Christine St Anne: For our year-end review, we thought we'd speak with our very own Ian Huntley and Daniel Needham to give us their views of the key events this year and their forecasts for 2012. Gentlemen, welcome.
Daniel Needham: Thank you.
St Anne: Ian if I can begin with you, you've been relatively optimistic about the share markets. Can we expect some sort of miracle rally for next year?
Ian Huntley: I donï¿½t know if you are correct in saying I'm usually optimistic. Sometimes I'm very -- quite pessimistic but I do make mistakes; I don't necessarily get it right all the time. Look, since 2009, I have looked for the market to see-saw broadly between 4,000 and 5,000 on the Australian All Ordinaries Index.
Now, take it which way you will, whether that's optimistic or pessimistic, some people had it going to 7,000, I certainly didn't, and I really haven't changed my mind a great deal this year. I looked for a Christmas rally from October, and certainly we have had an up-tick. That could easily go further, but I still think that it will then go back down into the middle of next year, and there will be a quite a bit of gloom around, but the stocks will be excellent buying. I basically think there is lot of fear around but Australian businesses are doing pretty well.
St Anne: Daniel, you've mentioned a black swan in your reports. Do you expect this swan to reemerge next year?
Needham: I mean, I think that one of the things that I talked about was not necessarily that an extreme event would happen, but the fact that Australia is very dependent on China, specifically metallurgical coal and iron ore, and effectively the bottleneck in the seaborne iron ore market caused significant increases in prices and that increased their terms of trade. That filtered through to profit margins, both in the mining sector as well as in the mining services sector, and that's meant that we have had an extreme expansion in profit margins in Australia over the last, probably seven years.
Now, should something happen in China, should the investment led boom stumble or should there be some type of unforeseen event in China, Australia could become significantly negatively affected from that, so we could see profit margins collapse in Australia, and so in that situation -- and I'm not saying it's going to happen -- but thatï¿½s a potential event, this Australian share market could trade on, you know, 4% profit margins with P/Es of 6 or 7. In that event, you could see the S&P 200 below 2,000.
Now, I'm not saying that's a base case. I'm saying that's an extreme event, but at the same time I think that, you know, on trailing valuation measures, the market looks inexpensive, but from a trend fundamentals perspective, which is what we look at, if you normalize earnings in Australia, it's still heavily overvalued in our view, but again, I take what Ian has said that there is a lot of fear around, a lot of investors are underweight equities, and that makes a potential buying environment for equities and probably supports them in the shorter term. I mean, I think that there is a lot of pessimism out there about the global economy at the moment, and in those types of environments, it doesn't take much to surprise investors to the upside and cause a short covering type of rally. So, on a medium to long-term basis, we still think Australia isn't an attractive equity market. We think that the China led investment boom is simply a credit bubble but has lots of stories around it.
St Anne: Finally, investors have faced an unprecedented level of volatility, whatï¿½s your tips for keeping their faith in the share markets?
Needham: The framework that we use is a evaluation driven framework and we focus on capital preservation and we're going to miss out on the big booms and the big rallies, the latter parts of them, but at the end of the day weï¿½
Huntley: Thatï¿½s nice.
Needham: But we think we can pick assets up that are very cheap when most other people are writing them off and that's where we make most of our money through the cycle, and from that perspective, I think focusing on capital preservation first is important.
I think that assessing assets based off of what kind of income you can get, having conservative assumptions about the capital appreciation, I think that framework is going to lead you towards having a reasonable amount in banks, property trust in Australia. You know, the term deposit rates are pretty appealing for Australian investors. I think relative to other parts of the world, you can get a decent return without taking too much risk.
So, I think that a diversified portfolio for an Australian investor is looking pretty good, and so I think making sure you've got a framework to assess markets that you don't get sucked into the emotion and the mania and the headlines, and you try to avoid making those bad decisions. I think this is the environment where investors need to have a framework.
Huntley: There are parts of that that I would question. Now, people think that putting their money on bank deposits has this wonderful security about it, I'm not bothered. I certainly think the banks are stable, I have no troubles with that, but I think interest rates can fall.
Now, if one takes -- looks at the interest rates in Europe and United States and says, well the worst case could happen if, my friend here says, the rest of world is going to end up in a deep hole down there and well, we could have our interests rates pretty low okay, if you just take, you know, our friendï¿½s view of the world. But in Australia, if you carefully look through, just as in the United States, you can find first class defensive income stocks that are quite happy to own, right through all that, and that's what we've been recommending for quite some time.
Needham: So, is that U.S. based?
Huntley: No, Australian.
Huntley: Well, I'm not working on U.S. stocks, but I do realize that ï¿½ I am sufficiently interested in the U.S. market to realize that they are there as well, and I'm sure if you looked at a quality, reasonable dividend paying, defensive stock portfolio in the United States over the last couple of years that would have outperformed indices, taking out Apple, that would have outperformed the indices pretty well. I think you got the odd skyrocket over there like Apple, but in Australia these things are just wonderful and you got security of capital and security of income. You don't have security of income in your deposits, but do have security of capital. And that's where retirees get really hammered, and I have seen it a number of times. For instance, when deposit rates came down from 17% to about 5%, retirees were screaming, where is my income? It's bloody sad and it's one reason I hope that our Australian interest rates donï¿½t fall much further.
Needham: I think that, you know, a diversified portfolio in my mind is a portfolio with some good companies in there and that have got good yields and they are inexpensive. If you can find some good property trusts that have got good yields, inexpensive. I think having some ï¿½ I agree that when the reinvestment risk for term deposits is probably ï¿½ it's not accounted for by many investors.
Huntley: Thatï¿½s what I am saying.
Needham: Yeah, exactly. I agree with that, but the good thing I guess in some ways is that when ï¿½ if rates do come down, it's normally associated with a difficult economic environment, and so you tend to find that stocks are probably cheaper. So, the cash frees up at the time when you can actually deploy it into more attractive. So yeah, I think the idea that you're going to be able to get these levels of interest rates term deposits forever I think is certainly not a ï¿½ is not a good assumption to make.
Huntley: That's where the risk is.
Huntley: People thinking, you know, the explosion and people putting money into bank deposits has been a wonderful thing for the banks.
Huntley: It's halved their reliance in offshore money.
Needham: Yep, yep.