Current market falls

Share market falls   Written 4/7/22

If you’re a share investor then like me I’m sure you’re feeling rather depressed and worried about the sharemarket falls. The value of my share portfolio has eroded considerably since it reached a peak a few months ago. I’m a self funded retiree and shares are my nest egg of investment value as well as producing a worthwhile income boost. I wouldn’t be honest if I said it wasn’t very disconcerting to see the value of my investments falling so much. These are natural emotions I’m feeling but as I’ve said in my books, emotional reactions shouldn’t be part of an investor’s strategy. So let’s try to dispassionately review the current situation to pinpoint the causes and more importantly, what you should do about it.

Cause

The root cause is the steep rise in inflation throughout most economies, but chiefly the USA because it’s one of the world’s largest economies and certainly one that has the greatest impact. The well-known quote that expresses this is: ‘when America sneezes, the rest of the world catches a cold’. The trigger for this steep rise was the continuing war in Ukraine that’s resulted in essential commodity shortages with consequent price increases. It’s also worth remembering that inflation has been at record low for many years so it’s not surprising that it’s rising again.

Basically governments don’t like it when inflation gets out of hand. In years past, governments weren’t as savvy as they now are and without appropriate governmental control economies often swang from big booms to equally big busts. Everyone like a boom but the busts often became depressions that caused great suffering. Nowadays governments try to even out the highs and lows of inflation and so keep the economy on a relatively even keel. In Australia, our government has a target of around 2-3% which is considered a suitable value resulting only in gradual price rises over time.

Control

The main way the government can exercise control over inflation is through interest rates. If interest rates rise, it directly affects those who have obtained funds by means of loan; which in Australia is almost everyone. The greatest amount of loan capital comes from home loans as home buyers usually need a mortgage to fund their purchase.  The consequent result of increasing interest rate is that goods and services become more expensive. This reduces consumer spending and dampens the economy and so puts a brake on inflation.  Our government will continue this process until inflation falls back to a more reasonable level.

Effect on the sharemarket

Rising inflation and interest rates affect company profits because rising costs can’t usually be fully recouped and this coupled with a lowering in demand results in a fall in profit. The real fear is that the economy could enter a period known as ‘stagflation’ – a combination stagnant profitability and rising prices. Profitability underpins share prices, so a reduction in profitability (either current or anticipated) results in share price falls and makes fixed-interest investments more attractive. Consequently some investors sell and transfer funds from shares in favour of cash, bonds or other types of fixed interest investments.

One sector that should be relatively immune from the fall in profits is the banking sector because banks usually pass on interest rate rises and thus recoup their increased costs. However, this time the situation is different because Australians have been steadily increasing their levels of debt and now the ratio between loan capital and earnings for our population is at an all time high. As interest rate rise it’s expected that many borrowers won’t be able to meet the increase in repayments and default – which isn’t a profitable exercise for the banks. So the banks have been hit hard and have followed the rest of the market down.

What should you do about it?

When I look at the evidence dispassionately it seems to me that the fall in shares has been overdone and the current situation is a classic case of panic and flight. As some investors became fearful and sold and share prices fell, other investors started to panic and decided the safest strategy was to follow the herd. So they jumped on the bandwagon and also sold shares. Before long, as further interest rate rises were announced, the initial wave became a tsunami which resulted in big market falls across almost the entire board. This effect (as described in my books) is also known as the ‘momentum’ effect.

In fact the Australian economy is in good shape and we have fared better than almost all other economies throughout the world. Demand for goods and services is high and unemployment levels are at an all time low so everyone capable of working and wants a job can get one. It’s true that wages growth has lagged interest rates but there’s every indication that wages are on the march as employers struggle to get the employees they need. Australian savings levels are at an all time high so most have a nest egg that will help cover cost rises.

There’s no doubt in my mind that the market will recover and rise to new heights again as it always has in the past – the only question is – when? Therefore I’m refusing to join the herd and my current strategy is to exercise patience and sit tight on my portfolio. Many analysts are suggesting that the current bear market presents opportunities and now is a good time to buy shares and pick them up at bargain prices. Topping up shares when prices are low is generally a good strategy but the danger is that you might do so too early in the cycle. Remember the well known saying ‘nobody rings a bell when the market hits bottom’ meaning it’s really impossible to tell when the lowest point is reached. Just because a share price is at an all-time low doesn’t mean it can’t fall even further. So if you jump in too early you can still suffer losses and it may be some time before those losses can be recouped.

Therefore I’m sitting on the sidelines and trying to accumulate funds so I have additional capital to fund future purchases. I’m keeping a close eye on the market and updating my watch list of shares that I think have good future prospects. This will enable me to jump in when I think the time is right and the market enters a bull phase. Generally in times of increased volatility (as we have now), the best strategy is to avoid speculative shares and stick to more stable and defensive types of shares. After all, consumers are less likely to upgrade their phones or buy the latest smart TV when they need enough money to pay the rent or the interest on their loans. Readers of my latest book ‘Starting with Shares’ will recognise this policy which I describe as the ‘core and satellite’ approach where the majority of your capital is invested in the core consisting of good quality shares. The satellites are just a few of the more speculative types of shares which offer prospects of large capital gains if their potential is realised.

Whether or not you want to adopt my policies is entirely up to you but you should really try to avoid panicking and make decisions based on evidence rather than emotion. I wish you all the best and I would like to think that a sharemarket reversal isn’t too far away.