This musings will look at predictions for a share market crash. Are they realistic? How do we know a market is going to crash? If 10 people tell you to sell and 10 people tell you to buy – which are you to believe? If one person says we are all in for a share market crash, how much credibility does that person need before you ignore 19 people and act on their judgement? It can be very difficult for investors to remain cool and aloof and objective when they are dealing with investment and preserving or profiting from their hard-won cash. Here are some thoughts from a financial planner whose aged mind has seen a share market crash or two. That doesn’t mean I can guess the next share market crash – it just means i have a fair degree of perspective on the issues that should be considered when you hear that 1-in-20 doom merchant or the 10-10 equal call on market direction.

Share market crash – predictions in an unpredictable world

There are a number of financial commentators who love to be gloomy. Here are some of my favourites from recent years:

• “There’s a storm coming” (an article that almost perfectly timed the lowest market point before a steady upward trajectory),
• “Investors will be blindsided” (they were – momentarily – then the US sharemarket make a blistering recovery. If it crashed, it crashed higher!),
• blah, blah, blah. You would have seem enough to be able to add your own examples..

Maybe there will be a share market crash tomorrow, and maybe there won’t – nobody knows the answer to that question, so I cannot really comment one way or the other. However, what is certain is that an investor who who sets out to follow every “big call” in the share or property market – or the bond or gold or iron ore markets or copper, milk, soybeans, coffee or scrap- metal markets, is more-often-than-not going to find themselves on the wrong side of the risk/return scales. That’s not Michael being clever – that’s basic mathematics and statistical probabilities.

Lodged firmly In my aged memory cells are examples of individuals or institutions deciding the market was “too high” or “too low” and allowing that to dominate their investment decisions. A couple of times it has worked out – but mostly it did not.

If you are in the mood for reading then here is a link to a musings i wrote back in 2011, when the world was looking just as uncertain..

Share market crash – why now?

Are we headed for a share market crash now?

As the previous comments have told you – I don’t know. No idea at all, in fact. And neither does anyone else – but that doesn’t stop investors or money managers or analysts from suggesting that it may fall.

This particular musings is prompted by the front-page news of a fund manager closing their share fund and handing money back to investors. Given that a fund manager makes money from holding on to an investor’s money, this would seem a fairly bold move.

You can read the ABC News perspective on this story by clicking on the image below..

As you would imagine, this is a very big deal in Australia’s effervescent funds management world. The story has been covered by all the major newspapers as well as many online and specialist investor forums. Here is just one example – from Livewiremarkets.com.

While the idea sounds full of integrity and good sense, you should be careful of falling into any one of a number of logic traps surrounding this idea.

At first glance, it does not make sense that an an active fund manager in Australian shares should decide that there is no benefit in investing into the Australian sharemarket. That is entirely counter-intuitive, and here’s why…

An active manager believes that their skill, knowledge, experience and training will allow them to buy and sell shares in a way that wins a higher profit than simply “buying the market” through a “passive strategy” such as an Exchange Traded Fund (“ETF”) listed security. In other words, the manager believes that the broader market is not correctly valuing this or that share, and by taking advantage of those mispricing moments, they can generate a good profit. If investors are over confident they may ignore high debt levels, reducing cashflows, increasing expenses, rising interest rates or any number of potential negatives to a company share price. The active funds manager would see that as an opportunity to sell their holding at a price above what they see as fair value. Similarly, if the general market mood is negative then it is possible that even well run, profitable companies with strong cashflows and low debt, will see their share price fall to the point where the active manager thinks the price is a discount to its fair value.

Usually, if a fund manager thinks markets or sectors are overvalued, they will reduce their exposure to this or that sector or companies showing this or that potential weakness (such as high debt levels, falling sales, loss of market share) and hold a lot more cash in their portfolio. When prices correct back to where the fund manager thinks they represent good value then the extra cash will be used to buy shares “at a discount”.

So markets moving to extremes is exactly the sort of stuff that helps an active money manager use their skills to greatest effect. Why then would you sell all your holdings and hand money back to investors?

If an active fund manager thinks there is potential for a share market crash then they simply check their portfolios to ensure they are strong and clean and tidy then sit and wait with extra cash, ready to pounce when the time is ripe. They don’t usually hand money back to investors because this is the time when they can really make a career and a reputation.

Share market crash – past performance as an indicator

There’s a basic disclaimer that the industry regulator ASIC wants shown next to any future money projection, and it goes something like this.. “past performance is no guarantee of future returns“. Such a simple message yet one that is very, very difficult to correctly understand. In effect, what ASIC is saying that the future is unwritten, and nobody can predict what will happen into that future. Every investment decision is a trade-off of risk and return, and that is how you should consider every money decision you make.

It’s one of the conundrums of investing that the best times to place money into share markets is when historical returns are lowest. That’s more likely to be the time when commentators are being negative about future growth or earnings. It’s when there are doubts about this or that sector or part of the market. It’s also a time when past investors are feeling very fragile, burned and a little – or even a lot – fearful. A share market crash is such a time and can be a time of great opportunity if an investor is prepared. Yet ASIC’s warning asks us to hesitate at just such a time and pause for a moment to think through any investment decision – as perhaps the market will not rise again in the same way it has done in the past? In other words, even an obvious money-making situation can still involve unseen risks and uncertainties, and just because a particular strategy worked in the past, there is no guarantee it will work this time.

A particularly horrible example that stands out in my memory is from the times of the Global Financial Crisis. Many people – and i was one of them – thought that the initial sell-offs of markets were a bit excessive and may create opportunities for investment. Very clear in my mind at the time was the example of the 1987 share market crash, where an investment soon after the large falls was profitable in a relatively short time. However, unlike the 1987 share market crash where the share market fell dramatically in mere days, the Global Financial Crisis episode saw share markets start to fall from their peak in November 2007, and they didn’t stop falling until March of 2009. Well over a year of steeply falling prices. That is an awfully long time for investors and onlookers to develop a strongly negative mindset. The end result for a brave investor trying to take advantage of the falls by investing cash into the share market at that time was inevitably just more losses. At least temporarily – but you could imagine that it doesn’t take too many burnt fingers for a person to stop putting their hands into the fire…

The point of all these examples is to suggest that up’s and down’s are a standard part of share market investing. If you are worried about a share market crash then why were you in shares in the first place? If your reason for being invested is to gain from that volatility and mispricing, why decide to stop being a money manager?

Rule 1 – Share markets are volatile

Reasons for a share market crash?

Let’s start with the broad picture – global markets have been in recovery mode for years as the world works through one of the slowest post-crash recoveries on record. So in a sense, you would *expect* that returns would be higher than average during such a period (this is counter-intuitive and regulators don’t want you to say it out loud but the logic is ridiculously straight-forward). That’s my view – but here are the results of a poll by the Markets Live section of smh.com.au this week…

Many of the huge structural worries of the past 7 or so years have come and gone without markets “tumbling into madness” (a bare-faced steal from a Midnight Oil song). Just think of a few of them, starting with the Global Financial/Banking Crisis…

• Failure of the money market – this is what caused the US Government and US Federal Reserve to step in and “take control” of major US financial systems. For a short time, the operation of the financial market itself was at risk – but eventually did make it through.
•  Bankruptcy of the USA Government – for a while, it looked as if the USA would default on government debt. It didn’t – but the world teetered on the edge of the abyss for a time. Interestingly, some of the key players in that debacle are now in positions of power.
• Failure of the Euro – Portugal, Ireland, Italy and Greece all looked as if they would fail to meet their debt obligations and the European Union Central Bank would not bail them out. It did, and Europe is undergoing a grindingly slow recovery – but it *is* a recovery.
• Failure of market systems – the May 2010 Flash Crash caused huge price changes in “blue-chip” shares, making some people a lot of money and losing money for others. After investigation the general consensus was that it happened. While this temporary system or market efficiency failure
• End of the commodity market – Australia’s main commodity markets fell dramatically after rising just as dramatically in response to China’s rapid urbanisation and the surge in global demand for these commodities. The fall has been followed by a bounce every bit as dramatic as the previous rise and fall. Yet the underlying demand has remained strong, and the move of developing countries into higher levels of growth /urbanisation / middle-class wealth progresses regardless.
• War or the threat of war – Military conflict or potential conflict continues unabated at all times somewhere in the world, yet full-scale all-out wars have somehow been avoided. For those with a gloomy mindset, purchase the book “The Better Angels of Our Nature: Why Violence Has Declined” by Steven Pinker. It will change the way you think. (Booktopia link here)
• The disintegration of Federalism around the world – the breakup of this or that “nation” or grouping has dominated headlines for many years now. The general breakup of the European Union (which may still happen – who knows?), the UK leaving the European Union, Scotland leaving the UK, Catalonia leaving Spain, Ukrainian “rebel” areas wanting to shift the Russian border, and a long list of other secession movements (Wikipedia link here) all provide leading media article stories that captivate our imaginations and fuel our worry senses – but should we allow this sort of issue to cloud our investment judgement? Here’s a New York Times article that suggests we should not.

The reality is that any one of these sources of worry could have blown up into a fully fledged disaster causing global disruption and potentially debilitating markets and demolishing investment returns. Could have – but didn’t. This is not to say that the sharemarket volatility caused by any one or more of these worries should be ignored – it shouldn’t. However, if you have investments whose value is exposed to these events and aren’t prepared for the volatility that they cause then perhaps you should reconsider your investments or your investment approach or your strategy or your understanding of markets or your investment specifically.

Unpredictability is the only certainty

What about now? What about the current set of circumstances – isn’t it different this time?

I. Don’t. Know.

Nor. Does. Anyone. Else.

OK Michael – what if this idea of selling up and returning cash to investors turns out to be a brilliant tactical decision? What if the Australian sharemarket actually does tumble into madness?

Good point. Let’s say that it does – what impact will this have on your investments and investment plans? I ask this because if it would dramatically ruin your plans or alter your life in ugly ways then you probably shouldn’t be invested in the way you are REGARDLESS of what you think of future prospects. In other words, the future is unwritten, and large scale market falls and rises can happen at any time. They aren’t always highlighted in advance. Actually, i’m being farcical there, aren’t i? They are NEVER highlighted in advance – that’s how large falls happen – they occur when they are not expected. If the broader population could predict large falls in advance and act to take advantage of such times then we wouldn’t be discussing this point in the first place, would we?

If my musings is too esoteric here then just remember this one point –

You should NOT be invested into the sharemarket if you are not prepared for at least a 30% fall in the value of your investments, at ANY given point in time. And if that share market crash turns out to be 50% or 60% then that possibility was always there. It has happened before and it can happen again.

Like any universal rule, this one is not universal. You could have a derivative-protected exposure or a portfolio strategy that is designed to minimise losses but for straight-forward sharemarket investment, you should expect that a large fall could occur without warning, at any time. Even “good” times. Even “bad” times.

What if?

Another well known investment fund manager – Fidelity – are suggesting “being braver for longer” may be appropriate for this particular market cycle. Fidelity’s spokesperson suggests “With cash and fixed income offering negative real returns, being braver for longer may be the only investment strategy that pays as we approach the late cycle”.