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20 lessons in 20 years – Part 18

Tuesday, April 9th, 2019
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When is the best time to invest in the sharemarket and what is the best strategy for the cautious investor?

By Anton Tagliaferro

 

At IML, over our 20-year journey, we have invested through several market cycles and we are often asked the question by investors as to when the best time to invest in the sharemarket is.

Over the longer term a sharemarket cycle will reflect the expansionary and contractionary periods of economic activity, as reflected in corporate profits. The truth is that on a month-to-month or quarter-by-quarter basis the sharemarket is virtually impossible to predict as it is often driven by the emotions and moods of investors.

In fact, the sharemarket seems to swing between euphoria and depression making it very difficult for most investors to know when to invest their money in the sharemarket for the best outcomes.

Many investors believe the sharemarket should do very well when the economy is doing well. Surprisingly, this is often not the case as a strong economy may put pressure on inflation, which in turn often leads central banks to raise interest rates – sometimes aggressively. Rising rates are generally a negative for stockmarkets as they often result in slower economic growth which generally impacts company earnings.

The stockmarket is often said to be forward looking and that it serves as a discounting mechanism to reflect investors views of the future. Having said this, the cynics often say that the stockmarket has predicted 9 of the last 2 recessions as share prices can often fall disproportionally to any negative economic news. We saw this happen as recently as the last quarter of 2018 when markets fell heavily on investor concerns of excessive Fed tightening and moderating world growth forecasts.

The price earnings ratio (or PE) of the All Industrials Index in Australia is one way to observe the valuations of Industrial stocks.  As can be seen in Chart 1 below, the PE of the index can be fairly volatile – with markets often heavily influenced by the perception of what the future holds (as discussed in Lesson 8: The market isn’t always right). As can be seen by the dips on the chart in 2009 and 2012, the PE of Industrial stocks will often fall when investors are concerned that economic growth may slow, or interest rates may rise – which are both negative for profit growth. On the other hand, when investors are confident about the future and they see no clouds on the horizon, the PE ratio and valuations of many stocks can get pushed up to high levels – as was seen during November 2007 and August 2018.

Chart 1: Long-term price to earnings ratio of the Australian All Industrials Index

Source: Bloomberg; 1 January 2006-31 December 2018

Sharemarkets often exhibit familiar symptoms when they are approaching a peak. Thus, at or near a peak the vast majority of commentators are upbeat about the market direction despite valuations that appear stretched. Generally, at these times money is cheap, and lenders are eager to lend as credit standards are reduced because of the optimism abounding. Generally, before a major correction occurs, speculative activity in the sharemarket appears to build into a frenzy in many ‘hot’ sectors – another indication of an overvalued market.

For example, before the 1987 crash, the best performing companies were those of little substance; speculative gold explorers that went on astronomical runs or other headline-making companies who were making large and often expensive acquisitions using plenty of debt – like Bond Corporation, Bell Group and Adsteam Group. Similarly, in the lead up to the 2008 stockmarket downturn, poor quality, over-geared companies such as Centro Group and Babcock and Brown, that didn’t make much sense to conservative investors were the high-flying stocks of the time.

We have been through several market peaks in the 20 years since IML was established and when the market looks toppy, and when we are finding it hard to find good value, we tend to move our portfolio to a more defensive stance by raising our cash levels and by selling stocks that look unsustainable, from a valuation point of view, and replacing these with more defensive stocks.

The problem for all investors is that these periods of toppy markets can go on for far longer than expected and it is very difficult for the conservative investor to know when it’s the right time to invest money in a conservative fund or good quality stocks. It is almost impossible to predict the timing of market corrections, but as an investor one can always be prepared – and in Lesson 17 we discussed what the best strategy is to prepare for the inevitable corrections in the stockmarket.

Similarly, while the bottom of the market is often the best time to invest in good quality stocks, it often requires nerves of steel for many investors to invest in the stockmarket when things look bleak especially as the headlines and many market commentators are full of doom and gloom stories when markets are falling heavily. For example, you can see in the chart below in the 2011-2012 period when the headlines were dominated by the Euro crisis and all sorts of gloom and doom predictions abounded, and as a result the Australian sharemarket fell almost 20% – in retrospect this was a great time to buy good quality shares such as Woolworths, Brambles and Amcor.

Chart 2: ASX 300 sharemarket movements

Source: Iress; 1 July 2009-31 January 2019

In Lesson 14, we discussed how, as part of a diversified portfolio, the sooner an investor starts to invest in the stockmarket the sooner that they will start to accrue the benefits that come from the compounding returns from the stockmarket.

Unfortunately, the inherent volatility in the stockmarket makes it very difficult and confusing for many investors to know when to start investing for the long term. Many are reluctant to invest when markets are falling heavily because they fear further falls. Whereas after markets have risen, many investors are reticent to invest as they worry that they have missed out on the best returns.

So what is a sensible way for new investors to build their investment in the stockmarket?

One useful method employed by many is the process of dollar cost averaging.  This practice involves investing the same amount of money into, for example, shares or managed funds at regular intervals such as every month or every quarter and doing this over a period of time, irrespective of whether the market goes up or down.

The advantages of dollar cost averaging are:

Conclusion: It is virtually impossible to perfectly time your investments in the stockmarket. For those investors looking to build an investment in the stockmarket, dollar cost averaging provides a mechanical, simple and non-emotional way to build up your investment.

 

While the information contained in this article has been prepared with all reasonable care, Investors Mutual Limited (AFSL 229988) accepts no responsibility or liability for any errors, omissions or misstatements however caused. This information is not personal advice. This advice is general in nature and has been prepared without taking account of your objectives, financial situation or needs. The fact that shares in a particular company may have been mentioned should not be interpreted as a recommendation to buy, sell or hold that stock.