demanded decreases. One can see it already in for example the new home sales or vehicles sales, both of which are significantly off their highs.
Because of the reasons mentioned above, demand for goods will decrease as prices rise. Therefore companies will not reap in as much profit as they have before. Profit growth will certainly slow. The share prices in September did not reflect that.
They are more reasonable now, but I do think that we have more to go before we reach a bottom. There are two main reasons for it. Firstly, markets always over and under shoot. Secondly, we have recently seen a few times markets that closed lower a couple days in a row, followed by a massive up day. The rallies tended to fade, and the next day Asia opened weaker again. That shows clearly that there is no more the glut of money waiting on the side just waiting to enter the market.
So why does that affect us? Simply put: If America sneezes, the rest of the world catches a cold. Since they are by far the biggest market, they will have an influence over the direction of the JSE. The tricky part is how to position yourself as an equity investor, because if history is a lesson, the Rand US Dollar exchange rate will weaken.
I took a dim view on South Africa, because we have structural problems that need to be addressed before we grow at 4%+. Thus I am underweight SA focused companies. Most of the selling I did recently were such companies that mainly serve SA. That portion is now held in cash. As before, I am overweight defensive Rand hedges such as BAT. Yes in general their shares would also go down in a bear market, but since I expect the exchange rate to weaken, it would absorb some of the losses and protect the value of the investment.
(please note that this is from a South African standpoint, it differs depending on where you live. Always consult with your own investment professional before you make any investment decisions)