As The ASX Falls, Should Aussie Share Investors Panic?

Australia’s stock market is in disarray, no doubt, but it is still outperforming US stocks. The S&P 500 is down 17% this year and the tech-heavy Nasdaq is down 26%.

Are more falls coming? Would your money be better off spending some time as cash? Or is this a time of consolidation before stock prices rise once again? Predicting the future is not easy, but understanding the forces that are driving stock prices is vital to be able to understand when they might turn.

The biggest moving factor in stock markets is the nexus between inflation and interest rates. As inflation goes up, interest rates follow. Central banks are trying to squeeze the economy, diminishing demand until firms feel like they can no longer raise prices.

Imagine a plumber. His phone is ringing off the hook with people wanting bathroom and kitchen remodelling, plus businesses fitting out new premises. He feels he can add 20% to every quote without running out of work. The central bank’s goal is to make that phone stop ringing of the hook so the quotes stay stable. That’s how they beat inflation: By lifting interest rates they reduce household budgets and business investment until the only people ringing for a plumber have a flooded bathroom.

Rising interest rates hit stock prices in an obvious way—firms will grow more slowly in an environment of slowing demand. But that’s not all.

Rising interest rates also change how patient investors are. When inflation is rising, the value of a dollar in the future is eroded. That makes people want a dollar today more than a dollar in the future, and so they are more willing to buy stocks that have strong returns in 2022, and less willing to buy stocks that will pay out in the future if everything goes right.

That’s why the ASX heatmap for the last year looks like this: IT stocks that once looked set to dominate the future have been dumped as investors pivot to safer options. Consumer staples are down less than consumer discretionary, for example, and health care is doing better still.  (While energy and utilities have shaken off the overall market downtrend to be up for the year).

Source: asx.com.au

You can see traces of the pivot to safer stocks in as little as a single day’s trading. Consider the next chart. Friday, October 7, was one of the worst days of the year for US markets, as the NASDAQ fell 3.8% and the S&P 500 fell 2.8%. Markets capitulated following the release of strong US jobs data. You’d think signs of a strong economy would boost the stock market, but in the current situation they only make investors nervous that the US central bank will raise rates further still.

So stocks were dumped. If we consider all the stocks that fell at least 2.5%, there is a correlation between their price-to-earnings ratio and their falls on October 7. Stocks with high price-to-earnings are bets on the future—companies where investors have been putting their money despite a lack of immediate earnings. They have been unpopular over the last year and fell once again in the hustle and bustle of the Friday sell-off.

The phenomenon illustrated in the above graph is the inverse of the trend of the last decade: lower interest rates, lower inflation, and a higher premium placed on firms that aimed far into the future. The way startups and Silicon Valley became part of the cultural conversation in recent memory is an illustration of how profoundly low interest rates and patient capital shaped the world. That phenomenon now appears to be in reverse.

If the trend to lower interest rates returns, perhaps owning growth stocks and speculative stocks will soon become popular again. But if it is over for the foreseeable future—if inflation is back and interest rates never again flirt with negative numbers—patience may be slow to return to markets. In that case, stocks in general may take time to recover, growth stocks especially.

So is it time to sell?

The analysis above has focused on stock prices. But stock prices are not the be-all and end-all. You can in theory own a stock with a falling price and still make impressive returns after income is taken into account—so long as the falls are modest and the income is strong.

This point can be overlooked  by international commentators: many Aussie stocks pay fat dividends compared to US stocks. In America, thanks primarily to tax laws, buybacks are the main way companies return money to shareholders. whereas many Australian stocks have reasonable yields and investors enjoy excellent tax treatment for dividends.

For example, Australia’s largest listed firm by market capitalisation, BHP, paid $4.63 in dividends last year. At time of writing the stock was trading at $40.07, meaning the dividend yield is 11.6%. Now, last year’s dividends were healthy and of course, future dividends may differ as trading conditions change, but giving up that sort of income is something an investor must take into account before selling.

Moving to cash may protect you against capital erosion but can also deny an investor income. Banks aren’t paying much interest right now—the best Australians can hope for is 2.125% on a bonus savings account, or 1.5%  on a one-year term deposit. That is well below inflation and guarantees a loss of purchasing power.

The advice and information provided by ForbesAdvisor is general in nature and is not intended to replace independent financial advice. ForbesAdvisor encourages readers to seek expert advice in relation to their own financial decisions and investments.

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