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When sharemarkets and the real world collide

Wall Street Flickr image by : : deNNis gErbECkx : :The relationship between the real world and the stockmarket can sometimes seem tenuous. The rout on financial markets is inescapable yet people are still going to work earning money, going to the supermarket or the pub to spend it, buying fridges, TVs and even luxury cars. Spring is in the air and football finals fever is building. In short life goes on.

So reconciling what is happening with sharemarkets around the globe, and trying to comprehend the mind-bending numbers that are tossed up regularly in the media about the size of losses or asset writedowns, is far from a straightforward exercise.

For the person on the street the problems besetting Wall Street investment banks seem a long way from life in downtown Australia. With the obvious exception of the bank employees who have lost their jobs, the gyrations of the sharemarket can appear strangely disconnected from everyday business.

With words like crisis, panic and financial contagion bombarding us via newspapers, websites and nightly news broadcasts it is no surprise that consumer and investor confidence has taken a battering. For the first time in 20 years bank term deposits top the rankings in consumer surveys as the wisest place to invest.

So the need for context — and a clear head — has never been more important. We know from previous market corrections/crashes that making emotional decisions in the heat of short-term events can simply turn bad to worse.

So a critical issue is whether you believe the financial market gyrations are a portent of bad things to come in the real world economy or that over time as confidence returns in company earnings that the sharemarket will return to realistic valuations based on the long-term growth in both our economy and the global economy.

There is no doubt those in the financial sector — notably US investment banks — have done a spectacularly good job at distancing themselves from the real world. Amazing profit growth within what has been dubbed the 'shadow banking system' in recent years has been exposed for what it is: increasing amounts of poor grade debt bundled up in a way that obscures the true level of risk.

Now that the default risk is there for all to see, suddenly we are faced with a system that is seizing up on itself. It's akin to driving a car with a fine engine but a gearbox that is struggling to engage the right gear. Repairs — be it via regulation or markets forcing mergers and takeovers — will clearly be required.

Yet there is plenty of good news around. Oil and food prices are down from their mid-year highs. The US economy seems surprisingly strong (the US economy had the strongest growth of the G7 countries for the June quarter) while unemployment rates — a critical economic indicator — both here and in the US are at low levels.

In the Australian economy the Reserve Bank governor Glenn Stevens reported to Parliament this week that domestic demand in Australia rose 4 per cent in the first six months of this year — down from about 5.5 per cent last year. That in itself is good news because, from the Reserve Bank's perspective, it takes the pressure off inflation, and gives them the flexibility to lower interest rates.

So the economic scorecard paints a much more positive picture than the daily gyrations of sharemarkets. But for investors who are receiving super fund statements or checking account balances online, that will be cold comfort. And there are lessons — albeit painful ones — to be learned from extraordinary periods like these.

With all the market activity swirling around us it can be hard to sit still and do nothing. If you are young, and invested in a diversified portfolio in your super fund, it should be easy to file the statement and write yourself a note to check back around the same time next year. If you are older, perhaps approaching or in retirement, the challenge may seem several orders of difficulty higher.

But at times like these diversification — spreading your money across a range of investments, a number of asset classes and over time — is the best way to handle the risk.

Australian shares — as measured by Vanguard's Australian shares index fund — is down 14.7 per cent for the 12 months to the end of August. In contrast the diversified balanced index fund is down a much more modest -4.7 per cent for the same period. No-one likes negative numbers but that really shows the power of having a portfolio that has a good level of exposure to fixed interest and bonds as your defensive asset mix.

The other perspective is to remind yourself that when you are investing in the sharemarket — and particularly with super — you are investing for the long-term. Looking over five years the Australian share market index fund has grown 14.3 per cent a year to the end of August. If someone had told you five years ago that was the return you would get, most people would have signed up happily.

When it comes to what happens next in the short-term, your guess is as good as the next person's. What a review of financial crises and crashes back to the 1929 Wall St crash does tell us is that they are typically caused by some speculative build-up which is where markets and the real world economy tend to part company.

After the bubble — and the seemingly inevitable hangover — the real world economic value can again be seen more clearly, and normal cyclical service is resumed.

Robin BowermanRobin Bowerman is retail manager at Vanguard Investments Australia. This article is being published simultaneously on the Smart Investing Blog and weekly email.


Topic tags: robin bowerman, vanguard, world economy, superannuation, sharemarket crash, wall street, reserve bank



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