2018 in Review

2018 In Review

Happy new year everyone… It’s summer holidays in Australia and you’re probably relaxing and wondering what 2019 will look like. I don’t feel like writing anything too mentally-straining, but we’d like to deliver a summary of market performance in 2018 along with Aviator’s performance.

2018 was a year that many investors will like to forget. The ASX200 finished the year with a loss of 6.9% – its worst annual performance in 7 years since the 14.5% loss during 2011. The market closed out last financial year (ended 30 June 2018) with a gain of 8.3%. The final 6 months of the calendar year turned a loss of 8.85% – it needs a very strong second half of this current financial year to recover.

We’re pleased to report that the Aviator Macro Opportunities fund closed the 2018 calendar year with a gain of 6.67% net of all fees – a tidy 13.57% outperformance against the market. Final quarter performance was particularly pleasing with a gain of 10.61% versus the ASX200 down 9.04%, delivering nearly 20% outperformance.

Returns were generated via long-held strategic positions – portfolio turnover and trading activity was minimal. In terms of this, what Andy and I are especially pleased with is “being right for the right reasons”. This goes to the heart of our investment philosophy – making investment decisions based on a sound understanding of how the modern monetary system works and a sound understanding of financial history. Luck always plays a part in investment timing however one of my favourite investment mantras is “luck is the residue of design” – you need to tip the probably of success in your favour and you certainly can’t rely solely on luck for success. This is the difference between investing and gambling.

2018’s returns were principally generated in three areas. Each of these is summarised below along with a brief overview of the key thesis behind the positioning.

The Macro fund has been net-short the ASX200 for the duration of 2018. They key theory behind this positioning has been a view that the Australian economy is entering a very challenging period.

I’ve written about what I believe is the key factor within this challenging outlook several times throughout 2018 – debt.

Household debt levels have reached extremes that have rarely been surpassed on a global basis. Household debt to GDP sits at over 120% compared with an advanced-economy average of around 75%. A major part of our thesis has been (and remains) that we will begin to see credit growth slow (or even go negative) and given the role credit plays within an economy, this slowing will prove to be a major drag on economic activity.

Our view is that the significant market weakness during the second half of the year can be traced to a deteriorating economic outlook and that credit growth (or lack thereof) is a major factor. While it will take time for credit growth numbers to evolve, the indications are that it is slowing – helped on by the fallout from the banking Royal Commission. It is not a coincidence that we’re seeing a barrage of stories about tightening lending standards and credit conditions alongside ASX-listed retailers issuing profit warnings due to challenging retail conditions.

Whilst we’re not doing “2019 predictions” today, we believe that the core components of our thesis remain very much intact and therefore the outlook for the Aussie economy as we enter into 2019 is not particularly rosy.

The fund has held short positions in the AUD against the USD. The principal argument for this is effectively the same as for the Australian share market – deteriorating economic outlook.

Our view has been that a deteriorating economic outlook would pressure the AUD with the AUD/USD being selected as an appropriate cross on the basis that the US economy and interest rate environment has been more positive – a change in the interest rate differential would be a drag on the AUD.

They key drivers for a weaker AUD remain. This won’t likely be a straight line down. With signs of economic weakness in the USA creeping in, there is the potential for a weakening USD. Therefore, unless the AUD falls at a greater rate, some outperformance in the AUD relative to the USD is possible. Whilst we believe there remains downside to the AUD versus the USD, we are exploring whether different crosses might present a superior risk/reward.

Declining US Share Market:

The fund has been net-short the US share market during the year – principally the S&P500 index. This was a significant source of positive returns in the final quarter and in December. There’s a lot of moving parts with an economy as big and complex as that of the USA. Our investment rationale can be condensed down to one key factor – valuations and market cycles (okay, two factors).

Reliable valuation models which have a track record of predicting future market returns have been at historically-extreme levels for a number of years. We presently don’t run any sort of proprietary valuation models ourselves – after 20 years of watching and learning, we’ve found a number of very useful models already out there with tight correlations to future performance.

Below is just one example of a valuation model that has demonstrated useful predictive powers (there are others that I prefer but this one is relatively simple, valid and useful in demonstrating my point). This is the “Shiller PE” – sometimes called the “CAPE” (Cyclically Adjusted Price-to-Earnings).

In essence, this model calculates the average PE ratio for the S&P500 over a 10-year period. It’s vastly more useful compared to a simple “current” or “forward” PE ratio as it adjusts for variation in profit margins during business cycles.

At somewhere around 28.6 (with the S&P500 at 2596, valuations are still very stretched relative to the long-term average (actually 69% above the historical average of 16.9). Part of the reason why markets have a history of falling quite significantly from extreme valuation levels is that a significant adjustment in valuations is required to lure “value investors” into the market.

This is important to understand – the transactions that occur every day in the market are the result of decisions made by the various market participants. Each has made a decision to buy or sell based on something. When valuations have reached extreme levels, the decision to buy really has to be based on something other than “it’s good value at this price!” – buy decisions are vastly more likely to be based on technical analysis or indicators – or even computer algorithms programmed around momentum and technical indicators without any “valuation” inputs whatsoever.

The market falls because the sellers are more eager than the buyers. For a transaction to take place and therefore a price-point to be set, a buyer needs to step in. With the market falling around 14% (like the S&P500 has from the highs), with valuations still dramatically above long-term norms, that’s not enough to raise much interest from value investors.

Momentum-based algorithms might say “sell”, but a much more significant price adjustment is needed before the likes of Warren Buffett check in with “Mr Market” and like what they see on offer from the sellers.

On the flipside, it’s unusual – but not unheard of – to experience meaningful falls when valuations are depressed or even “average”. This is because there’s enough people with vast amounts of capital ready to step in because they know the price represents good value. In summary, knowing where you sit in terms of valuations matters a lot. We all acknowledge that markets move in cycles, but another way to think about this is that valuations move in cycles. Having a preference to the short side when valuations are high, and long when valuations are low/average means the wind is at your back – you’re tipping the probability of success in your favour.

Looking forward, I fully expect that the completion of this market cycle will see reliable valuation metrics return to “average” – if not below average. This implies falls of around 50% from the highs reached this year around the 2900 mark for the S&P500 (yes, I know that’s another 1,000 points from current levels). It won’t be in a straight line and this isn’t a prediction for this year – timing is the hard part. However, history teaches us that a return to average is almost a given.

With this in mind, it is worth remembering that if corporate earnings are expanding, “fair value” is rising. In other words, whilst 1,500 on the S&P might be fair value at present, if the market muddles along for a few years it might meet the rising fair value at a higher level.

US market direction is obviously a key factor globally for all investors and something we think about a lot. I could be writing about trade wars, economic data, stock buybacks, the Fed and interest rate outlook – we do think about all these things. But in my view these issues aren’t especially vital based on our investment approach. Understanding where you’re at in the cycle is often more valuable than trying to predict “the reason” the market will rise or fall. If your investment strategy is active trading, then trying to predict the market direction next week (or next hour) matters. If, like us, you’re out to produce consistently positive returns throughout the entire market cycle, capturing daily swings isn’t a high priority.

So there we have it. During a year that many investors will like to forget we’re pleased with our performance and, even more satisfying, being right for the right reasons. Here’s hoping that 2019 yields equally pleasing results no matter what the market throws at us.