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Thursday, 21 May 2020

Fighting investment FOMA as the market continues to climb the 'wall of worry'

Life as a personal investor is a constant battle of the internal demons of fear and greed. We'd all like to make buckets of money during a bull market, at which time strategies such a gearing (or even double or triple gearing) are attractive and making use of OPM ('other people's money') to invest with makes perfect sense. Would wouldn't like to borrow at x% and get a total return of x+y% (with the added benefit of the interest being tax deductible, effectively 'converting' some of your current income (taxed at your marginal income tax rate) into long term capital gains (taxed at half your marginal tax rate))?

Then, of course, the market inevitable goes from 'bull' to 'bear' market, often with a few minor corrections' thrown in during the 'bull run'  just to tempt investors to move into cash too soon, often with the net effect of paying transaction costs, unnecessary capital gains tax, and missing out on some of the bull market gains while they sat overweight in cash until, eventually, getting tempted back into the market as the bull run continues.

When the market turns 'bear', the investor is either regretting staying 'fully invested' and wondering whether it is now too late to move into cash (or other asset allocations), or whether this is just the start of a down-trend and it should be 'everyone into the life boats' asap?

The current situation is that the US and Australian markets ignored the start of the Covid-19 pandemic during January and February, hoping that the spread could be restricted to China and any economic impacts would be mitigated via central bank action. Then, when the severity of the health crises became all too apparent in March the stock markets tumbled, hitting a deep low around 23 March.

Since then US and Australian markets have made surprising (to me at least) gains - recovering a large proportion of the value loss during Jan-Mar. Small amounts of potentially good news (such as early positive signs for a potential vaccine development) boost the stock markets, and even if such speculation proves to be premature (a vaccine will take many, many months to develop, test, manufacture and distribute to a significant proportion of the population, assuming a vaccine that provides enduring immunity to Covid-19 is ever developed), the markets remain in a generally positive trend since the March low-point.

So I'm sitting at home (where else during a pandemic?) wondering whether we should have (or should) shift some of our SMSF investments back into 'High Growth' rather than sitting 70% in 'Conservative' and 30% in 'Bonds' (and just having a trickle of $2k/mo of our Cash (bank account) funds being invested in 'High Growth' each month). I raised this question with DW and DS1 (the other two member/trustees in our SMSF) about a month ago, and we decided the risk of a further market decline was much higher than the (negligible) chance of a rampant bull market returning, given the rate of Covid-19 spread (new cases) and deaths (heading towards 5% of the number of civilians killed during WWI already, and still rising!). Since then, the US and Australian stock markets have continued to rise, so it is increasingly looking like switching to 20% Bonds, 40% Conservative, 40% High Growth last month might have been prudent after all.

However, the worse economic impacts of Covid-19 are yet to show up in employment and GDP statistics, company results, dividend payments, and enduring changes to company prospects. But there are enough signs that suggest that those economic impacts will most likely be a lot worse than the current market sentiment suggests.

For example, the reality that many jobs have simply evaporated due to 'lock-downs' has meant that the official unemployment rate (in Australia) is understated (as many people have left the 'work force' as they know that there is Buckley's chance of getting a job in the current market), and the figures will continue to get worse as many companies that were placed into 'hibernation' realize that they are no longer profitiable in the 'new normal' that takes hold as social distancing rules are relaxed, but not removed entirely.

In the longer term (6-24 months) a lot of other negative economic impacts will start to become apparent, which should be reflected in current stock market pricing, but apparently isn't. For example, immigration into Australia has practically stopped, and won't get back to pre-Covid levels for several years (if nothing else, boosting immigration when there is high domestic unemployment is hard to sell politically, even if, in the longer term, immigration boosts economic activity and generates new jobs). The lower immigration levels, coupled with higher unemployment and no wage growth, will reduce housing demand and construction for the next several years, which in turn will impact demand for white goods etc. So the Covid-recession of 2020/21 is likely to be quite severe.

Based on the likely impact on the housing industry I would expect the 20/21 recession to be at least as bad as the 1991 recession in Australia. But that doesn't automatically mean the stock market will perform badly. At some time we're going to have to reallocate back towards our long-term asset allocation target ('High Growth' Index Fund), given the historic long term performance of equity investments. But for the moment, our FOMA is still being outweighed by uncertainty regarding the magnitude of the recession that will result from Covid-19.

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