Market turmoil - buy, hold or sell?

With markets down by another 10% this year everyone is asking themselves whether this is a buying opportunity or the start of something worse. The market is unsettled and you will hear many views, which can only make it harder to decide on an approach. Perhaps the question we should ask ourselves is: How are we going to feel about any decision made today in a year’s time?

The problem is no-one knows where stock prices are going to be in a year, just as we don’t know whether it will be raining next month (although some people claim to be expert amateur meteorologists).

A much easier question to answer, especially in light of recent market falls, is whether the shares in a portfolio are still going to help you achieve your savings goals. If we are thinking long-term (7-10 years) then you can reduce this to three key considerations:

1. Current dividend levels. Think of these regular distributions as your base case for long term returns as it is highly likely that most companies will be able to maintain dividends or grow them at least in line with inflation over the long term.
   
2. How much are these dividends expected to grow by? Think of this as the upside (there might be some downside but only if we are looking at a very protracted economic depression).
   
3. Are shares particularly cheap or expensive at the moment, and is that likely to significantly affect my return if other investors change their mind? Think of this as an override to guard against excesses of greed or fear in the market. Much of the time valuations are somewhere in the middle and you can ignore this element.

Investors in Australian companies currently get about $5 back as dividends for every $100 dollars invested in the local share market. That’s a 5% return if nothing changes. Over the next 7-10 years you might expect those dividends to grow in line with the growth of the overall economy. That has been quite high during the resources boom. However, while things are unlikely to be quite as easy for the Australian economy in the near term, growth of between 1% and 3%, excluding the effects of inflation, is not too heroic an assumption. In that context, if you just ‘discovered’ that global growth was going to be slower next year and thought that could put Australia in recession with flat or falling dividends for a year or so then a 10% drop in markets probably compensates you for that 'new information'. Therefore you are more or less back where you started.  

Lastly, what about the final point mentioned above? Are shares already so expensive that those ‘fundamental’ sources of return (current yield plus growth in dividends) could be cancelled out simply by other investors becoming more fearful for an extended period (as we saw before the GFC and the dot com crash)? Most measures of value we use would suggest Australian shares are more or less in line with the historical average so we think this is probably one of those times when  you don’t have to make a significant adjustment for the fear or greed factor (for Australian shares at least).

In summary, the reasons for holding Australian shares have not changed significantly, despite market volatility, and a return of between 5% and 8% per annum over the long term is not to be sneezed at. Yes, the fact that the market is justifiably worried about a slowing China is not great for Australia but at these prices that really just means less upside. On the other hand markets have not fallen enough yet to make Australian shares a real steal (remember that adjustment factor), so it’s probably too early to think about buying more.

If you are still worried about where prices will be next year, think about it this way; by then either markets will have fallen and you will have had the opportunity to buy some cheaper shares or they will have risen and it might be time to think about selling some. For now the maths still stack up for long term investors, so it’s worth holding on.

This is not the same for all markets and next week we will look at the return prospects for some overseas markets through a similar lens.