The origin of the term "frothy" - in an investment context - is disputed, but many attribute it to Alan Greenspan. The former Chairman of the US Federal Reserve is believed to have normalised the word in his response to the state of the US housing market in 2005. 

Since the global financial crisis, the use of this word when referring to the markets has been looked upon ominously. 

In early 2019, the buzz surrounding the state of the frothy ASX was a lasting discussion. 

A frothy market is a state in which markets begin trading well above their tangible asset values, often because investors are ignoring fundamentals and making emotionally driven and speculative decisions (periods of which can endure for many quarters, if not years). 

The reason frothy markets are often so topical is historically these periods precede a burst of a market bubble. 

At least this was the case for the dotcom bust in 2001 and the housing crash (GFC) of 2007-2008. Given the almost two years since COVID19 first disrupted our lives, perhaps this latest episode is also one for the history books. 

The current argument we are seeing is the significant growth and interest in alternative 'asset' classes, mirroring the speculation-style dotcom and housing market catalysts for the two most recent frothy periods that preceded a burst bubble. 

With our eyes firmly on equities, we couldn't help but notice that Bitcoin, the most mainstream of the cryptocurrencies, took the quickest time (12 years) to reach $US1 trillion in market capitalisation. 

Bitcoin now joins an elite club of trillionaires alongside US household giants Microsoft (44 years), Apple (42 years), Amazon (24 years) and Google (21 years). 

Whether cryptocurrency will be the catalyst for the next bubble popping will likely only be realised in hindsight, however at the risk of playing into a false causality (falsely assuming events appear related and therefore causing one another) we prefer to remain impartial and observe. 

So are equities frothy right now? When comparing the equity markets amongst peer asset classes, there is some potential explanation to the current upward trend(s) that have occurred. 

Considering that many fixed income yields are currently heavily compressed, property rental yields in Australia aren't shifting nearly anywhere as quickly as the capital growth trend line and that bank term deposits are a heartbeat above zero, there is an argument to suggest that the stock market's liquidity, prospective growth profile and risk (in comparison to viable alternatives) is the beneficiary of this struggling peer group. 

Further, there is an argument to be made that equities, in contrast to some of these alternatives, might fare better in a rising inflation environment - a topic for another time. 

This enduring low yield environment does however shed light as to why some investors have found themselves including cryptocurrency as part of their asset allocation; when looking at the state of asset classes in this current environment the options for return (via speculation or yield) have become suddenly fewer. 

The final point we would add goes hand-in-fist with frothy markets; investing at all-time highs. Let's look at the below graph and reference what JP Morgan found when investigating all-time highs. 

Source: Ben Carlson, A Wealth of Common Sense, 'Investing in Stocks At All-Time Highs' 

As illustrated, it has been more lucrative over the last 30 years to invest at all-time highs, rather than shying away from these points and thereby attempting to market-time. 

We feel this is somewhat of an underappreciated phenomenon; whilst the brain naturally seeks out patterns in charts that highlight drop-offs such as the GFC, or the COVID drawdown (and consequently drives feelings of fear aversion and a flight to safety), it fails to identify the many, many times a market reaches an all-time high, and then continues to rise further. 

Startlingly, on average, key markets such as the US S&P500 set 16 new all-time highs a year. 

Like with all risk assets, including property, fixed income, shares and others, the long-term success of these asset classes has stood the test of time. 

The only true certainty is that diversification and patience are your best friends. Further, if diversification and patience are your best friends, conviction likely follows closely behind. 

As a fund manager, we approach each trading day with the pursuit of identifying mispriced equities and not trying to time this up or down movement of the broader index. 

Nor do we seek to fluctuate our cash weighting by keeping the fund's total assets 98-99% invested at all times. 

This approach minimises the human tendency to buy assets when prices are rising (and potentially overpaying) and selling when things get scary (and potentially selling at a discount). 

By maintaining a smooth and consistent approach to investing, irrespective of the asset class, one can work against this natural tendency. 

In conclusion, whilst the market might be considered frothy right now, we suggest in light of the above information that this might not necessarily be a bad thing. 

As Peter Lynch so famously said, "Far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in corrections themselves."

A change of Prime Minister usually doesn't result in much change in Japanese policies, because almost all Prime Ministers are created by the Liberal Democratic Party machine, which pursues power rather than policies. But the new PM, the 64-year-old Kishida Fumio, has made some Cabinet appointments which might lead to major changes. Of course, all the top Cabinet posts went to long-serving party stalwarts in order to pay Kishida's debts to the faction bosses who supported him, but he also added several of the LDP's rising stars to his Cabinet.

The most surprising appointment was to a newly created job - Minister of Economic Security. Kishida described the role as "securing strategic technology and goods and preventing technology leaks so we can achieve a self-sufficient economic structure." That translates to ensuring semiconductor supply and innovation, strengthening cyber security, and thwarting Chinese theft of Japanese intellectual property. The new Minister has of course denied that the economic security measures have anything to do with China.

What is really interesting about the job is that its theoretical functions cut across several existing ministries, which will cause vicious turf wars with entrenched bureaucracies. The new Minister will only be able to do his job if he has the firm support of the Prime Minister.

Fortunately, the new Minister seems to have all the right qualifications and connections. Kobayashi Takayuki is the product of an elite education (Kaisei Academy, Tokyo University Law School) and an elite career path (Ministry of Finance, Japanese Embassy in Washington). On the way, he also picked up a Master of Public Policy degree from Harvard's Kennedy School of Government.

We will watch Minister Kobayashi's progress with great interest.

Two interesting trends have emerged from the pandemic. Australians are having more babies and they are swapping out their city lifestyle for the beach and bush. In contrast to short term phenomena such as the hoarding of toilet paper, these shifts have potential long lasting implications for the economy and listed companies. In this article we discuss these two trends and the opportunities they have created for companies in the Firetrail Australian Small Companies Fund.

COVID baby bump or boom?

When large mortality events occur including diseases, earthquakes and wars, birth rates decline and on average, reach a trough some nine months later. As shown in Figure 1 below, this pattern holds for events such as both World Wars and the influenza outbreaks of 1918. Following an initial drop, fertility tends to rebound. Birth rates begin to recover ~11 months after an epidemic and then increase in the subsequent 1-5 years.

The end of World War II sparked one of the biggest baby booms of the 20th century. Could we be at the start of a post-COVID generation? Estimates by academics regarding the post-COVID birth recovery vary widely. The Institute for Family Studies notes that COVID has the potential to boost births over the next four years by anywhere from 0.3% to 40%. We admit this is a wide range to draw a conclusion from just yet. However, recent trends in birth rates and anecdotal evidence provide reason for optimism:

• The number of babies born in NSW public hospitals during the June quarter was the largest on record. A total of 19,113 births were reported, an increase of 9% on the prior year. This is a significant upswing compared with the declining fertility rate over the last 10 years.
• Prior to the pandemic IVF volumes had been increasing gradually over time. But in FY21, 98,290 IVF cycles were recorded, up 29.3% compared to FY20 and the highest figure on record.

The increase in IVF volumes has benefited portfolio holding Monash IVF. During FY21, Monash recorded a 40% increase in new patient stimulated cycles and there are no signs of a slowdown. New patient registrations in 2H21 were up 8% compared to 1H21, and up 35% on 2H20. ~70% of patient registrations are converted into patient treatments within ~3-6 months.

COVID-19 has sparked a behavioural shift amongst Australians. Restrictions on travel and a greater focus on family, health and wellbeing is resulting in a re-direction of priorities. While it is still early days to call it a baby boom, recent birth rates and trends IVF trends indicate we are at the onset of a baby bump. 

Looking beyond the headline impacts of escaping the city

For decades the lack of job opportunities in regional areas has seen many Australians relocate to capital cities. Then the pandemic hit. The sudden shift to working from home has made a tree change or sea change possible and more attractive for many Australians. ABS data shows net migration to regional Australia is the highest since records began two decades ago. In the 12 months to March 2021, net migration to regional areas increased 87.1% year-on-year. The impact of demand for housing on prices in regional towns has been widely publicised. Digging beneath the headlines, second order impacts are more interesting and perhaps even more important.

Demand for products and services across some industries increase as more people move to regional areas. Regional houses are larger and hence require more bricks to build and more lights to illuminate. For listed companies with strong brands, regionalisation has created an avenue to expand store footprints, increase sales, and grow market share. Portfolio holding Beacon Lighting is capitalising on this opportunity. It plans to open three additional regional stores this year including Ellenbrook (WA), Butler (WA) and Melton (VIC). The City of Melton, where Beacon Lighting is expected to open a new store in FY22, is one of the fastest growing areas of Australia. 11 new suburbs have been proposed to be added to it! In 2020, the city recorded a population increase of 4.6%, more than double the increase for Greater Melbourne which grew at 1.6%.

Increased sales in regional areas often come hand-in hand with supercharged margins. This is a direct result of limited competition and lower costs of doing business. A key cost line for many retail companies is rental expense. Bendigo is over 150km away from Melbourne CBD. Looking at recent advertised rents, it is ~50% cheaper to rent a large retail space in Bendigo than it is in areas close to the Melbourne CBD like Southbank. Going regional also comes with less competition from smaller niche retailers that often compete on price. Regionalisation has created an opportunity for companies like Beacon Lighting to increase sales, grow market share and generate better returns on a per store basis.

Conclusion

There are many interesting phenomena that have emerged from the pandemic, many with direct and lasting implications for listed companies. Restrictions on travel and a refocus on family has contributed to a spike in birth rates and IVF volumes. The sudden shift to working from home has driven many Australians away from the cities to regional areas. The baby bump (or potential boom?) and regionalisation trends have created an opportunity for many companies in the Firetrail Australian Small Companies Fund.

Disclaimer

This article is prepared by Firetrail Investments Pty Limited ('Firetrail') ABN 98 622 377 913 AFSL 516821 as the investment manager of the Firetrail Australian Small Companies Fund ARSN 638 792 113 ('the Fund'). This communication is for general information only. It is not intended as a securities recommendation or statement of opinion intended to influence a person or persons in making a decision in relation to investment. It has been prepared without taking account of any person's objectives, financial situation or needs. Any persons relying on this information should obtain professional advice before doing so. Past performance is for illustrative purposes only and is not indicative of future performance.

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Three key issues - inflation, the power crunch, and China's economy - reverberated during the third quarter of 2021 and continue to present a complex backdrop for global equity investors.

As we move into 2022, we think it will be critical that global equity portfolios are appropriately positioned to provide exposure to the potential opportunities while providing protection against risks that may emerge such as an economic growth shock (perhaps from a hard landing in China), or an inflation shock.

There's also the possibility of a combination of both - the stagflation scenario.

Inflation

Antipodes has been saying for some time that we think inflation is going to be more sticky than transient, while central banks have taken the view that near-term inflation will fade.

Recently we've seen more and more evidence of inflationary pressures building around wages, rent and now energy prices, and in the last couple of weeks we've started to see a break amongst Fed members on just how transient or persistent inflation is.

It's almost a certainty that tapering will begin before the end of the year and rate hikes may start from late 2022 as opposed to 2023.

The risk is that the Fed is tightening as economic growth is slowing, which may compound the problem.

A power crunch?

Europe's gas price is at a record high, the US gas price has more than doubled over the year, and oil is back above $80 per barrel, the highest level since 2014.

Energy is becoming another pressure point.

Europe is facing a shortage of gas due to a strong rebound in economic activity, coupled with supply issues and an underinvestment in power infrastructure.

In recent days Russia declined to pump extra gas into continental Europe which compounded fears. Moscow's position may change in the coming months, but even if Russia does decide to supply some additional gas, Europe is unlikely to find enough volume from traditional suppliers to fill the deficit.

With LNG and European gas prices equivalent to $150 per barrel of oil we're seeing a shift to burning oil in Asia. This shows how the gas rally is also fuelling an oil rally.

Consumers are going to start to feel this. The cost of filling the tank will rise, as will the cost to power and heat homes in the northern hemisphere's peak winter demand season. 

At the same time, power shortages have hit China.

China's power demand has been strong due to domestic and global activity, but hydropower output - which is almost 20% of total power in China - has been hit due to low rainfall, and coal production has also been subdued due to capacity controls and tightening policies around mine safety and emissions. We've started to see shutdowns in high energy intensive industries, and if this accelerates through the broader industrial sector there will be implications for domestic and global economic growth.

So, we have a very real risk of a power crunch across major economies and higher power prices through winter months. As well as the impact to economic activity, this could have meaningful implications for inflation. Meanwhile, we think there are some US gas producers that look like particularly attractive opportunities.

The Chinese economy

China has been tightening property policies on and off over the last five years. Growth had become unsustainably high again in the first half of this year, so policy was tightened again to curb speculation and house price inflation.

Housing starts began contracting in August, which quickly exposed the weaker property developers.

We all know the Evergrande story - but the Chinese banking system can handle an Evergrande default, if it comes to that.

If you combine Evergrande's debt with that of other risky property developers, it still only accounts for around 2% of system loans. Under an extreme stress test, banks' Tier 1 capital would remain well above the minimum 7.5%, meaning there's still plenty of capital in the banking system to continue lending.

The bigger question is whether an Evergrande default seizes up financing for other developers, which spills over into weaker housing prices and a broader economic slowdown. Residential development accounts for around 10% of GDP, so it's a material contributor to China's economic activity.

There would also be implications for commodity prices, particularly commodities where China is a major consumer but an immaterial producer. Copper and iron ore look the most vulnerable here.

However, with Government debt less than 70% of GDP, China has the firepower to re-stimulate - and we think it's a question of when rather than if.

This time around we think stimulus will focus on consumption, reinforcing the social safety net and decarbonisation. China wants to accelerate its transition to a consumption and services driven economy. To do this, household spending needs to grow at a faster pace than incomes via running down China's extraordinarily high savings rate.

With changes in the regulatory backdrop now well-progressed, investors are going to start to re-focus on long-term opportunities, particularly around consumption trends.

Most of us read about behavioural biases and acknowledge they exist, yet there is no evidence the financial community is any better at dealing with them. Understanding the impact of biases improves our ability to apply guardrails and combat them, leading to better decisions and investment outcomes.

With that in mind, let's look at three of the most common biases, where we come across them in everyday life and investing, and how we can minimise their impact.

Optimism bias

It is natural to take the view that good things will happen more often than they do. While positive thinking makes life more pleasant, the evidence suggests excessive optimism can be to our detriment.

Optimism bias regularly appears in investment thinking. For example, the graph below shows the change in analyst earnings per share estimates for the S&P 500 across each calendar year from 2006-2020. Of the 14 years included, 10 showed meaningful downgrades.

On average, analysts overestimated EPS growth by about two times. The high proportion of downgrades illustrates analysts repeatedly overestimating business prospects at the beginning of each period, demonstrating optimism bias in practice.

Source: Aoris research, FactSet

Optimism bias can be exaggerated when investing in companies with a wide range of outcomes, where little past information is relied on for the basis of bold future assumptions.

By focusing attention on the large potential gains, it can be difficult for investors to visualise potential losses. For example, the electric vehicle market is in its early stages, and it is difficult to gauge how stable the market will be and which manufacturers will ultimately succeed.

How can we combat our natural optimism bias without turning ourselves into killjoys? Paying attention to history will help keep our expectations grounded.

Social proof bias

Social proof is a phenomenon that involves people copying the actions of others in situations of uncertainty. Humans naturally believe there is safety in numbers and want to fit in with the crowd. We also avoid confrontation, so going along with what others think provides the path of least resistance.

Humans feel there is safety in numbers. Investors can panic amid a sell-off and follow the crowd, even if selling is contrary to the information they have on hand. In contrast, at the peak of an economic cycle investors can flock to well-performing stocks in an attempt to ride the momentum wave and avoid the dreaded feeling of FOMO (fear of missing out).

FOMO and the impact of herding behaviour can have very real consequences. For example, in Singapore in the 1980s an unexpected bus strike had created an abnormally large crowd at a bus stop outside a bank.

Local customers mistook the gathering as people waiting to make a withdrawal, so they too lined up thinking the bank must be in financial trouble if there were so many customers waiting. The bank was forced to shut its doors to prevent an actual bank run.

How do we counter social proof? A simple (but not easy) way to combat this behaviour involves developing independent thoughts and conclusions, with reference to objective reasoning and facts and not the "sway" of the herd.

Anchoring bias

Anchoring bias causes us to rely too heavily on the first piece of information we are given about a topic. We then typically adjust slightly away from the original anchor point when making decisions, even if it has little relevance to the problem we are trying to solve.

Anchors are used in negotiations every day. Take the used car salesperson for example, who will always give you their best price upfront. They have now dropped an anchor, and any price you can get below that will seem like a better deal to you when it could still be a price well above the car's value.

This will now play a larger role in your decision, rather than more relevant indicators of value such as the age of the car and its current condition.

Source: The Decision Lab

Similar behaviour regularly occurs in equity markets. Investors have a tendency to anchor on the current stock price and use that as a gauge on where the stock will go in the future, or use current multiples compared to historical values.

Like the car salesperson example above, this single indicator has little relevance and offers no insight into the value of the underlying business.

How do we deal with anchoring? Dropping your own anchor is an effective way to combat this. Thinking about the value of a business independent of the current price or purchase price can keep the focus on business fundamentals.

Key takeaways

In conclusion, let's reinforce the key considerations for investors when dealing with the three behavioural biases mentioned above.

Optimism bias: If we participate in parts of the market characterised by narrower ranges of outcomes, it mitigates the chances of excessive optimism. Exciting themes, emergent markets and unproven technologies are fertile grounds for optimism bias.

Social proof bias: Maintain independent thoughts and conclusions. Be wary of herd following behaviour and think carefully about the reasons for a purchase or sale.

Anchoring bias: Delay decisions and drop your own anchor. Slowing down our decisions allows us to develop a more holistic view of the problem we are facing and can avoid anchoring off that first piece of information we receive. We can make more informed transaction decisions if we focus on the value of the underlying business, without reference to the current price or our original purchase price.