For Australia’s taxpayers and most of its corporations (including Leithner & Co. Pty Ltd), the financial year begins on 1 July and ends on 30 June. The autumn and winter are therefore appropriate times to conduct two exercises. The first is to contemplate the twists and turns, triumphs, trials and tribulations of the financial year just ended; and the second is to subsume these events within broader principles, revisit these principles, learn one’s lessons and adjust one’s sails for the new year.
This circular and its companions set out the results of these exercises. Part I summarises some major themes from the 2000-2001 financial year. Bearing these themes in mind, Part II reviews two premises underlying investors’ valuation of assets. Part III reasons from these premises to a disconcerting conclusion: regardless of the extent of any rebound of economic activity in Australia, and particularly in light of the record highs they reached beginning on 18 May, the prices of the ‘blue chip’ equities which comprise the bulk of the All Ordinaries and related indexes are prohibitively dear.
This result is not a prediction that the prices of Australian assets will fall; for all I know – and I clearly don’t – they might increase substantially. Rather, it is to caution that to the extent that it necessitates buying and selling shares of Australia’s largest listed companies, the achievement of results which even remotely approximate those presently expected by most market participants must rely upon emotional and speculative and not cognitive and investment operations. For these reasons the case for caution, outlined in circulars entitled ‘Irrational Exuberance’ in Australia and Reasoned Scepticism Vs. Irrational Exuberance, remains just as strong in the new financial year as it was in 2000-2001.
Part IV explores some wider and disturbing implications of these results. First and foremost, not many market participants seem to recognise the disparity between expected and reasonable results. More than a few are spouting nonsense, parroting things they want to believe or, like Dr Pangloss, expressing the optimistic hope that all will come good and they will land on their feet. For many, in other words, the lesson of the ‘tech wrecks’ of 2000 and 2001 – i.e., that price and value are distinct phenomena, that price may for a time exceed value but that it must eventually regress to it – remains unappreciated and therefore unlearnt. Many continue to obsess about prices and their near-term fluctuations but remain resolutely oblivious about enduring value.
Some Dour Background Themes
A perusal of circulars to shareholders posted since July 2000 uncovers four sombre themes. First, despite the ‘tech wrecks’ of 2000 and 2001, many of the Internet, IT, telecommunications and other ‘malinvestments’ of recent years remain only partially detected and incompletely liquidated. Particularly in light of Nasdaq’s recrudescence since April, soft words and hard numbers are telling ever more divergent stories about ‘New Economy’ assets. If so, then the market prices of this equity and debt remain far greater than their intrinsic value (to the very limited extent to which that value can be ascertained), and the default, bankruptcy and liquidation of these assets has by no means run its course.
The sudden placement in the hands of administrators One.Tel Ltd, an Australian junior telco backed most prominently by Publishing & Broadcasting Ltd, News Ltd and BT Funds Management, is the latest instance of this general phenomenon. This decision was taken on 30 May – less than eight weeks after one of its joint-CEOs stated that the company would have a cash balance of $75m by 30 June; five weeks after the investment bank Goldman Sachs published a report entitled “Great Start: One.Tel Is Here To Stay”; three weeks after a joint-CEO gave a journalist from The Australian an upbeat assessment of its current condition and future prospects; one week after both CEOs were sacked because they had failed to meet their forecasts; and two days after the realisation that a further injection of capital would not revive its fortunes.
Second, the actions undertaken by some individuals and businesses in order to redress the economic distemper of our times are widely disparaged. These actions include retrenchment, i.e., the increase of savings and reduction of debt, expenditure and expectations about the future. These actions’ critics include most economists, politicians, bureaucrats, central bankers and commentators. They beseech consumers and businesses to maintain and increase their expenditure, regain their ‘confidence’ and, in effect, deepen their indebtedness. Hence the third dour theme: the root causes of these malinvestments are largely undiagnosed and proceeding apace. Australians’ attention has been distracted by the introduction and implementation of the Goods and Services Tax. Much less prominent but more noteworthy is the maintenance, arguably for the past several years, of interest rates below their natural levels; the accompanying creation of and reliance upon bank credit not backed by savings; the increasing emphasis upon ‘confidence’ and expenditure – and the consequent accumulation of consumer (and to a lesser extent corporate) debt.
As a final theme, there are grounds to doubt that the most visible action undertaken ostensibly in order to counteract the recent deceleration of the pace of economic activity (i.e., the most rapid and pronounced decreases of interest rates in a generation) will produce its intended beneficial impact. Quite the contrary – in the medium term these cuts may have unintended and harmful consequences. Debts are debts; and bad debts, whatever new loans’ market rate of interest, must eventually (even the Japanese are beginning grudgingly to agree) be written down or liquidated. Yet most fundamentally, in the “welfare state of credit as James Grant has characterised post-Smithsonian monetary arrangements, governments muffle and anesthetise this process of trial and error, retrenchment and renewal. They attempt in effect to underwrite the risk which inheres in investment and entrepreneurship (in the Austrian senses of those terms). In so doing, and largely unwittingly, they create moral hazards.
Lax monetary arrangements, in other words, are encouraging consumers to assume more debt than they could otherwise afford; are enabling seemingly-cautious businessmen to undertake riskier actions than they would otherwise contemplate; in some instances are shielding wealthy speculators from the destructive consequences of their own actions; and – most unintentionally – in a few but nonetheless prominent instances are exposing consumers and taxpayers of modest means to the negative externalities of others’ actions.
Modest Results in 2000-2001...
Reflecting these sobering points is the gist of the Quarterly Review of Managed Funds published by The Australian Financial Review (18 April 2001). It stated that “the bull run of the late 1990s is fast becoming just a happy memory for investors in managed funds, with returns this financial year set to be the lowest in more than a decade. Most managers this financial year are unlikely to earn more than 3 per cent. If you were lucky enough to be with the top performer in the InTech growth funds survey, Maple Brown Abbott, you would have earned 5.5 per cent. If you were with the bottom performer, BT Funds Management, you would have gone backwards by 2.8 per cent.” The AFR added on 9 May that “superannuation fund members will be lucky to have more than 6 per cent credited to their balances this financial year if the performance revealed in this week’s InTech balanced fund survey holds out. The survey showed that fund members are sitting on average returns of about 3.7 per cent for the financial year to date – with just two more months to go.”
Since the autumn, however, Mr Market’s outlook has brightened considerably. Most notably, “the aggression shown by the US Federal Reserve in slashing interest rates to bolster the economy is gradually encouraging a revival of risk appetite for global investors” (AFR 8 May). In Wall Street, “many investors now believe the deepest and longest sharemarket decline since the seventies is over” (AFR 2 May). In Collins Street and Martin Place, too, “the underlying tone is definitely bullish. There is certainly confidence in the economic outlook” (The Australian 21 May). Reflecting this increasingly sunny disposition, the All Ordinaries Index attained a string of record closing highs beginning on 18 May.
... But Great Expectations for 2001-2002
Perhaps this has occurred because, according to Robert Gottliebsen (The Weekend Australian 5-6 May), “much of the stimulation being applied to our economy is without precedent. As a result, unless we have a surprise overseas catastrophe, the Australian economy will almost certainly surge forward either later this year or early in 2002.” Alan Kohler (The AFR Weekend Edition 19-20 May) goes considerably further: “forget the R-word: Australia wasn’t, and isn’t, in recession. The question now being asked is whether we may actually be headed for a boom – that is, strongly rising property and share prices, a return to 4 per cent-plus economic growth [and] a resurgence of inflation and rising interest rates.”
Major investors around the world seem to be taking these revised assessments seriously. A survey of American funds managers published in Barron’s in early May found that a large majority are bullish to varying degrees about the next twelve months. So too are influential Americans’ assessment of Australian conditions: according to Bridgewater Associates (cited in The AFR Weekend Edition 19-20 May), for example, “Australian equities have been the strongest in the world over the past twelve months and yet remain the cheapest. [Recently] they have been fit as a Mallee bull. We expect more of the same.” Finally, Australians are warming to this theme. As a result, and according to The Australian (21 May), “the share market is set to continue its march into [record high] territory. In the past eight weeks the ASX 200 has gained as much as 9 per cent, and according to investors and analysts, the surge should continue.”
The AFR (18 May) summarised major Australian investment institutions’ responses to these ebullient sentiments. Drawing upon figures compiled by InTech and CSFB, it reported that the average Australian manager’s holding of cash is presently 4-5% of its total assets under management. Average holdings have fallen precipitously from an estimated 10.5% of assets in 1998 and 1999, and are presently lower than at any time since 1993. Indeed, it noted that one manager’s cash weighting was 0.5%. Conversely, the average holding of international equities, roughly 19% of assets under management since 1991, grew to 22% in 2000 and presently stands at almost 25%. According to one economist, “low interest rates are the key driver of all this. They enable investors to look through falling profits and earnings downgrades.” The AFR thus inferred that Australian “fund managers are spending their stockpiles of cash on equities following aggressive cuts to US and domestic interest rates that they expect will lead to brighter economic times.”
Plus ça change. In The Intelligent Investor, first published in 1949, Benjamin Graham noted that “aside from forecasting the movement of the general market, much effort and ability are directed in Wall Street toward selecting stocks or industrial groups that in matter of price will ‘do better’ than the rest over a fairly short period in the future.” He concluded that “we do not believe [this endeavour] is suited to the needs and temperament of the true investor. As in all other activities that emphasize price movements first and underlying values second, the work of many intelligent minds constantly engaged in this field tends to be self-neutralizing and self-defeating over the years.” Further, “if as we suggest the average market level of most ‘growth stocks’ is too high to provide an adequate margin of safety for the buyer, then a simple technique of diversified buying in this field may not work out satisfactorily.”
...continued in Part II
