In the last 12 months, the financial markets have been tumultuous, to say the least. With a dramatic end to a volatile year, we will no doubt begin to see some press on the poor performance of super over the past 12 months. I can guarantee that the media will sensationalise superannuation results and, as usual, they will only report on part of the big picture. With this in mind, I feel that it is important to give some context to the current turmoil.

To explain, I will limit my discussion to Australian shares, but remembering that all markets are cyclical, and most asset classes have performed poorly in the last 12 months.

No one can deny that June was a difficult month to end a difficult year. A number of factors including the US sub prime crisis, oil prices and higher interest rates here at home have effected the worst financial year since 1981-1982 for Australian shares.

This is part of the natural flow of the investment cycle. Remember, it’s typical for 1 in every 5 years to be negative in Australian Equities.

The S&P/ASX 300 Accumulation index fell 7.6% in June to be down 13.7% for the financial year and 30% from highs late last year. In price terms it was the worst June since 1940.
Image: Source: Thomson Financial, AMP Capital Investors

so what should you do?

First, think long term and remain calm – in short, be an investor not a speculator. Second, consider how have these market declines affected your total portfolio given the great returns yielded in the past 4 financial years.

Something many investors haven’t realised is that if you were invested in Australian shares over the 4 years to 30/6/07 your investment would have grown 230% and then declined 11.4 % this financial year. That’s a compound return of around 15%p.a which is a good result in a 5 year context and more than double the return you would have achieved investing in cash over the same period.

Finally, accept risk. Remember that to achieve a higher return than cash over the long term, you will experience negative returns from time to time. What we are experiencing now is the painful part of a normal investment cycle.

now vs previous bear markets

Back in the bear markets in global shares in 1973-74 and 2000-03, shares were overvalued. This time around, they are not overvalued. In fact, after recent falls, they are now cheap. Global and Australian shares are now trading on lower forward price/earnings multiples (P/Es) than was the case at the end of the last bear market in March 2003.

Australian shares are trading on 12 times, which is their lowest since 1995 and compares to a 10 year average of 15.2 times.

As a result, the Australian sharemarket is trading below the bottom end of its fair value range. See the below chart.

Image Source: Thomson Financial, AMP Capital Investors

However, the slump has taken shares way below the level suggested by corporate profits. But, keep in mind a number of issues.

No. 1 – The current situation is very different to 1987, when shares took more than six years to make new highs due to the length of time needed for profits to rise to justify the 1987 high.

No. 2 – Right now it is unlikely there will be a sufficient profit slump to justify the current level of share prices. Thanks to economic stimulus, low inventory levels, a lack of corporate overinvestment and a strong contribution to growth from exports, the US economic slump is unlikely to be deep and should be over by year end.

Growth in the rest of the world (including Australia) will slow but it’s unlikely to collapse. Growth in the emerging world is slowing, but is still likely to remain very solid providing an important buffer to the slowdown in the developed world.

No. 3 – Low interest rates in the US are providing a significant boost to global liquidity and some of this will find its way into shares. With US growth likely to remain low and inflation expected to fall, it’s hard to see the Reserve Bank raising interest rates again in the near future.

in conclusion:

  1. Take a long term view (reflect on the past and look to the future as now is just a moment in time).
  2. Remember that markets are cyclical – they move up and down.
  3. To achieve a higher return than cash and combat inflation over the long term you need to invest in growth assets. In doing so you must accept risk, such as volatility. There will be years that produce negative returns.