“Print, baby, print” echoes the chorus of economists, investors and currency speculators worldwide. The strong possibility the US will create more money out of thin air has led to a significant depreciation of the US dollar and an appreciation of asset prices, including equities and bonds.

Investors do not seem to be concerned by the fact that money is not really being printed. It appears to matter even less that all that occurs when quantitative easing takes place is that banks sell the Federal Reserve treasuries and receive cash (in the form of a credit on the Feds’ balance sheet) in return for the hope they will lend the extra money out.

Importantly, none of this new money actually buys anything – not gold, shares, or even Australian dollars. Investors buying these assets are mostly speculators expecting a debasement of the US dollar or an increase in risk appetite.

What is most interesting, however, is that banks are not short of cash to lend. Excess cash on US bank balance sheets is over one trillion dollars. The real problem is that borrowers – scarred by weak demand, no employment growth and increasing regulation – just don’t feel the need to borrow to invest. Consumers have learnt the long-forgotten virtue of thrift in conjunction with a decline in the value of their collateral. Hence the problem of too much cash and not enough borrowers is unlikely to be solved by injecting liquidity. It appears this is a route chosen when all other alternatives are exhausted.

The US economy will march to its own rhythm and not be significantly swayed by the odd purchase of treasuries by the Federal Reserve. The bigger issue is whether investors should sell assets that have most recently been inflated, or buy more in the expectation it will continue.

Only time will tell, but our view is that purchasing assets in the hope that central bank policy actions will steer a complex series of economic events is fraught with danger.

It is true that equities currently represent fair to good value and a long term investment at these prices will likely be well rewarded. However, it would be foolish not to acknowledge a sense of short term euphoria that is liable to produce some level of disappointment in the near future. When the excitement of the second round of quantitative easing in the US fades, perhaps so will the froth in these outperforming assets.

For domestic investors, the surge in the Australian dollar has been of tremendous interest. We note with a healthy dose of cynicism that the higher the Australian dollar rises, so too do the forecasts of where it will go. Concepts of overvaluation seem to be discarded in favour of a belief in a new world where China is king, the US and Europe are declining empires and the Australian dollar is a proxy for the changing of the guards. The euphoria surrounding the local currency evokes the myopic views towards dotcom versus old economy stocks a decade ago.

At the moment, the market does not appear to be pricing in any risks to the Australian dollar.  However, any wobble or sneeze in the global economy – or the mere hint of a slowdown in China – will be met with a significant and sudden currency reversal.

It should not be forgotten that the pillars of local strength are the Australian property market and Chinese growth. The former is regarded as one of the world’s most overvalued markets while the latter is, by many accounts, overheating. Both countries are raising interest rates, which is never good for economic growth or property prices.

If for no other reason than risk management, investors should be taking advantage of the strong currency and purchasing assets globally.

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What we are seeing at the moment are two very strong trends that are having opposing impacts on markets.  Low interest rates, low valuations and a lack of alternatives (as neither bonds nor property are seen as prospective) are key supports for equities and are helping to fuel brief periods of exuberance. However, the persistence of weak economic growth, fiscal deficits and high unemployment, are all contributing to subsequent despair and apathy which saps any market rally.

The result of such opposing forces is some unexpected outcomes.  Uniquely in a volatile market with a decidedly uncertain and negative bias, a number of small speculative companies are performing very strongly. Many small caps are at 52-week highs while quality blue chips languish at multi-year low valuations. Speculation in small caps is symptomatic of a low interest rate environment whilst at the same time investor disillusionment is keeping investors away from the big end of town. This market behaviour provides very little predictive value.

In addition to macro-economic uncertainty there have recently been attention-grabbing statements and sound bites from market commentators that seek to add insight but rather disclose a weakness of analysis.  Such statements only add to the confusion level for investors.  For example, following a 10 year period of flat equity markets, it is now often said that “buy and hold” is dead.

Bold, game-changing statements such as these are common after periods of above or below trend outcomes. Recall the tech boom of 1999-2000 and how investors scoffed at valuations and earnings. “Earnings don’t matter” they cried as they rushed to embrace the dotcom economy at all costs. That strength of conviction is back in force but this time in reverse. These days it’s “P/Es don’t matter” as the marginal buyer seems not to care about the long term given so much uncertainty.

Adopting this assumption fails to grasp the components of investment returns or, more specifically, that a share price is a function of valuation and earnings. Suggesting that stock prices will not rise over time is an explicit statement that earnings will stagnate or valuations will drift lower. But historical evidence is firmly against this assumption.

Over the past 10 years the average earnings growth of S&P 500 constituents was 3% per annum despite two severe recessions. It is prudent to assume that at least a similar rate of growth can be maintained over the next 10 years. With the addition of dividends, returns of 6-7% per annum are achievable in the medium term with no change in valuation.

On the valuation side, company earnings are currently valued very cheaply at around 12 times earnings. The reason share prices went nowhere over the past 10 years was exclusively due to valuations contracting from about 25 times earnings to close to 12 times today. The long term valuation range is between 10-25 times earnings with only brief periods above and below this range. Given corporate balance sheets are in great shape and investor sentiment is so poor, the risk to valuation is arguably to the upside. In this environment, rising valuations can easily lead to double digit returns even assuming weak earnings growth.

For these reasons, at Wingate we believe the bull case for equities has significant fundamental underpinnings. The negativity bubble engulfing investors has delivered this opportunity but investors need to get away from the immediate noise in the market and maintain their focus on fundamentals.

In addition, the strength of the Australian dollar, which for many reasons will likely revert lower over time, provides local investors an exceptionally strong currency. Using the strong currency to purchase international equities provides an additional investment benefit that is unavailable on domestic stocks.

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