Where to next for the share market – the positive ( “Bull”)  case

Those predicting higher stock prices believe that very low-interest rates are likely to persist for years and this justifies much higher share valuations than have historically been normal. They believe low interest rates will stimulate economic growth and help to make equities more attractive than low-yielding defensive assets, like cash and bonds.

The bulls are also optimistic that the unprecedented effort to develop a vaccine for Covid-19 will soon be successful and this will boost confidence and lead to corporate earnings resuming their strong upward trajectory that prevailed post the GFC and up until the end of 2019.

Where to next for the share market – the negative (“Bear”) case

The bears believe that the share market is already expensive (high prices relative to earnings) and that It is hard to get excited about the equity market, already close to all-time highs, given the global recession. This is why the bond market is painting a grim picture of the economic outlook; the US and Australian bond yield are at record lows.

The bears are concerned that no effective vaccine for Covid-19 is likely to be widely available for at least another year, and possibly much longer, and this will mean many borders will remain closed, globalisation and trade will be in retreat, and heavily indebted governments will struggle to pull the world out of a harsh recession. They note that new cases of Covid-19 are not slowing down and that no country is even close to achieving herd immunity.

The bears are also concerned about the negative impact of the escalating tensions between the US and China.

My view on where next for the share market

There are currently so many uncertainties in the world, in particular the future path of Covid-19, that I have little confidence in making any predictions. But, on balance, I believe the risk-reward ratio is not very favourable for riskier assets.

There can be no economic recovery until an effective vaccine can be widely deployed. Most people in developed economies, like Australia, work in the service sector, rather than manufacturing, mining or agriculture and there can be no lasting recovery until a vaccine that people have confidence in can be widely deployed. However, with interest rates so low there remains a strong case  to “hedge your bets” by retaining at least some exposure to higher-yielding assets like shares.

Gold is running hot

Gold has jumped to over US$2,000 per ounce recently, believed to be an all-time record high price in AUD. Bullion’s rapid move higher comes as the US dollar slides against major currencies amid negative real rates in the US and concerns about the huge size of the US Federal Reserve’s stimulus program. Investors are buying physical gold, gold mining companies and exchange traded funds (ETFs) that own gold or gold mining companies.

Many are predicting further gold price increases for reasons, such as:

  • Low interest rates globally e.g., the US 10-yr bond rate recently fell to 0.55%, the lowest level in history.
  • US real rates have fallen to around negative 1.0%, below the previous post-GFC Sep 2011 cycle low.
  • Budget deficits are rising hugely all over the world as governments seek to offset the coronavirus induced downturn.
  • Central bank stimulus has seen global liquidity expand rapidly – over 20% year to date.

The case against gold rising further includes such arguments as:

  • Most gold ever produced still exists (unlike other commodities such as oil or iron ore).
  • There is no return on gold (no interest or dividend).
  • The high price will lead to increased production.
  • It is just another speculative bubble.

How dominant are the big  5 US Tech companies? Very!

The FAAMG group (Facebook, Apple, Amazon, Microsoft, Google) are benefiting from the changes being wrought by coronavirus and nowhere more than on the stock market; these 5 businesses now make up 21.7% of the S&P 500.

Collectively their market capitalisation has increased by 50% over the past year which is extraordinary for such large companies. Investors seem to be assuming that some of the behavioural changes accelerated by coronavirus, such as online shopping and working from home, will be permanent and these companies will continue to dominate.

More broadly, the Tech and E-commerce sector has accounted for 78% of the total US share market gains for the past 5 years. Many of these companies pay no dividends but that hasn’t deterred investors.

Tightening Bank Credit Standards

As might be expected in a recession and, given the uncertain economic outlook, banks are tightening lending standards so it is becoming more difficult for borrowers to obtain new loans.

This is happening to both individuals and businesses in Australia despite cheap funding – very low deposit rates – and ready access to liquidity for banks. Banks tend to be pro-cyclical – it’s much easier to get a loan in good times than in challenging circumstances such as we face today.

The same thing is happening in other countries and even people and businesses with sound credit scores and repayment records are seeing unused credit facilities reduced or cancelled. These tighter lending standards will likely be somewhat of a headwind for the property and small business sectors.

The good times for Bank investors ended some time ago

Many Australians have put their faith in the big four banks, which provided strong and growing dividend income and capital gains for many years after the 1990/91 recession, with only a temporary interruption during the global financial crisis.

However, the strong performance ended some years ago and looks unlikely to resume soon given the weak economic environment. Low credit growth, rising bad debts, increased capital requirements and a narrowing gap between lending and deposit rates make for a challenging business environment.

In June 2015 the big four banks accounted for 25% of the ASX 200. They now account for 13.4%, almost halving their share of the index.

If you strip the big for banks (CBA, Westpac, NAB and ANZ) out of the ASX 200, the ASX 200 index would be up 153% since March 2016. The big four banks are down nearly 21% over that period so the ASX 200 is, in fact, only up by 35.9%. This is a dramatic example of the danger of a simple “buy and hold” approach to investing, particularly when it is narrowly focused on a limited range of companies and one sector.

This newsletter contains general advice. It does not take into account your individual objectives, financial situation or needs. You should consider talking to a financial adviser before making a financial decision.

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