Why the SVB saga shouldn’t change your investment strategy

It’s easy as an investor to get caught up in the dire headlines of the past week. It’s easy to worry about your current investments. And it’s certainly easy to be concerned about what the future may bring to markets.

It’s much harder to step back from what’s unfolding. To stick to your investment principles. To stick to your long-term plans.

To do these things, it’s important to bottle your emotions and put recent events into perspective. To help with that, I’m going to look at the big picture of where markets currently sit and make some tentative, long-term guesses for the future. You’ll see that there’s cause for cautious optimism.

Australia continues to be a great place to invest in stocks

Australia has been one of the world’s best performing stock market over the last 100 years. It’s also the world’s wealthiest country, according to Credit Suisse estimates. The former has obviously helped the latter.

The secrets to our success include having democratic, stable governments, high immigration, favourable tax treatment for stocks/assets, big gains in property values, a superannuation scheme that enforces retirement saving, and generous dividends.

The chart below shows the performance of difference asset classes since 1970.

Australian shares including franking credits have returned 11.2% p.a., compared to annual CPI of 5.2% and the average cash rate of 6.8%. The return from stocks has meant that you’ve doubled your money every 6.5 years.

The performance of shares compares favourably to the returns from residential property (Sydney housing 8.3% p.a.) and Australian bonds (7.8% p.a.).

Australian bank shares have been the standout over the past 52 years, clocking a 12.6% p.a. return, and US stocks have marginally outperformed the ASX 200, thanks in part to stellar outperformance during the 2010s.

There’s little reason to think that Australian stocks can’t also perform well in future.

Stocks can be impacted by inflation, but they’re likely to perform better than most alternatives

Monthly inflation data shows the Consumer Price Index rose 7.4% over the year to January - well above the RBA's 2% to 3% inflation target. It's reasonable to ask whether high inflation could derail long-term stock returns. And the simple answer is, it could.

The table below is instructive. During the high inflation of the 1970s, stocks returned 6.6% p.a. versus annual CPI of 10.3%. In other words, stocks couldn’t keep up with inflation.

That changed in the 1980s when annual CPI averaged a still high 8.7% yet stocks returned 18.2% p.a. Economic deregulation and the privatization of major banks helped drive the performance of shares in the ‘80s.

Stocks act as store of value over the long term as they comprise businesses that charge prices and pay wages, so if these two things are roughly matched, then the cash flows from these businesses should keep pace (theoretically) with inflation.

Overseas research has shown value stocks perform particularly well during periods of high inflation. This makes sense as they essentially function as cheaper stores of value.

Equities are volatile but that’s the price that you pay for admission

You may be thinking that the above is well and good, but what about the chances of a repeat of 2022 in 2023?

There’s no denying that stocks are more volatile than most other asset classes. In investing, returns and risk are correlated. If you want higher returns, it will invariably involve taking greater risk.

Yet over the long-term, the data for owning stocks is compelling. Shares have positive nominal annual returns about 70% of the time. Over any seven-year period, the chances of having a positive return from stocks is 99%, as the below chart from Firetrail Investments shows.

Australian market valuations are in line with long-term averages, which augurs well for the future

The ASX 200 is trading at close to 15x trailing earnings, largely in line with its historical average. And it’s sporting a 4.5% dividend yield, again relatively close to the long-term average.

The market is forecasting 11% earnings growth over the next 12 months, which is healthy though may prove a touch high given cost inflation and the expected hit to consumer spending from higher interest rates.

The US stock market is the outlier globally, being still relatively expensive. The S&P 500 is trading at more than 21x trailing earnings, and it only carries a 1.7% dividend yield.

Future long-term ASX returns appear reasonable

Estimates of stock returns are fraught with danger, yet there are simple methods to get a rough gauge of what’s to come.

I’ll use the formula employed by the late John Bogle to calculate future market returns over a 10-year period:

Starting dividend yield + earnings growth + percentage annualised change in the price-to-earnings (P/E) multiple.

For the ASX 200, the current dividend yield is 4.5%. The earnings growth of stocks is highly correlated with nominal GDP growth, which makes sense as business growth normally follows economic growth. Historically, earnings growth has averaged around 5.5%, and that’s not an unreasonable assumption moving forward.

If you assume no change in the current P/E multiple, that gives you a 10% annual return.

Of course, you can make your own assumptions and tweak the formula if you wish.

Are there any current concerns that could impact long-term stock performance?

As a long-term investor, it’s important to focus less on short-term volatility and more on what may cause irreparable damage to your portfolio.

One area worth monitoring is the valuation of illiquid assets. Unlike stocks which are priced daily and are highly liquid, private assets are priced less frequently and are less liquid.

What’s happened over the past 12 months is that interest rates have increased rapidly, yet the yields on illiquid assets have adjusted more slowly.

For example, Australian commercial property is yielding around 5% - the yield is lower for industrial property and higher for retail and office. That yield compares to the Australian 10-year government bond yield of 3.45% - or what’s termed the ‘risk-free’ rate.

Historically, commercial property is priced at 4-5% above risk-free rates. It’s nowhere near that right now and yields are set to adjust higher.

It’s a similar story with residential property where Australian houses yield 3% and apartments 4.5%. These yields don’t offer large enough premiums above the risk-free rate to make sense.

And the final area to monitor is venture capital and private equity.

Morningstar’s Mark LaMonica noted this week that private assets don’t have transparent pricing, though it’s obvious they haven’t adjusted to the new reality of higher interest rates.

Many superannuation funds have high exposure to private assets. These funds increased allocations to private assets in recent years to reach for higher yields and returns when interest rates were close to zero.

As private assets are revalued to reflect current market conditions, super funds will certainly be impacted.