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Shani Jayamanne: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs.

Mark LaMonica: Okay, so today, Shani, we are going to do one of, I guess we'll call them periodic because there's no set time that we do these exactly. One of our periodic market updates. And I looked back because I didn't quite remember. It's been a while since we've done this. We did one in April.

Jayamanne: That feels like a lifetime ago.

LaMonica: It does.

Jayamanne: Your birthdays in April.

LaMonica: It is. So I was probably younger when we did this before. And I think if we think back to April, think about how long ago it was. If you think about that time, inflation was high. Market participants were optimistic that interest rate increases were coming to a close and we would start seeing cuts. And a lot of people worried about the impact to the economy of the increases in interest rates.

Jayamanne: So I guess not much has happened at all, apart from getting older.

LaMonica: Yeah, no, no, exactly. And I know what the answer will be because apparently we have not seen any of the same movies, but have you seen the movie Groundhog Day, Shani?

Jayamanne: I haven't, but we did have a conversation about Groundhog Day before this because it's an actual thing. It's not just a movie.

LaMonica: Yeah.Well, okay. So let's start with the movie. Then I'll talk about the thing.

Jayamanne: Okay.

LaMonica: Since you and you claimed all Australians are not aware of this.

Jayamanne: I don't think all Australians, but I feel like most Australians wouldn't know what this is and it's very crazy.

LaMonica: Okay.Well, the movie is like the premise of the movie is Bill Murray keeps living the same day over and over again. And that day that he keeps living is Groundhog Day. And this is the part that you said no Australians know about. So basically in February, there's this little town in Pennsylvania and they pull a Groundhog out, which is like basically a large rodent and they pull it out of this tree stump. Like it's not a real tree stump. They set it up on stage.

Jayamanne: Yeah. Like it's been placed inside this tree stump.

LaMonica: Oh yeah. They put it in there and then they pull it out and the Groundhog's name is Phil.

Jayamanne: It's the same Groundhog.

LaMonica: Well, no, they die.

Jayamanne: Okay.

LaMonica: But they just rename them Phil every year. And if the Groundhog has seen its shadow, then there's six more weeks of winter.

Jayamanne: But how do we know if the Groundhog has acknowledged its shadow? Like how do we know that it's seen its shadow?

LaMonica: Okay. Well, it's safe to say that this thing's made up. And because I knew you had questions, I looked it up. The Groundhog has only been right 40% of the time. However, we define this as six more weeks of winter.

Jayamanne: That's more than active managers.

LaMonica: It is. That's true. That's true. And in Australia, right, like winter lasts about six weeks in total. So they'd have to pull out the Groundhog on the first day that it gets cold.

Jayamanne: This is all very interesting, but this is an investing podcast.

LaMonica: Yes. And the premise of this before we got into this whole diatribe about what Groundhog Day is, is that markets seem this way, right? It just seems like for the past couple of years, the same things are happening over and over again. But in reality, nothing has really changed except for the fact that investors have been going through this kind of bipolar, I guess, for lack of better way to describe it, like just cycling back and forth between optimism and pessimism when nothing's really changed in reality.

Jayamanne: Yeah.So let's take a step back and we can look at what we've experienced. So we can go back to COVID. We had a two-month steep drop in markets and then governments around the world and central banks started shoveling money into the economy. Going into COVID, interest rates were already fairly low and as a result, valuations were fairly stretched.

LaMonica: Yeah. But of course, interest rates dropped even lower during COVID to practically zero, which means we got even higher valuation levels. And for both established businesses and certainly startups, the cost of capital was practically nothing, which made any project you wanted to invest in a good one.

Jayamanne: And after conditions started to change, we all lived in denial. So we proclaimed that inflation was transitory. We admonished each other to buy the dip. We postulated that interest rate cuts were just around the corner.

LaMonica: And then of course, in 2022, share and bond prices fell throughout the year. It seemed like a more realistic outlook was starting to color less. And then of course, the world got introduced to ChatGPT. And maybe if conventional intelligence kept letting us down, we should give the whole artificial variety a shot.

Jayamanne: After all, ChatGPT could write cover letters or compose (mediocre poems). But I actually use ChatGPT. I use it to plan holidays. So if I'll say certain days.

LaMonica: So not to create cover letters.

Jayamanne: No, I do them myself. I want them to be quality.

LaMonica: Is that why you're still at Morningstar? Maybe you should use ChatGPT.

Jayamanne: Maybe.

LaMonica: Okay. Well, AI, I think, will probably change the world. But I think with each of these new technology leaps, it's hard to figure out who will benefit. So sometimes a company that actually creates the products, so in this case, we can call it Microsoft as an example, will make a significant profit off this new technology, in this case, AI, or potentially it's just an add-on service. And in that case, maybe the true beneficiaries will be companies that use AI to get more efficient.

Jayamanne: Regardless of the ultimate beneficiaries, the immediate impact was that U.S. share prices surged in the first half of the year. We've all heard about the Magnificent 7 surging in price and dragging indexes upwards when most shares weren't doing well.

LaMonica: But of course, regardless of that, it was time to celebrate. So as Shani said, share prices in the U.S. surged, the bear market was over, which means we could forget about stubborn inflation, increasing interest rates. We could ignore all the geopolitical uncertainty, the pile of debt we've collectively got in. And of course, the fact that valuation levels were still high. And Australia was a little bit different. The market just kind of muddled on. There wasn't a huge drop in 2022. And there wasn't a huge rally in the first half of 2023. And so in fact, over the last four years, the market has expended a lot of energy to end up in almost the exact same place. So, we're recording this in November of 2023. The ASX on the day we're recording it is sitting at 6,838. In November of 2019, the ASX was slightly higher at 6,846.

Jayamanne: And recently it seems like the market is a little more optimistic despite the recent rate increase in Australia. There are many professionals that are saying an end of year rally may happen.

LaMonica: And it's sometimes helpful to go back and look at what has recently happened. But what really matters, of course, is what the future holds.

Jayamanne: And we do these periodic updates, not because we think any investors should worry about short-term market movements, but just as a check-in on where the market currently is. So, Mark, let's talk about where we are right now.

LaMonica: Well, one thing we've always advocated is that the most important thing an investor can do is focus on valuation. So let's start our check-in there. And we've come up with three different types of market environments that we typically find ourselves in.

Jayamanne: And I'd like to say that Mark came up with these names, but the first is what we've called the backup the truck phase. And that is when the market is so cheap that many investors want to invest every dollar that they have with the exception of emergency funds.

LaMonica: And figuring out when the market is in this phase is easier said than done. The market often looks cheap in retrospect. At the time, it's likely that earnings are also falling, which means the market doesn't look cheap using relative valuation measures like price to earnings.

Jayamanne: The other challenge is that the market is likely cheap because the economic environment is terrible and investor sentiment is negative. It's hard to go up against the grain. And even for investors who have the fortitude to go against the herd, it can be hard to figure out an entry point since the expectation is that the market will keep dropping.

LaMonica: Yeah.And this was this was my personal problem during COVID where I was ready to buy, but I thought the market would keep dropping. And I guess I got greedy for lower prices.

Jayamanne: So onto the next phase. And it's the nothing to see here phase. This is where we find the market most of the time. The market isn't overly cheap and it isn't overly expensive. This is where you stick to your plan and investment strategy. For most working age investors, this means investing regularly, which is the best pathway to building wealth over the long term.

LaMonica: And then the last phase, which Shani obviously does not like any of my names, but I have coined bubbleville. And this is when your Uber driver is giving you investment tips and high schoolers skip class to day trade. So bubbles are, of course, also clear in retrospect. But like a severely undervalued market, it can be hard to identify at the time. There will be a narrative attached to the surge in prices. With some perspective, we can look back and see that the narrative was simply justifying a rationality, but it seems hypnotically compelling at the time, especially because investors want it to be true.

Jayamanne: This is a time when investors may want to build up some cash. A share that has appreciated and may be overvalued does not necessarily mean it's time to sell, given potential tax consequences and the fact that you may simply be wrong. New savings can be directed towards cash instead of the share market. Dividends can be retained instead of reinvested.

LaMonica: And so now we're going to look at the market right now and we're going to try to place it within one of those three phases. And we'll look at two different valuation approaches today. The first technique is using relative valuation measures. And a relative valuation measure is a financial ratio, such as the price to earnings ratio or P/E.

Jayamanne: Other ratios, such as price to sales or price to cash flow, are also used. A relative valuation measure is representative of how much investors are willing to pay for a dollar of earnings or sales or cash flow. The higher the ratios, the more investors are willing to pay. One critical element of a relative valuation measure is that the number doesn't tell us anything. A P/E of 15 or 20 tells us nothing in isolation and we must focus on the relative. We need a point of comparison.

LaMonica: That's right, Shani. So if the market is trading at a P/E of 15 and it traded at 20 times earnings last year, we can say that the market is cheaper than it was a year ago. The Australian market's trading at 10 times earnings and the U.S. is at 20. We can say that the U.S. market is more expensive than the Australian market. What a relative valuation measure cannot tell you is if the differences between the two markets, two points in time or two different companies are justified.

Jayamanne: There are many reasons why a market or a company would trade at a different valuation level. For instance, when comparing two points in time, the level of interest rates would influence valuation levels. Expected growth rates between countries or companies will influence valuation levels. If earnings are expected to fall in the future, valuations would be lower.

LaMonica: And when we do these market updates, we look at the cyclically adjusted price to earnings ratio or CAPE ratio as a relative valuation measure for the overall market. The CAPE ratio uses the average earnings from the past 10 years to smooth out the cyclicality of earnings.

Jayamanne: According to data from Robert Schiller at Yale University, the U.S. is trading at a CAPE ratio of around 30 as of September 2023. That is down from a recent high in 2021 of 38, but higher than the low during the market fall in 2022 when the CAPE reached 27. Historically, the CAPE ratio is still higher than average. The average monthly CAPE since 2000 has been 27.

LaMonica: And in Australia, the CAPE ratio on June 30, 2023 was around 19. The publicly available data is less robust than the U.S., but the CAPE has come down from 23 in 2021.

Jayamanne: And there are limitations to relative valuation measures. Investors need to understand how the conditions of the overall economy and the particulars of an individual company impact the level of valuation as measured by something like the P/E ratio. In other words, valuation measure is that is build as a shortcut requires significant analysis to be relevant in decision making.

LaMonica: And this is why investment analysts typically resort to a discounted cash flow model. An analyst will estimate what a company will make in the future and discount those cash flows back to the present day. And that is an overly simplified explanation. But you can learn more about that in our Swipe Right for Shares episodes.

Jayamanne: The point of this approach is to estimate what a company is worth based on the specifics of that company and the external forces that will influence how the company performs. Our analysts estimate the fair value for the 1,600 shares in our coverage universe. We can roll those valuation levels up to the country level and look at markets.

LaMonica: So in Australia, the price to fair value is 0.87, which equates to 13% under value. The only time the Australian market has been this cheap was during the pandemic and the GFC. The price to fair value for the companies we cover in the U.S. is currently at 0.89, which means they are 11% undervalued. The U.S. share market has only been this cheap 12% of the time since 2011.

Jayamanne: In reviewing these two sets of valuation data, we think it's safe to say that the markets are currently in the nothing to see here range. This isn't a bad place to be considering that we both thought that we were in bubble territory in 2021.

LaMonica: Where we go from here, of course, is anyone's guess. Perhaps the rally in the first half of 2023 was simply an AI induced anomaly that impacted seven large shares in the U.S. Maybe we will look back and view the first half of 2023 as a rally during an otherwise downward trend in markets.

Jayamanne: We do need to remember that not all bubbles spectacularly pop and fall into the backup the truck range. Sometimes they simply meander on until valuations become more reasonable.

LaMonica: And meandering on is not exactly where we want to be as investors, because returns are often below average during these periods. They certainly have been since the end of 2021. And that is the issue with buying during bubble periods. There's very little margin for error when investor expectations are so high.

Jayamanne: So we recommend that everyone stick to their plan. Make sure you have a goal and an investment strategy that you're following. And remember, if we are in a lower return environment, it is the little things that matter, dividends, minimizing taxes and minimizing fees.

LaMonica: Exactly. Something that we talk about all the time here. So personally, and we can talk about you in a second, I have gone from, I guess, this sort of building up cash phase to personally, just a more normal investment cycle as I've been trying to cut down on that cash a little bit. And of course, as I get paid and forever long, Morningstar continues to pay me. I'd be investing more. So I think I'm back to what we've been advocating. Follow a plan, come up with a plan, stick to it and continue to follow it. What about you, Shani?

Jayamanne: I'm just continuing on, just regular investments into my investments. And it's always been that way.

LaMonica: Well, there we go. So anyway, we hope that this added a little bit of perspective on where we are from a market environment. And of course, talked a little bit about the different approaches that investors could take. But thank you very much for joining us. We really appreciate it. Send me an email if you have questions or comments. And of course, we would love ratings and comments in your podcast app. Thank you very much for listening.

(Disclaimer: Any advice in this podcast is general advice or regulated financial advice under New Zealand law prepared by Morningstar Australasia Proprietary Limited and/or Morningstar Research Limited without reference to your financial objectives, situations or needs. You should consider the advice in light of these matters and any relevant product disclosure statement before making any decision to invest. To obtain advice for your own situation, contact a financial advisor.)