Tim Farrelly is an asset allocation specialist who provides asset allocation advice to the Australian Unity Pro-D funds. These are diversified investment products which aim to generate positive long-term inflation-relative returns for investors. Tim has been providing asset allocation advice to Australian Unity since 2006.
Tim has shared his views below on why this is a time to be fully invested.
It’s a time to be fully invested
I strongly believe that there are times to be fully invested and times when it pays to be substantially underweight in growth assets. Based on our valuation indicators, I believe investors should be fully invested today. In contrast, 2007, prior to the Global Financial Crisis was one time when our valuation indicators were strongly suggesting that growth assets were significantly overpriced and that an underweight position was recommended. *
Valuations guide the way
Our valuation methodology estimates long-term returns from growth assets and compares them with returns available from risk free assets such as secure government bonds. When expected returns on a growth asset class are less than risk free assets (no risk premium) we assess them as ‘Overpriced’ and prefer not to own the asset; by contrast, when expected returns are more than 5% higher than risk free assets, we assess them as ‘Cheap’.
This methodology is based on expected income and long-term growth to produce 10-year return forecasts for different asset classes such as Australian and International equities and commercial property investments such as Listed Property.
These forecasts vary based on the price we have to pay for different assets – the more we pay for an asset today, the lower are our expected future returns (the current dividend yield is lower, as are expected future price gains).
What does an ‘expensive’ market look like?
The chart below shows the status of various markets in December 2007, just prior to the Global Financial Crisis. The red zone indicates a market that is in Overpriced territory, with the green section being Cheap. At times like December 2007, when there is little or no reward for taking on investment risk, it makes sense to have low exposure to growth assets.
Source: (c)2007 Farrelly’s Research and Management Pty Ltd
The valuation methodology did not predict the GFC, but it did highlight that share and property markets were expensive, and likely to disappoint relative to risk-free investments in the ensuing period.
Our valuation methodology suggests that, today, most assets are cheap
In contrast to the Global Financial Crisis, as we entered 2020 the valuation methodology viewed most growth assets as ‘fair value’ or ‘cheap’. Dividend yields were well above risk-free bond yields and price/earnings multiples were a little higher than long-term averages, but broadly appropriate given the low returns on offer from risk-free assets.
The recent heavy falls in most asset markets have made most assets much more attractive to investors – notwithstanding the current fears and uncertainty surrounding the long-term impact of COVID-19.
In times of extreme uncertainty scenario analysis provides clarity
None of us have a good understanding of how the COVID-19 crisis will play out other than that, at best, the world is potentially facing a deeper recession than any time since the 1930s. The uncertainty relates to the breadth of the recession rather than the depth. If the world is broadly back to work by early 2021 it implies very different economic outcomes than if the medical crisis triggers an economic crisis that persists for years. However, both are real possibilities.
To get clarity at such times we can prepare different scenarios and estimate how returns might pan out in either scenario. Our model looks at likely dividend income and how fast profits and rents might grow. We also estimate how much investors may be prepared to pay for a dollar of earnings or rent in 2030. (This last item is surprisingly stable in the long-term, and surprisingly unstable in the short-term. It is why we focus on long-term outcomes; they are much easier to forecast.)
The table below shows our forecast for a deep but short-lived ‘V shaped’ recession scenario and in the much worse doomsday scenario.
Table 2: Expected 10 year returns from different asset classes
Source: April 2020, Farrelly’s Research and Management Pty Ltd
In both scenarios returns from growth assets are well above those we expect from risk free assets – hence we believe it is time to be fully invested.
The markets will remain volatile for some time
Until the current COVID-19 crisis is resolved, we expect that markets will remain volatile – or, to be more accurate, unpredictable. There are three ways of trying to deal with this volatility – be cautious; to attempt to trade the ups and downs; or to take a long-term view.
Being cautious, reducing the risk that you are exposed to, sounds like a good idea in theory. In practice, waiting until markets have stabilised normally means selling growth assets today and waiting to buy back at the (likely much higher) prices that will prevail when the crisis has passed. In my experience, this approach normally produces poor long-term results.
Trading the up and downs of a market that is essentially unpredictable will, by definition, probably also produce poor results.
Taking a long-term view and riding out the bumps is, superficially, the least attractive of the three. However, while uncomfortable, it is also the approach likely to produce the best long-term results. Volatility and discomfort are often a necessary price to pay to achieve those better results.
Blind faith is not a strategy
We all know that, historically, growth assets such as equities have tended to outperform cash in the long-term. However, to assume that this will always be the case requires blind faith. The facts are that equities tend to outperform cash which is very different to always outperforming cash. Japanese sharemarket investors who lost significant capital between 1990 and 2009 know this only too well.
Furthermore, I believe that many of the factors that lead to long-term equity underperformance are predictable. It is why we carefully monitor valuations and why our scenario analysis is so important. We need to do this analysis because we do not have blind faith in equities. This analysis is what gives us the confidence to be fully invested in a time of such high uncertainty.