A Simple Way to Profit from the Correction

Well, it doesn’t take much for the mood to turn does it? Then again, as the saying goes, market’s make opinions. And yesterday’s sell-off is certainly doing that. From the Financial Review:

Australian shares have had their worst day in seven months after the global bond market’s sell-off hit the ASX, leading some investors to speculate that the bull run in global equities has been shattered.

“We don’t know if it’s the top yet, but I view it as the natural end game of an enormous liquidity injection over the last 10 years, something like this was always going to happen given the amount of money that’s been pushed into the system,” said Chris Daily, chief investment officer at Tribeca Investment Partners.

A natural end game, huh? Sounds pretty drastic! Emotive language too.

Having said that, the Financial Times stuck with a ‘keep calm and carry on’ theme. Which is not surprising, given that most of their quotes come from the big Wall Street investment banks. They would keep calm and carry on losing other people’s money in the face of the most violent market storm.

For example:

Jan Hatzius, chief economist at Goldman Sachs, wrote in a research note published at the weekend: “The expectation of tighter policy is now, at last, starting to weigh on broader financial conditions. “We are not particularly concerned about the move so far . . . Nevertheless, it might indicate that the equity and credit markets will need some time to digest the recent repricing before taking the next step.”

Whatever that means…

For what it’s worth (not much, believe me) I’ve been saying for a while now that global markets are due for a decent correction. But I’ve also said that this isn’t going to be a replay of 2008.

Yes, stocks are very stretched in terms of valuation. But the US is moving out of a deflationary/disinflationary period and into an inflationary one. That shift takes some time, and it is only in its early stages.

For years now, central banks have been trying to generate inflation. They need to for the sake of their governments, who have increased their debt loads massively since the 2008 crisis. Inflation reduces the real value of debt.

Do you think central banks will jeopardise this nascent inflation cycle by pushing rates up too fast? Do you really think they would do that?

I don’t. I think it’s more likely (not definite, but more likely…I always think in terms of probability) that inflation will pick up and interest rates will remain low relative to the pick-up in inflation.

In other words, real interest rates (nominal rates minus inflation) will stay low for an extended period. The real rate of interest is what matters for the economy, not the nominal rate.

So while the nominal rate of interest might rise this year, if the rate of inflation rises too, then there is no monetary tightening happening. So what’s everyone getting in a tizz about?

Well, there is one thing… 

Profiting from the correction

There are three main factors that influence stock prices; earnings, the earnings ‘multiple’, and nominal interest rates.

Global earnings growth has been good, especially over the past few years. And with the US and global economy doing well (which is why interest rates are on the rise) earnings should continue to do well.

It’s the other two factors that are now posing a bit of a problem for stocks. Since the 2016 low, earnings AND the earnings multiple have increased. The earnings multiple is what investors are prepared to pay for a given amount of earnings. It’s often expressed in the form of a price-to-earnings (P/E) multiple.

If earnings increase 10% each year for two years, and the P/E of the market rises from 15 to 20 times those earnings, you’re looking at a stock market rise of 53% over two years.

That’s pretty similar to what the S&P 500 index in the US did from the 2016 low point. To be exact, it increased 58% to the 29 January high. In the above example, 20% of the increase came from rising earnings, while P/E multiple expansion accounted for 33% (20/15–1).

P/Es are a function of two things; investor sentiment and nominal interest rates. When nominal rates fall, it improves the relative value of stocks. That pushes prices up (even if earnings remain flat) and the P/E expands.

However, in the recent cycle, P/Es have expanded while nominal rates have increased from historic lows. And they’re now at levels that are amongst the highest in history.

In my view, we could be at the start of a shift in investor sentiment. It’s a shift that now acknowledges P/Es are too high, given we’re in a rising nominal rate environment. So while rising rates won’t derail the economy (because they will only keep pace with inflation) they will derail investor sentiment.

Which means P/E contraction will be the driving force behind this correction.

The investment strategy to deal with this is to buy quality companies trading on a below-market P/E. There will always be exceptions, of course, but if you follow this basic rule you should come out of this correction without too much damage.

Greg Canavan,
Editor, Crisis & Opportunity

Greg Canavan is a Feature Editor at Money Morning and Head of Research at Port Phillip Publishing.

He likes to promote a seemingly weird investment philosophy based on the old adage that ‘ignorance is bliss’.

That is, investing in the Information Age means you have all the information you need at your fingertips. But how useful is this information? Much of it is noise and serves to confuse, rather than inform, investors.

And, through the process of confirmation bias, you tend to read what you already agree with. As a result, you often only think you know that you know what is going on. But, the fact is, you really don’t know. No one does. The world is far too complex to understand.

When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases.

Greg puts this philosophy into action as the Editor of Crisis & Opportunity. As the name suggests, Greg sees opportunity in a crisis. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines traditional valuation techniques with charting analysis.

Read correctly, a chart contains all the information you need. It contains no opinions or emotion. Combine that with traditional stock analysis and you have a robust stock-selection strategy.

With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the basic, costly mistakes that most private investors do every time they buy a stock.

To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Money Morning here.

And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here.

Official websites and financial e-letters Greg writes for:

Money Morning Australia