Shani Jayamanne: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs.

Mark Lamonica: And then, one more note, and this is for Will. So, if you hear any background noise today, it's not Will's fault. We have glass doors. So, we do this in a conference room. We have glass doors. One of them fell off its hinges the other day.

Jayamanne: Not in this conference room.

Lamonica: Not in this conference room. But now, we are banned from closing the doors on any conference room because they don't want somebody to die. But anyway, if you hear background noise, it's not Will's fault. So, there we go. That's our other disclaimer.

Jayamanne: Good disclaimer.

Lamonica: Alright. So, let's get started. So, it is early January. So, of course, there are lots of attempts to preview and predict market movements in the coming year. And these are, of course, popular with investors, but they are also impossible to do. But the fact that the task is impossible doesn't really stop anyone from trying.

Jayamanne: Well, we've deliberately taken a bit of a different approach, which is, why the name of this episode is the State of the Market at the Beginning of 2023, and not what will happen in 2023. And we want to take the opportunity to step back and look at the big picture.

Lamonica: And the point of this exercise is two-fold. The first is to give us an idea of what we might expect over the next five years or so out of markets. So, one year is impossible timeframe to predict. But as we look longer term, we can make some more assumptions. The second point is that it gives investors an opportunity to look at the way their portfolio is positioned and see if it still makes sense and is aligned with their goals. The beginning of a new year is a great time to do that.

Jayamanne: So, why don't we get started? We're going to start with valuation. And for listeners to Investing Compass, this should be a familiar place for us to begin. But before exploring valuation levels of the market, let's remind everyone why valuation levels are so critical for investors.

Lamonica: The main reason is that they give you an idea about the expectations that investors have for the future. High expectations will result in high valuation levels. We can see this on an individual share perspective as the share that trades with the highest valuation level is generally a growth share or the one that is expected to grow fastest in the future.

Jayamanne: And that's perfectly natural. You should be willing to pay more for a company growing faster. But the more you're paying, the higher the valuation level, the higher those expectations are about the future. So, as the market gets more and more expensive from a valuation perspective, and those expectations get higher and higher, the market gets riskier, because at a certain point, those expectations baked into share prices are impossible to meet.

Lamonica: And this is counterintuitive to people because valuation levels generally go up when the market goes up, and the fact that it went up makes investors feel safer. But the opposite is actually true. It is getting more risky.

Jayamanne: Another critical reason why valuation levels are so important is because they can give you a clue about future returns, and this is pretty simple conceptually. Returns come from three places – dividends, earnings growth, and changes in valuation level. If you're at a historically high valuation level, you're going to lose that as a source of returns, because it's unlikely to go any higher. That leaves you with dividends and earnings growth, and if valuation levels drop, that has a negative impact on returns.

Lamonica: And I saw this, Shani, during the 60s and 70s. Valuation levels shrunk to a degree that outpaced earnings growth and dividends. So, investors got negative returns. In the 80s and 90s, valuation levels rose, and more than the return investors received. So, this is really important.

Jayamanne: And if we turn our attention to current valuations, we've talked a lot about the CAPE Ratio, or cyclically adjusted price to earnings ratio. As we've said many times, that is an adjusted valuation level for the cyclicality of earnings through the business cycle, and it's a more conservative way to look at valuation because it averages earnings over the last 10 years.

Lamonica: You know, Shani, we should really get a sponsorship by Professor Shiller, and he's the one that came up with the CAPE Ratio because we do talk about it a lot.

Jayamanne: We do, we do. We should. According to the data on Yale's website, the December CAPE Ratio of the S&P 500 was 27.95. Now, that's down from where it was in December of 2021, when it came in at 38.3.

Lamonica: But it's still slightly above the average monthly CAPE Ratio since the year 2000, which is 26.95. So, let's call this an average valuation level, not cheap, but average. So, why don't we turn our attention closer to home, Shani?

Jayamanne: Well, the data in Australia is not as robust as we have monthly data in the U.S. that goes back to 1871. But in Australia, it was just over 20. In June of 2020, when the effects of the COVID crash were still being felt, it was just under 18. So, that's a demonstration of how the Australian market is trading at a lower valuation than the U.S. and how the run-up post COVID was less spectacular.

Lamonica: So, what does this tell us? Valuation levels have come down, but no sense of the world is the U.S. market cheap. Australia is clearly relatively cheaper. As we said, valuation levels impact future returns, and this is one of the reasons our investment management team projected returns for the next 20 years are 7.9% for Aussie equities and 6.75% for global equities.

Jayamanne: And the drop in valuation levels can be explained by interest rates going up. But once again, the future is what we care about. So, let's see what happens in 2023.

Lamonica: So, why don't we turn our attention to the economy? And before we get into the economy, I think we need to be very clear about one thing. The stock market is not the economy, and the economy is not the stock market. And what that means is that there can be differences between what is going on in the economy and what's going on in the market.

Jayamanne: Since 1929, markets experienced 26 bear markets but only 15 recessions. But in this case, we've already had a bear market in the U.S., and that may have anticipated an economic slowdown related to the increase we've had in interest rates. And there is certainly widespread commentary and predictions of a recession, but we will just have to see what happens. We're here to talk about possible implications to the share market.

Lamonica: Once again, we're talking about the short-term here and we will very quickly pivot to the long term. But the market is forward-looking. So, you can make a case that the market has priced in a recession and that if the economy falls into a recession, it will not result in large scale share market losses. And that happens. The S&P 500 has had positive returns in half of all recessionary periods since 1948. So, that is at least a plausible scenario.

Jayamanne: So, is that what you think is going to happen?

Lamonica: No. No, I don't. But once again, I'll qualify this. This gets back to valuation levels. As I said, we are at average valuation levels. But according to T. Rowe Price, during a recessionary period since World War II, the median decline of the S&P 500 earnings has been 13%. So, where do you think I'm going with this, Shani?

Jayamanne: Well, I think it's pretty obvious. If the market doesn't change at all and earnings dropped 13%, that means that that valuation levels will go up, not 13% up because we focus on the CAPE Ratio, which looks back 10 years, but it will still go up.

Lamonica: Exactly. But we are looking long term, because once again, that is what truly matters and that allows us to take more of a look at where we are.

Jayamanne: And if we look out longer term, we need to ask a pretty big question when it comes to investing. Have we reached an inflection point in markets? And what I mean by that is, have things fundamentally changed from the period most of us have gotten used to investing in, which is a period of lowering interest rates, low inflation, and increased globalization?

Lamonica: So, let's set the scene here. We've gotten used to consistent drops in interest rates in tons of fiscal and monetary stimulus to the economy anytime there's a crisis. And what economic theory tells us is that all this stimulus should be inflationary. When interest rates are low, when there have been periods of things like quantitative easing, which is central banks buying longer-term government bonds and when governments have pumped money into the economy through increased spending, you should see inflation.

Jayamanne: But we didn't. This traditional relationship seemed to have broken and no matter what was done in response to the GFC and during a series of crises before, we didn't get a whiff of inflation. And one potential reason for this is that there were a bunch of deflationary forces that were happening that basically cancelled out all these inflationary forces.

Lamonica: And these included things like outsourcing manufacturing to cheaper locations like China, for example, as well as offshoring of everything from call centers to back-office processing, which has taken a lot of costs out of supplying goods and services. That is deflationary.

Jayamanne: And there have been some other things that have happened over the decades that also contributed to this. We've seen declines of union membership, which has reduced bargaining power of workers, and we've had technology, which has replaced jobs and led to efficiency.

Lamonica: And all of this has offset some of those inflationary forces. And this is not a political show, but what we've seen is that things in the aggregate have hurt a lot of workers. We have seen jobs being outsourced and offshored and replaced by technology. And they've also seen slowing wage growth. But because all of these actions have allowed lots of stimulus and low interest rates and low inflation, it has helped people who have assets, because those asset values have gone up, assets like shares and property, for example.

Jayamanne: And this has been going on since the last surge of inflation during the 70s and into the early 80s. These are the decade-long trends that drive returns, and these forces are far more impactful than trying to focus on what shares will do in the next month or two. And that brings us to today. This long-term trend seemingly broke in the response to COVID. Central banks and governments went back to the playbook to rescue the economy from the latest crisis.

Lamonica: Yeah, central banks cut interest rates. They bought a bunch of longer-term bonds, and we had governments introduce a bunch of stimulus in Australia through JobKeeper and JobSeeker, and the U.S. through direct payments to people. And the expectation was that this would save the economy and once again, there would be no inflation, because every other time this has been done in recent history, there was no inflation.

Jayamanne: But this time we did have inflation. And one of the reasons that central bankers kept telling us that inflation was transitory was because they were so used to not having inflation. The question for today is, has this cycle been broken or is this temporary and just aberration and we'll get back to the same old period of low interest rates and low inflation?

Lamonica: And this question matters. It matters because it will dictate what returns we have going forward and what types of investments will do well. And there are two sides to this argument, and we'll do our best for the rest of this episode in making the arguments for both sides so that all the listeners can decide the best way to position their portfolio.

Jayamanne: So, let's start with the first argument that the world has fundamentally changed, and we're going back to a more traditional relationship between low interest rates, stimulus, and inflation. The argument goes like this. COVID and a reverse in the post-Cold War geopolitical environment have fundamentally altered these deflationary forces. So, let's start with history since Mark loves history. So, I'll let him do this part.

Lamonica: Okay. Well, the 30-second argument goes like this. Two things happened in 1989. First thing is that the Berlin Wall fell, and this led to the incorporation of Eastern Europe with the EU and the integration of Russia and the former Soviet republics into the global economic order, which was based on Western style capitalism. The second thing that happened is we had the Tiananmen Square massacre in China. And this happened after a profound shift in Chinese policy that's popularized by the famous quote tributed to Deng Xiaoping, and that is "to get rich is glorious." So, after the Tiananmen Square massacre, the economic reforms accelerated, and a new bargain was introduced in China's – economic growth would follow a free market model, but politically, China would continue with one party rule and a lack of political freedom.

Jayamanne: So, having these huge parts of the world join free market capitalism led to an acceleration of globalization – more trade, more offshoring, more outsourcing. This created a world of just-in-time manufacturing where parts showed up in a factory the day before they were to be used where things we consumed were sourced from the cheapest place possible. All of this makes it cheaper to produce goods and services, so price increases slowed for consumers.

Lamonica: But things have changed in China and things have changed in Russia. Chinese nationalism has broken the cycle of more globalization. Less and less companies are comfortable manufacturing and offshoring and outsourcing work to China and less companies are comfortable selling products into China. There's been intellectual property theft. There have been tariffs that have come out of economic concerns in Western countries, and there have been political tensions which have banned the manufacturing of things like semiconductors in China.

Jayamanne: And then, COVID hit. And all of a sudden, trade was disrupted, and a lot of countries started to figure out that being so dependent on foreign countries for basic goods was a problem. This also led to a push to bring critical manufacturing and expertise back onshore.

Lamonica: And we are seeing this impact World trade as a percentage of GDP went from 37% in 1990 to a high of 59% as a flurry of free trade agreements came into existence. It since fallen to 52%. International lending has fallen off a cliff as a percentage of bank loans to foreign markets increased from 27% in 1990 to over 56% before plunging to 36% by 2021. Exports are dropping as the number of sanctions in place globally have expanded from 112 in 1990 to 411 in 2022.

Jayamanne: So, all of this is these deflationary forces getting rolled back, and then there is climate change. There is large-scale agreement that we need to decarbonize in order to save the world. But there are lots of arguments about how fast this should occur. And a lot of those arguments are because this will be incredibly expensive. McKinsey looked at the cost to decarbonize four industries that make up 45% of all carbon dioxide emissions – cement, steel, ammonia and ethylene. The estimate is $21 trillion by 2050. Someone is going to need to spend that money – governments, consumers, companies, somebody. But either way, that is a lot of spending and that is not deflationary.

Lamonica: Let's turn our attention to the other argument, and I'm going to call this the Cathie Wood argument. Cathie runs ARK Innovation and is one of the most famous fund managers in the world. And she's very well-known for investing in disruptive technology. Many of these unprofitable growth shares that had the huge run-up are in her portfolio. Of course, that was prior to 2020 when many of these same companies crashed.

Jayamanne: And as a result, her headline ARK Innovation ETF with the ticker symbol ARKK has dropped more than 60%. And this stunning reversal has, of course, come in the face of high interest rates, which reduces the valuation levels of all assets, but particularly those with earnings far out into the future, the very companies she sees transforming the future.

Lamonica: Now, Cathie is very much in the camp of thinking, what has happened is temporary. She disputes the narrative that we just described and actually thinks that we are still in a deflationary environment and central bank policies have gone way too far.

Jayamanne: She points to a couple of different deflationary forces. She thinks that inflation is not yet embedded into the economy. She sees drops in commodity prices and housing as pulling inflation down. She also believes there are longer-term forces leading to deflation, including artificial intelligence, bringing down costs in every industry.

Lamonica: She is predicting that inflation has not only peaked but will reverse to such a degree that we'll see deflation in six to nine months, and her investment actions back this view. She has basically not changed her approach at all even after that terrible year. She has instead doubled down on large positions that have had crummy years, like Tesla and Coinbase.

Jayamanne: This is obviously a very different world view and basically, brings us back to where we were before 2022, an opportunity for central banks to again significantly drop interest rates. 

Lamonica: So, let's go through the investment implications of these two scenarios playing out, because these different visions of the future will mean very different types of investments will do well. So, let's start with Cathie Woods. In many ways, her scenario just means that what has been working prior to 2022 will continue to work, so growth shares in the technology sector would likely see their valuation levels rise again.

Jayamanne: Now, if we're truly at an inflection point, things get a little more complicated, and this is the view of The Future Fund here in Australia. The Future fund is Australia's sovereign wealth fund responsible for investing for the benefit of future generations of Australians, and there's currently $200 billion in it. Well, their head, Raphael Arndt, thinks that waiting for things to go back to the way that they were is a terrible plan for investors. 

Lamonica: They recently put out a white paper in late December saying that the economy and market environment is changing, and that persisted inflation will lead to a world of higher interest rates. They think that we're going to see stagflation like we had in the 70s, which is high inflation and low economic growth. And they think this time will be worse because of demographic challenges from aging populations and way too much debt for consumers, governments and companies.

Jayamanne: Not a pretty picture. And there was an interesting quote from Arndt when he said, the investment industry's approach is to really just blindly assume that the past will be repeated in the future. We just don't think that there's a good way to understand what's going to happen.

Lamonica: Which is pretty much the argument that Cathie Wood is, the whole nothing to see here, things will be fine, and coincidentally, the exact investment approach her funds are taking will once again take off.

Jayamanne: And The Future Fund outlines the approach that they're taking and how they've repositioned their portfolio. If we're in a world with lower economic growth and persistently high inflation, what has worked will no longer work. They are increasing their exposure to infrastructure and real estate that have built-in inflation protection through contracts that increase rents and fees based on inflation.

Lamonica: They've also reduced cash levels since we are still seeing negative real returns as interest rates are below inflation.

Jayamanne: So, what do you think about these two arguments and does one resonate more with you?

Lamonica: Yeah. I mean, the first thing I would say is nobody should probably be doing anything radical with their portfolio based on this.

Jayamanne: Yeah, exactly. And remember that both, ARK Innovation and The Future Fund has very different goals, and everyone listening has a different goal. So, this is about getting back to what you're trying to accomplish and making sure you design a portfolio around those goals and what makes you feel comfortable and what resonates with your world view.

Lamonica: And I will say that The Future Fund view of the world makes a lot more sense to me. It's just a lot more intellectually appealing to me, matches my goals and frankly, my current portfolio and strategy. So, I might be a little bit biased here. But I just can't get my head around a portfolio full of companies with really high business risk, high valuations and no profits. What we've experienced in the run-up to 2022 just seem to fit the classic definition of a bubble and just seem completely unsustainable if we look back on market and economic history.

Jayamanne: So, I think, more than anything, the state of the market is uncertain. Are we at an inflection point? Are we headed back to where we were? No matter what I will hold on for more volatility in 2023 as investors try to figure out what's next. Anytime there's uncertainty, there's a period of significant rallies and drops, much like we saw in 2022. In fact, during 2022, of the approximately 240 trading days, the Dow Jones Industrial Average has closed up or down by over 500 points on 52 days.

Lamonica: And volatility creates opportunities but can also cause investors to make mistakes. So, hold on for what might be a continuation of the wild ride. Keep the focus off the market and all the commentary and instead keep it on you. Make sure you understand where you need to get, what you need to get there, and the strategy that makes sense for you and to you.

Jayamanne: And there we have it. Hopefully, we gave you some food for thought, which is way more valuable than pulling some prediction out of a hat about where markets will end next year. Each year, we should all strive to be better investors, which means more thinking and less trading. We'd love to hear your thoughts. So, please send them through to the email address in the episode notes.

Lamonica: Yeah. And thank you very much. We, as always, would love ratings and comments in your podcast app and hope you enjoyed the first episode we reported in 2023.