The first quarter of 2018 had everything from euphoric buying to panic selling. While markets started January with a record-breaking run, February saw that evaporate, and March saw further volatility that led to losses in equities for the quarter. Concerns about rising interest rates, trade wars and overall valuations were too much for crowded and expensive parts of the equity market.

In Australia, the big four banks did the index damage, leading the S&P/ASX200 to a 5.0% capital loss for Q1, the worst quarterly performance since the GFC.

The question clearly becomes: is this the end of the 9-year bull market in equities, or is it a long-overdue correction in equity markets that is a buying opportunity in the right stocks?

I favour the latter as we continue to see many buying opportunities in stocks around the world, at what we consider cheap valuations relative to the growth they should deliver over the years ahead. However, I must stress it is a time to be more selective. The rising tide will no longer lift all equity ships, and I firmly believe the best of “passive” returns are behind us. The best returns from here will come from active investors and particularly long/short equity funds, which have the ability to profit on both sides of the equation.

Buckle up

We must also condition ourselves for continued higher volatility. In fact, it’s not even really higher volatility; it’s simply higher volatility than the ultra-low volatility we experienced over 2017. The end of the ultra-low volatility period ended with the implosion of ultra-low volatility funds, which were short volatility via the VIX at record low prices. I expect more normalised volatility and that’s really what quarter one offered, albeit it seemed worse when you have just come out of a period of record low volatility.

Risk assets are volatile. We need to remember, and embrace, that this year and beyond. My view remains that to capture the best returns available in equities this year, you will need to trade your portfolio a little more. It is not going to be pure buy and hold wins all, and is precisely why the peak returns from “passive” strategies are behind us. In fact, some of the most significant losses in quarter one came from the biggest index weighted stocks, as money exited passive index products. This includes the previously infallible US FANG stocks. When the tide turned out the FANG’s didn’t have very sharp teeth because they are so grossly over-owned. When everyone owns a small group of stocks, it is hard to find a new marginal buyer until prices become cheap enough to be attractive.

Of course, periods like quarter one bring out the noisy bears, who all come out of hibernation and boast about how much “cash” they are holding and how “worried” they are. There is “peak bearish commentator quotes” at the bottom, and people who missed making +400% in Facebook or Amazon are now experts on them when they fall 15% from their peak.

Think for yourself

I encourage you to form your own views in periods like this. I suggest you’d be better not to read the financial press or particularly social media. I think it requires clear, forward-looking thinking. I don’t find reading daily noise helps, in fact, I find it hinders the investment process. I prefer to consider the fundamentals and whether the risk/reward equation has changed for the medium-term investment horizon. Taking a touch of short-term pain is fine, if the longer-term reward scenario remains clear.

While it was frustrating to give back a strong start to the year, I remain highly convicted in my concentrated long positions. I believe they all passed the earnings and outlook test, yet have generally pulled back with the overall sell-off in markets. I believe I am buying improved structural earnings growth streams at cheaper multiples, a combination I consider attractive over the medium-term. A classic example of this is our largest Chinese investment, Ping An Insurance (2318 HK), which I wrote about last week https://switzersuperreport.com.au/betting-on-the-chinese-consumer-ping-an-insurance/ . The chart below overlays Ping An’s share price and consensus CY18 EPS estimates (red line).

Ping An earnings forecasts vs share price; buy the gap

I also continue to view the risk reward on a short bond position as very attractive for the following three key reasons: (1) After a decade of QE, Central Bank support for bonds is set to disappear this year as the Fed’s balance sheet shrinks and the ECB ceases QE in H2 this year; (2) Bond issuance will pick up materially this year largely thanks to the US fiscal expansion and tax cuts; and (3) Our expectation that inflation will increase meaningfully beyond the Fed’s 2% target.  I expand on this last point below.

Inflation warning

I see several indicators pointing to a pick-up in inflation data in the near term. The first chart shows ISM Prices Paid versus US Inflation. ISM Prices Paid for 31 March were the highest since 2011, at which point CPI was around 3.9%. This potentially accelerates the theme of the Fed being behind the curve and suggests that they will not be able to stop this tightening cycle.

US ISM Prices paid (advanced 3 months) vs CPI inflation

The following charts (with thanks to Shaw and Partners) provide another warning on inflation. In simple terms the charts show that we are about to roll-off some very weak CPI data points from the first half last year which (from a simple mathematical stand-point) will see headline numbers kick-up. Inflation has averaged 0.31% over the past seven months, after being zero for the previous five months. Assuming CPI averages 0.31% each month, US CPI will print 3.81% by July.

While bond yields rallied in March, I believe it’s merely in sympathy with falling equity indices and absolutely not reflective of the scenario I paint above being wrong in the year ahead.

Interestingly, bond sensitive equities on the ASX didn’t prove “defensive” at all in quarter one, with Transurban (TCL) -8.13% , Sydney Airport (SYD) -4.82%, APA Group (APA) -5.04% , Macquarie Atlas Roads (MQA) -8.11% and Ramsay Healthcare (RHC) -11.3%. I realise there are differing views on some of these stocks from Switzer Super Report commentators, but I remain cautious on these names (along with long-duration bond sensitives) as we enter a higher interest rate environment. It is also worth remembering most are high P/E and overvalued versus their future growth prospects. I think there remains greater capital loss potential than dividend/distribution yield offset.

Warming to banks

Put it this way, I am cautious on these high P/E, highly geared, bond sensitive names but I’d have to say I am warming to Australian banks at these lower prices during the Royal Commission. I’m doing some more work in Aussie banks, and I do tend to believe the risk/ reward total return equation is starting to swing in favour of reward for patient investors. Bank P/E’s have dropped, dividend yields have risen, capital ratios have risen but on the other side demand for credit is weak, house prices are falling, wholesale funding costs are rising, and earnings growth is all-but non-existent. They are like growthless more regulated utilities that are priced for that outcome now, and that’s why I am warming to them.

Don’t get me wrong, I’m not saying run out and buy more Aussie banks today, but I do believe they are getting interesting for the first time in about four years from a valuation and potential total return perspective. They could easily get cheaper again in the short-term, with more negative headlines from the Royal Commission, but it is time to start sharpening the pencil on the sector, looking for the moment to start increasing weightings again.

All in all, it was a rough first quarter of 2018. It was roughest in Australian equities, which did worse than most of the developed world indices. We didn’t go up with Wall St, but we went down with it. That’s a pretty weak outcome and reminds you that having all your eggs in domestic equities is simply the wrong asset allocation.

That said, I do see opportunities globally and locally, to make positive total returns for the rest of 2018, albeit we will endure bouts of volatility, unlike 2017.

I look forward to presenting at the Switzer conferences this month in Sydney, Brisbane and Melbourne on where we see those opportunities.

It’s always darkest before the dawn…

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regard to your circumstances.