How Much Longer Can Stocks and GDP Diverge?

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I want to, if we can, get away from all the trade war talk for a moment.

Yes, Trump rose tariffs on China. Yes, that could be followed by retaliatory tariffs by China.

But I want to talk about something else today. Something that is going on in the background while everyone focuses on the trade war, interest rates and economic growth.

Have you given a bit of thought to stock prices recently…?

It’s defied all odds…

You’d think with all the uncertainty going on, stocks would be having a terrible time. Not the case.

Stocks on the ASX continue to climb. The largest 200 shares are now up 13.3%. The small-cap Aussie index (the Small Ordinaries) is even higher, sitting at a year-to-date gain of 15.2%.

Of course, rising stock prices alone says nothing. Maybe earnings are growing. Maybe investors are expecting growth in the next few months…or years.

However, I find that hard to believe.

With an all-out trade war on the cards, economic growth, which is made up of business production, doesn’t scream higher earnings. Not to me, at least.

Take a look at Australia’s ratio of share market to GDP…

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Source: Guru Focus
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It continues to climb, inferring that our stock market is getting more expensive. Because while GDP (business output in monetary terms) stands still, stocks continue to rally.

Maybe another interest rate cut is on the way, making yields for fixed income securities (bonds) that much less attractive, pushing more long-term investors from bonds into stocks.

But I think there are more than a few reasons for why our central bank, the Reserve Bank of Australia (RBA), won’t cut rates further.

They’ve got a currency, a volatile housing market and low wage growth to think about. My best guess is the RBA will leave things as they are and hope it all gets better.

But is that even possible?

According to Bloomberg, ‘Australia has had its weakest six-month expansion since the global financial crisis…

It’s also in the middle of its worst housing slump in a generation, as plummeting property prices and a credit squeeze weigh on consumers.

And amid this, with global pressures of course, Aussie shares have continued to march upwards. Bloomberg continues:

When a country’s economic growth slows, its stock market usually follows suit. Not in Australia.

Despite a backdrop of troubling economic signals, the nation’s benchmark S&P/ASX 200 Index rallied almost 10 percent in the first quarter — its best-ever performance to begin a year in data going back almost three decades. Strong commodity prices and promises of easy monetary policy from central banks are working in the gauge’s favour even as Australia’s property slump deepens and its economy continues to wane.

Money Morning

Source: Bloomberg
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Bloomberg also cites comments from Eleanor Creagh of Saxo Capital Markets, who said:

‘“It’s defied all odds and we have continued…I would question for how long this rally can continue.”

I think Creagh is bang on the money. How long can these elevated multiples and expectations last for?

Hopefully not for too much longer…

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There are no bad days

There’s a quote from Columbia Business School Professor, Bruce Greenwald that I absolutely love. Not always the optimist, Greenwald told a group of value investors that there are only good days in the market.

When the market is down, you’ve got bargains, and it’s lovely to think of what you are buying at low prices. When the market is up, the bargains have gone, but you’re rich.

I couldn’t think of a better way to think about it. When prices are down, get active. When prices are up, sit on your hands.

As you might know by now, investors at large tend to react in the opposite way. When markets are up, the majority buys more. When markets are down, the majority sells more.

The only caveat to what Greenwald says is that it assumes you’ve bought bargains at some time in the past, and are still holding these stocks today.

But what if you’re sitting here, in 2019, watching stocks rise higher with no portfolio of your own? Be strong, dear reader. The last thing you want to do is buy when prices are heading towards the very top.

Consider the story of legendary investors Stanley Druckenmiller, told by the Safal Niveshak Post…

The man in charge of Soros’ high profile technology funds was Stanley Druckenmiller — one of the best-performing hedge fund managers of all time, till date — and he was busy warning his team that the sell-off could be near and could be brutal.

As the markets soared further in March 2000, Druckenmiller was quoted as saying, “I don’t like this market. I think we should probably lighten up.” Soros himself would regularly warn his team that tech stocks were a bubble set to burst.

Yet despite this, Drunkenmiller bought in, anyway. In his own words:

I bought the top of the tech market in March of 2000 [after quickly making money in the same space in mid-late 1999] in an emotional fit I had because I couldn’t stand the fact that it was going up so much and it violated every rule I learned in 25 years.

I bought the tech market very well in mid-1999 and sold everything out in January and was sitting pretty; and I had two internal managers who were making about 5% a day and I just couldn’t stand it. And I put billions of dollars in within hours of the top. And, boy, did I get killed the next couple months.

Of course, our present situation is not entirely similar. Yet, the point still stands: Don’t get caught up in the hype.

If your neighbours just doubled their money on Nearmap Ltd [ASX:NEA] (the best performing stock on the ASX to date), it doesn’t mean you can too.

Instead, keep looking for bargains. The market may be heated, but there are still pockets of value for investors late to the game.

Who knows, maybe the market will drop soon, littering the ground with bargains.

Like Greenwald said, there are no bad days in the market…

Your friend,

Harje Ronngard,
Editor, Money Morning

PS: These could smash the ASX 200… find out our three favourite small-cap stocks. Get your free report right here.

About Money Morning Editorial

Money Morning is Australia’s most outspoken financial news service. Your Money Morning editorial team are not afraid to tell it like it is. From calling out politicians to taking on the housing industry, our aim is to cut through the hype and BS to help you make sense of the…

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