Yesterday, I asked a question about the future profitability of the big four banks. The sector kicks off its earnings season today. The ANZ Bank [ASX:ANZ] just reported a 23% jump in cash profit for the six months to 31 March. That’s a solid jump, but was just short of market expectations.
While recent interest rate rises by the banks will increase earnings in the short term (and will flow through in the second half of this year), the big question is, will higher rates dampen activity in the housing market and eventually lead to a slowdown in lending and earnings growth?
It’s an important question if you’re curious about whether the bull market will continue or not. The big four banks make up around 25% of the ASX 200 index. When they do well, ‘the market’ does well.
The banks are also a good barometer for the health of Australia’s heavily financialised economy. The household sector is one of the most indebted in the world. The banks hold that debt, and the interest payments flow through their profit and loss statements.
If households are taking on more debt, this increases a banks’ asset base. A higher asset base means greater interest repayments, which increases revenues. Assuming bad debt charges don’t rise, this means greater profits for the sector.
Pretty simple, right?
Yes, but the difficult question is what happens next? You might think that surely debt levels and house prices can’t keep going forever. And, therefore, bank earnings can’t keep increasing.
Or, if you’re a shareholder, you might think that the banks are financially strong, pay a healthy dividend, and will deliver solid long term results.
Either of these positions is fine to have. As long as you recognise them as opinions driven not by assessment of all the facts, but by your personal biases. If you see opinions for what they are, you’ll be quicker to recognise when you’re wrong, rather than holding stubbornly onto a position and losing money by doing so.
This is a really important point. If you want to be a successful investor, you have to recognise your own fallibility. You have to recognise that the world is an incredibly complex place, and your ability to correctly interpret it is not very good.
Despite the obvious inability of anyone, ever, to correctly and consistently predict the future, we are desperately willing to listen to anyone’s prognosis as long as it conforms to our own views.
How dumb is that?
Yet we keep doing it, and blame external factors for getting in the way of our predictions playing out.
To avoid this costly (and constant) human error, you need a strategy. My strategy is to check my biases off against share price charts. Charts contain a wealth of information, and if you know what to look for and how to read them properly, they can tell you if your biases are leading you into investment error.
Take the banks. Let’s look at the ASX 200 financials index, which is mostly made up of the big four banks. Here’s the chart…
Collectively, the banks are trading at their highest level in around two years. For the past six months, they have been moving away from their lows. This tells you the profit outlook is improving, and the market is no longer concerned about rising bad debts or falling profitability.
The market could be wrong, of course. But it’s a low probability play to bet against the wisdom of the market. The market only gets it badly wrong at major tops and major bottoms. And you can recognise these moments when there is a big increase in emotion. You’re not seeing that here.
So if you’re bearish on the banks — maybe because you think the housing market is about to implode — you need to reassess your views. It doesn’t mean you’re wrong forever, but just that you’re wrong now. And that’s all that really matters in investing. To make money, you have to be right at the right time.
And speaking of the housing market, it still looks strong. Building materials company CSR Ltd [ASX:CSR] just hit its highest share price level since early 2011. Check it out…
And last week I showed you a chart of property developer Lend Lease [ASX:LLC]. Its share price has been rising since July last year. It’s at a near two year high.
Capital doesn’t flow into these companies if conditions on the ground suggest a downturn is imminent. That’s why chart reading is so important. Charts are an illustration of capital flows. They show you where the money is flowing.
Sure, there is dumb money around, and you cannot blindly follow a chart…especially when it comes to smaller stocks with lower trading volumes. You have to take into account the fundamental factors that drive prices.
This makes reading the housing market tricky. Because huge household debt levels and sky high house prices make a good argument for thinking this can’t go on.
But with official interest rates at 1.5%, there is every reason to think it can and will go on. Nearly all asset bubbles only end with a tightening of credit. There’s been a minor tightening lately with banks raising rates selectively.
But the Reserve Bank has no intention of raising official rates yet. You’ll get another confirmation of that today when they announce their decision on rates at 2:30pm.
So the bottom line is, this bull market looks set to continue. You may think it’s crazy, but what you think doesn’t really matter. The sooner you understand this, the better investor you’ll be.
To make money, you have to run with the herd. It only pays to be deeply contrarian at major turning points. And they are few and far between.
My colleague Sam Volkering is at the head of this herd. He thinks the ASX is going to new highs. And while the banks should continue to do well, Sam sees the big opportunities at the smaller end of the market. You can check out Sam’s latest presentation here.
In the meantime, enjoy the raging bull…