Bearing Up: By Scott Francis

Gerard Minack has done such a thorough job in painting a picture of how that scenario will pan out - providing information on interest rates, real (after inflation) economic growth, currency movements and unemployment - that as investors we can start to think through what our response to the situation might be. The real benefit is that if such a situation were to pan out it might provide the greatest opportunity to invest in shares in our lifetime - and thinking ahead might give us the courage to take advantage of that opportunity in an environment where, if it eventuates, markets will have fallen by 50 per cent from their highs in 2007 and the dominant emotion on the markets would have to be fear and despair. However, as one of the world's great investors Warren Buffett says, we should be fearful when others are greedy, and only be greedy when others are fearful.

If the ASX200 fell to a level of 3500 in 2010, perhaps even Gerard Minack (who by now would be a celebrity market forecaster well known for his 3500 2010 forecast) might be a bull going forward?

Three Reasons Why I think that it is an Unlikely Forecast

Reason 1 - A three in a hundred chance.

A further 30 per cent fall in the ASX200 to 3500 points from its current level of around 5000 is a statistically unlikely event. Let us simplify what is needed to get to the 3500 level in 2010 -15 per cent returns in each of the next two years.

For all annual sharemarket returns since the start of July 1970 to now (38 years of data) the average annual return has been 13.01 per cent a year. However we are interested in looking at two-year returns. I calculated the simple average of each two-year return starting July 1970, then July 1971, then July 1972 through to the two years starting July 2006. For this period we have 37 lots of two-year returns, with the simple average return being 27.5 per cent a year*. The standard deviation of returns, which measures the spread of returns, is 36 per cent. If we make the common assumption that sharemarket returns have a specific sort of distribution - being a normal or bell shape distribution - we can calculate that the chance of having a two-year negative return of -30 per cent or worse is a 3 per cent, or three in a hundred chance.

Reason 2 - The failure of forecasting

The argument could be made that the sharemarket is not like a game of keno, where numbers are randomly generated. The market reacts to economic conditions, and so a forecaster may be able to forecast what is going to happen in advance. There is, however, little evidence to support the effectiveness of forecasters as a group.

A recent Eureka Report article looked at the forecasting efforts of T Boone Pickens, the legendary Texan oil baron who is one of the most famous investors in the US. He missed his forecasts for the oil price by nearly 100 per cent in a short time period.

My favourite "failed forecast" is from 1979, and the well regarded Business Week publication in the USA. The cover story announced "The Death of Equities". The magazine went on to argue that this "death of equities can no longer be seen as something a stock market rally - however strong - will check. Only the elderly who have not understood the changes in the nation's financial markets, or who are unable to adjust to them, are sticking with stocks". Of course we know what came next - an extraordinary bull market in US equities.

Reason 3 - The Market is a Pretty Good Forecast

The market itself is a sophisticated forecasting mechanism. The full range of market participants - fund managers, financial institutions, stockbrokers, private wealth funds and individuals look at the market on a stock by stock basis, and decide whether it is in their best interest to buy, sell or short sell any individual stock. Their decision depends on their assessment of their company given both the broader economic outlook and the outlook for the individual company. There is exactly the same number of shares bought as are sold every day - and both buyers and sellers are equally convinced that they are making a profitable decision. Of course this "forecasting" process is not perfect - as expectations change because of $US140 per barrel oil, the credit crunch and rising inflation - Australian markets fell sharply in recent weeks to reflect these changed expectations.

Therefore a 30 per cent fall in equity values in the next two years would mean that there are significant and relatively grave economic factors in play that, for some reason, the collected wisdom of market participants has not yet been factored in.

Before looking at specific recommendations for how we might react in 2010 if markets did get to the level of 3500, the key benefit in considering this now is to think about what the emotion would be like at the time. Markets would almost certainly be gripped with pessimism and fear, and it would be difficult for people to react in a rational way. Thinking about the scenario ahead of time might provide a cooler head in the unlikely event that we ever find ourselves there.

3,500 in 2010 Key Assumptions

The key assumptions used in the "The Bear View" are:
GDP growth slows but remains positive in ?after inflation' terms.
Australian company earnings miss the 20 per cent analyst expectations for the next two-year period. I will take what I think is a pessimistic stance and assume that company earnings actually have 0 per cent growth over this period (ie stay flat).
Interest rates to come down by more than 150 basis points. I will assume that they come down by 150 basis points.
There is a fall in the Australian Dollar.

The Opportunity - For People Still Accumulating Wealth

For people still working and accumulating wealth this will provide a unique opportunity to invest in companies with a high level of earnings compared to their price. It will be hard for those people to witness their share holdings - whether held directly or through superannuation - fall by a further 30 per cent, however the opportunity to invest in shares with such strong earnings would be extraordinary.

Currently shares are offering a dividend yield of 4.47 per cent (according to the RBA website - other data I have read suggests even higher yields, which will only make the scenario more attractive). A further 30 per cent drop in sharemarket value will see this income increase to 5.8 per cent, plus franking credits valued at another 2 per cent (assuming an average franking level of 80 per cent). This is based on company earnings not growing all in the next two years, and the dividend payout ratio's for companies staying constant.

Gerard Minack's forecast suggests a fall in interest rates of at least 1.5 per cent, meaning borrowing rates will fall from about 9 per cent to 7.5 per cent. I am generally very cautious about borrowing to invest, however if interest rates were around 7.5 per cent and shares were earning (grossed up dividend yields) income around 7.8 per cent, the opportunity to borrow to invest and create wealth would be extraordinary - with the chance to borrow and invest in shares, in a "cash flow" positive way (albeit after the benefits of the tax offset/refund from franking credits are included).

The following table sets out the cash flows from a $100,000 positively geared Australian share portfolio:

The opportunity - for people who are retired

Though there will always be fear for 'the retired' when equity markets drop substantially, the truth is that for people in retirement, a key opportunity will be that shares will now be paying a gross income of 7.8 per cent. This will be higher than the return they will be getting for their cash and fixed interest investments, probably paying around 6.5 per cent after the 1.5 per cent cuts in interest rates. So there will be an outstanding opportunity to use some of the cash and fixed interest investments to invest in shares and property investments that are immediately paying a higher rate of income.

Not only would the income from the listed property and share investments immediately be higher, they both pay income that tends to increase over time, with sharemarket income having the attractive quality that it tends to increase over time at a rate greater than the rate of inflation. The Australian sharemarket reaching a level of 3500 in 2010 would be an opportunity that retirees, with modest levels of cash and fixed interest, will be able to take advantage of to set up their income needs.

The fall in the Australian dollar

It has been a long time since Australian investors who hold international investments have been rewarded. Global market returns over the last nine years have been less than spectacular, and with the Australian currency nearly doubling in value over this time it has been a generally poor time for Australian investors holding overseas investments.

A fall in the Australian dollar, as predicted in part of "The Bear View" 2010 scenario, will reward those investors who have stuck with using some unhedged global diversification in their portfolios.

In the end it's no fun to think about the possibility of a fall in the ASX 200 to 3500 over the next couple of years. There are good reasons to think that it is an unlikely event - although one that is within the realms of possibility.

However there is absolutely no harm in thinking through such a scenario. How would you react? Is your portfolio positioned to cope? Is this an opportunity that you would have the courage to take advantage of?

My thinking is very much that if you can survive the worse case scenario, then anything better than that is just a bonus.