Is the share market at risk of de-risking?

Welcome To Finance and Fury. Is the market at risk of de-risking? Bit of a mouthful – but over the past 12 months the share markets has been going on a run with higher flows of capital going to higher risk shares over those that could be considered defensive shares – those with lower historical risks due to the backing of fundamentals, such are earnings

In this episode – we look at the cycles of share markets – looking at the longer-term trends of periods of risk taking and periods of risk avoidance – in which prices of different segments of shares can move independently from the overall index price movement – index may be going up but segments of the market can decline in prices

As previously mentioned, certain sectors of the market have performed very well over the past 12 months – Tech sectors, financials, commodities and other highly leveraged share sectors have performed well - This has seen segments of the market start to underperform the index in Australia – as a massive chunk of the ASX is made up of the banks and commodity companies – in the US, the upper end of the index is tech companies and financials

In Australia - Under performance has occurred in the historically lower risk segments of the ASX – communication services, industrials, utilities, Health Care, even Gold mining companies – whilst these companies are all incorporated in the ASX index, it means that other companies have outperformed by a larger margin If the index is 50/50 split between lower risk and higher risks segments, and the index has performed 20% over the past 12 months – in reality any combination of returns could have occurred to get this aggregate outcome – however – let’s say that higher risk shares have provided a 40% return, whilst the lower risk segment have provided 0% returns – then this means the index would have performed by 20% over this timeframe – in hindsight, where would you have wanted to be invested? The lower risk shares, the index, or the higher risk segments of the market? Obviously, the high-risk segment But what about looking forward? Can these higher risk share categories constantly outperform?

Markets have cycles – ups and downs – the nature of market volatility –

But these ups and downs of the market are viewed as an aggregate of all shares in all sectors when viewed as an index – but what makes up the index? Thousands of individual shares When separating out the underperforming companies to the over performing companies, the ASX has had an incredible return – especially over the past 18 months Growth/Risk companies have returned 70% over 18 months Value shares have returned only 8% over this same time period – this by itself is a below average return, but when compared to growth companies, it is a significant underperformance The prices of shares is based upon the behaviours of the investors in the market – The price responds to inputs – the number of buyers and sellers in the market – which can be broken down further into economic human action which is actuated to what is anticipated Praxeology - is the theory of human action, based on the notion that humans engage in purposeful behaviour, as opposed to reflexive behaviour (like increasing saliva in your mouth when you see food and are hungry) and other unintentional behaviours (like slipping over on ice) People want to make as much money in markets as possible – so when economic dynamics are present – the market is anticipated to respond in a certain manner – therefore, people change their investment positions around this, and the price of these shares change – how much of this is a self-fulfilling prophecy is anyone’s guess – regardless, the historical numbers don’t lie When it comes to investing – whilst emotions can be the catalyst to your response, which may not be rational or in your best interest, people believe that they are responding with purposeful behaviours when investing – that is to make the most money possible – or to avoid losing money – even if the end result does not work out in this manner – i.e. you end up losing money – you still are acting in a purposeful manner – even though it may not be rational or work out for us in the long term - we have myopic risk aversion built into us epigenetically There is no such thing as perfection – a humans we will always get things wrong – but our behaviours to help avoid further losses in markets is to follow crowds – if everyone is selling and we aren’t is there something wrong with us? Do we not know something that they do? Our brains then think that obviously, they know more than us, then this means we also need to sell – which locks in potential losses in the portfolios This is the issue with human behaviours in the market – because the market is millions, if not hundreds of millions of investors participating in the selling and purchasing of securities which are publicly available to anyone So in the end the price of any share comes down to the sentiment of the market – supply and demand – When markets are hot, they are hot – when they are cold, they are cold – this cycle follows human responses to the inputs provided to the market – i.e. all publicly available information which translates into market sentiment

But this behaviour translates into both rational and irrational investment behaviours – when greed is prevalent in the market, fundamentals are thrown out the window – therefore risky companies do well – but when sentiment turns, then investors can have the realisation of their precarious positions – want to exist these and seek other unloved investment opportunities

Average cycle from 1955 for the S&P500 index – full cycle is around 70 months or just under 6 years – this is the average, some go for 50 months, some for 100 months The share market can be broken down into two share segments – PE expansion companies and EPS Growth companies Remember - When I talk about the market – I am talking about the millions of buyers and sellers that exist – who each are making their own decisions on whether to purchase a security or not

Phases of the market cycle – four phases, despair, hope, fundamental and optimism

Despair – this is the stage where the market sentiment is basically in despair - investors which make up the market are worried about losing money on their investments, so they are selling – this creates a situation where prices on listed securities decline – when you have an excess in supply of sales orders, the prices will decline – often quickly when not money people are willing to purchase in this period of despair – this cycle normally lasts around 13 months Drawdowns – historically the market has declined by 26% PE Expansion companies have declined by 23% and EPS focused companies declined by 3% So the brunt of the market decline has been due to Growth companies, with value companies seeing lower declines Hope – this is the next phase that the market enters into after the initial despair – that is hope that market returns will become positive once again – but there is little fundamental reasoning for this – lasts on average for around 11 months Therefore the shares that do the best in this period are those that investors are investing in our of hope – i.e. those that do not have much basis in regards to logical reasoning why people should be purchasing them As an example – let’s say that a company is expected to grow their earnings 20% p.a. for the next 10 years, this would sound like a great investment – but what if they are starting off at a point of a negative $200m of net earnings – then after costs they are expected to break even in 10 years’ time The price of this share going up massively in this period is an example of hope – the hope that the projections of this company become manifest – these is a chance they do not, there is a chance that they do, but investing in a company today that is losing money to see potentially bigger earnings growth in 10+ years is an example of hope – investing out of hope that a company will do well in the future even though it is losing money today – the issue with this is that anything can happen in the market – this company could be out competed and replaced by a competitor – or their costs go up, or revenue growth is now what was estimated – therefore, the investment into this is purely based on hopes of major returns in the future – The more people invest in their period, the greater the overall returns to companies will be – i.e. the more hope there is in the market that we are out of the worst, the better the overall returns because more investors are willing to sink their money into the share market PE expansion companies do really well in this period compared to the market returns – the market returns have been 32% - whilst the PE companies have been 42% - which means the fundamental companies are sitting at a negative 10% returns This creates a situation where if you were investing for fundamentals, you would have been sorely disappointed Fundamental – this is where the market starts to regain some sense of pricing and focus on what matters – earnings and underlying performance of companies Risk is attractive in periods of high hope – but the fundamentals begin to matter more when hope in the market has gone When market fundamentals matter and clearer heads prevail, then the focus on fundamentals become more prevalent in markets The market is still up in this period – at a total level of 34% - but Value companies account for a return of 54%, whilst growth companies are at a -14% This cycle of the market is the longest – at 32 months Optimism – when the market is getting into the late stage of the cycle – when the price gains of the fundamentals companies outstrip the reality, people think that the tough times are over, and that things are looking up for the future - In this cycle – the market tends to move by 25% and last for around 14 months The PE companies grow by 23% of this and the EPS companies grow by only 2% - fundamental companies no longer justify the prices based around their cashflows and the previously unloved PE companies are back in favour Optimism prevails for around a year – before the cycle repeats Then the despair kicks back in and PE companies crash whilst value companies decline as well, but not by the same extent – important to point out that these timeframe have been the average over the past 66 years, doesn’t meant that every cycle is the same – some may see much longer periods of despair, like in the GFC, or shorter periods such as at the start of 2020, where despair only lasted 3-4 months instead of 13 – But what is important is understanding the cycles – every cycles timeframe will be different – every returns for each segment will be different in absolute terms – but what will be the same is that when thing are in despair, value companies do better than growth, when hope is present, growth companies do better than value, when fundamentals are important, value companies do best and then in the final stage of optimism, growth companies do well again

Certain shares do well in certain cycles – In only two stage of the cycle do fundamentals do well – so 2/4, or 50/50 are fundamental shares outperforming - but it is for the longest period of time that they do so, which makes up around 64% of the cycle

Risk and High beta shares do well due to emotions in the market – not realities – they also suffer at the extreme ends – The largest downturn for fundamental companies is -10% during the hope period whilst the market is at an overall positive return – however growth companies lost 23% and 14% in the despair and fundamental period respectively, which underperform the index significantly Where does the market currently stand? It appears that we are still in the hope period – but we may be nearing the end of this stage in the cycle – This means we may be soon be entering into the fundamentals period – timelines are off – but the return comparisons in magnitudes and market cycles are still on point There was a despair period back in march and April of 2020 – hope soon took over, which has lasted for the last 12-18 months – now things are starting to calm down and due to economic realities like inflation and potential interest rate increases, fundamentals are now more in focus

When fundamentals become important – however, the timeline will likely be off this time – the growth companies may continue to shoot the lights out – but if the market starts to turn, the things to look out for

Value – Assess the expected cash flows and earnings, dividend payments Enterprise value and book value Intangible elements – management and brand Quality – prefer higher quality companies with proven business models (not start ups with no market share or proof of concept for their product) Resilient and financially robust – and have higher operating efficiency Sentiment - An improvement in the expectations Can this relate into higher expected flow through into better earnings and cash flow, dividends – leading to capital growth Risk – are they lower volatility Lower sensitivity to the market (measured by Beta) Or a purchase that allows additional portfolio diversification

Summary –

Whilst growth companies have outperformed value companies in two of these periods including the current one we are in, not only do value companies have a greater time period being positive, they also avoid the long term declining trends when markets have a downturn From here – there is a high chance that fundamentals, value companies will become in favour with the market What could drive the risk rally further from here is a lowering of the cash rate and a general optimism in markets that the economic reality doesn’t match – however this is totally possible – But at some point this trend of hope will fall flat – leaving the currently in vouge share susceptible to a decline

The risk rally can continue – but the better place to be in risky assets based around historical data is the non-hope assets – those that have earning backing them, and can provide some basic utility to society

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