In the News

Destruction A Creative Force

Herald Sun - 11/24/2008

We are all just about ready for a recovery in share prices. After nearly thirteen months of falling prices we are becoming weary of bad news. Hoping for a turn around doesn’t necessarily make it happen, however.

Share market prices begin to recover when all of the bad news and more, has been factored in to prices.

In the same way that markets often over shoot on the upside, they typically also overshoot on the downside. Everyone was too optimistic about future prospects a year or two ago and it is likely we are now becoming too pessimistic about the period ahead. There is no doubt in my mind that we will have a recession in 2009 but the share market has already factored this into current prices.

The share market rapidly factors into prices the most expected outcome. It is a leading indicator. Falling share prices are indicative of an expectation of falling earnings. The share prices fall and then the earnings get downgraded. The share market action is an indicator of pending recession. It will also be a leading indicator of a recovery and it almost always rises in the very year that the down turn finally hits the real economy.

The market looks across the valley and sees an improvement in earnings long before the pickup is evident in any statistics. During a recession not only do company earnings fall but as this is happening the businesses start laying off staff and cancel recruitment plans. This creates a rise in unemployment and the recession is felt by everyone.

Many businesses that are too heavily in debt or are badly managed are the first to collapse and go to the wall. As more businesses go bankrupt this paradoxically sows the seeds of recovery. It has been termed ‘creative destruction’. In the same rule as in the law of the jungle, it is the weakest and less fit that are first to fall prey to the predator.

By way of explanation, instead of trying to figure out how an entire economy works let me try to explain this phenomenon by using as an example, the economy of a small country town. During the good times, when cash flow is plentiful a number of competing businesses open up. They could be any type of business but let’s use as an example, three petrol stations.

When a severe down turn hits they all struggle to stay profitable as they divide the limited business between the three of them. During the good times they may have gotten a bit sloppy but when survival is on the line they work hard to be efficient. Ultimately, the least successful business fails and goes out of business.

Ironically, it is this event that allows the remaining two to grow their earnings. They each increase their market share by about 50% as they divide the amount spent in their town by two instead of three and they start to grow their profits and enterprise value accordingly. This is what is meant by the term ‘creative destruction’.

After more than a year of bad news and depressing falls in share valuations we can be forgiven for not being able to imagine anything turning things around but at some stage it always happens. It is the way the business cycle works. Waiting in cash until the perfect time to buy back in won’t work because by the time you are sure it is happening the market will have well and truly recovered.

The Australian share market has already fallen by approximately 50%. This has been a particularly vicious downturn but the final result over an investing lifetime is still likely to be close to the 12% long term average achieved over the last 100 years. The most recent ten year result for the ASX 200 still stands at 8.85% pa despite the tech wreck and the disaster of the last twelve months. The next ten years performance is likely to be at least as good as this or far better when you consider we are starting from such a low base.

From where we stand today, regression to the mean is all in our favour and yet we fear the next six months rather than focusing on the next six years. No one knows when the market will bottom or even if it has bottomed already but we do know that it will recover. The key lies in having broad exposure to the whole market rather than trying to pick winning stocks or time market turn arounds.

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