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What to expect…next


The current boom in share prices in Australia is difficult to ignore but caution should always be at the back of every investor's mind.

As a growing band of retirees are forced – by low interest income on their term deposits – into a narrowing band of sufficiently high quality company shares with stable income, their price-to-earnings ratios are reaching multiples that simply won't be sustainable over the next few years.

It's quite simple really: locally interest rates are currently expected to decline further, and armed with plenty of cash and an understanding of the income required to fund lifestyle and general living expenses in retirement, the biggest cohort of the population are marching headlong into what I believe will be another catastrophe.

Now, I know, in a rising market and with interest rates expected to remain low for some time, I will, like Cassandra, never be believed. It is probably right to dismiss my forecast of impending doom upon the retirement nest eggs of many millions of investors but the sad truth is that despite decades of experience, those baby boomers have learned little about successfully navigating the market's booms and busts.

Keep these two truisms in mind:

  • First, the stock market has never allowed a majority to grow sustainably wealthy at the expense of the minority - it's always been the other way around.
  • Secondly, the stock market is merely a transfer mechanism that transfers wealth from those who have no patience to those that do.

What is the action that the majority has commenced? They are being herded into stocks and property by low interest rates. Will the majority be smart enough to get out before everyone else? By definition they cannot.

As interest rates continue their incessant decline, investors searching for income are moving further and further up the risk spectrum. By way of example, Real Estate Investment Trusts now trade at up to 40 per cent over their Net Tangible Assets and such is their popularity that their investment bankers would have no trouble securing billions of fresh equity for them. Only problem is they cannot find assets that stack up.

The enthusiasm for more risk is willingly encouraged by an increasing chorus of advisers, some of whom are now suggesting investors look at the yields available on equities on a 13-month basis! Promoting dividend yields by picking up three dividends over 13 months fails to recognize you have borrowed a dividend from the subsequent year.

Longer term, equity market returns will be determined by two drivers. They are earnings and the P/E ratio investors are willing to pay.

Starting with earnings there are, in turn, two further drivers. The first is GDP growth and the second is profit margins. GDP growth is driven by changes to the labor force and changes to productivity.

Our analysts at Montgomery have discovered that countries responsible for 72% of world GDP growth will see old-age related dependency rates rise significantly, and double in some countries, in the next 20-30 years. The working age population, which is a key determinant of aggregate demand, will represent a smaller share of the global population.

In other words, there is a very large negative demographic influence on global GDP growth rates.

Turning to profit margins, once again the analysts at Montgomery have discovered that profit margins are the highest they have been since 1974, especially for mega cap companies. These margins cannot increase indefinitely because other sectors of the economy, such as wages and social security, begin to come under pressure, and inevitably, the margins mean revert.

Having established that the drivers of corporate earnings – GDP growth and margins – will in future come under pressure, we turn to the other driver of equity market returns, the P/E multiple.

One of the major factors driving the multiple investors are willing to pay is interest rates. As interest rates fall, so do discount rates used to calculate the present values of business cash flows. These have been on a steady decline since 1981. Given risk-free rates cannot fall below zero, the 30-year tailwind that has helped boost stock market returns might now be ending.

So there you have it. Three major long-term drivers of equity market returns are now turning from tailwinds into headwinds.

Many investors believe that rising interest rates will be required before a stock market correction follows. I am not sure that we need rates to actually rise. You see, this time around, low rates have driven a stampede into alternative assets with higher yields. When those yields cease being higher, because shares have been pushed up too far, and/or the stampede ends (boomers are done buying and little cash reserves left with which to buy), asset prices will stop rising. When they stop rising the most nervous investor is the last one in. He or she will then be one of the first to exit and that might be all that is required to see the gains reverse.

Warren Buffett once observed that the long-term drivers of aggregate stock market performance – in other words, the index, are corporate profits as a percentage of GDP and interest rates.

Between the years 1964 and 1981, for example, interest rates rose and corporate profits as a percentage of GDP declined. As a result, the Dow Jones rose just 1/10th of a percent over that seventeen year period.

More recently, interest rates have been declining and corporate profits have been expanding. Hence the very strong rises – to new highs in the US – seen in the stock market. But all this will one day reverse again.

While don't know the precise day and time, we do know the higher the price you pay, the lower your returns. The higher shares go, the more convinced an era of lower returns is ahead. And as the stock market is anything but smooth, violent reactions will be what cause investors the lower returns they are currently happy to accept.

Roger Montgomery
Roger Montgomery

Roger shares his stock market insights at his Insights blog, Investors can also follow Roger on Facebook and watch media interviews at his YouTube channel. Grab your Second Edition copy of and learn how Roger Montgomery values the best stocks and buys them for less than they're worth. Grab the book now at special price!