A ROADMAP FOR THE AUSTRALIAN STOCKMARKET

-Predicting Bubbles and Crashes from 137 years of ASX share price history
But few gain sufficient experience in Wall Street to command success until they reach that period of life in which they have one foot in the grave. When this time comes, these old veterans of the Street usually spend long intervals of repose at their comfortable homes, and in times of panic, which recur sometimes oftener than once a year, these old fellows will be seen in Wall Street, hobbling down on their canes to their brokers offices. Then they always buy good stocks to the extent of their bank balances, which they have been permitted to accumulate for just such an emergency. The panic usually rages until enough of these cash purchases of stock is made to afford a big rake in. When the panic has spent its force, these old fellows, who have been resting judiciously on their oars in expectation of the inevitable event, which usually returns with the regularity of the seasons, quickly realize, deposit their profits with their bankers and retire for another season to the quietude of their splendid homes and the bosoms of their happy families - Henry Clews Twenty Eight Years in Wall Street (1887) Buy on the sound of cannons, sell on the sound of trumpets. -Baron Nathan Rothschild (1810) Buy at the point of maximum pessimism. -Sir John Templeton, (1990) Be fearful when others are greedy, and be greedy when others are fearful. -Warren Buffett, (2008) To every action there is always an equal and opposite reaction Sir Isaac Newtons third law of motion (1686)

Boris Pogos July 2012

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HERDING INVESTOR BEHAVIOUR SIR ISAAC NEWTON

First, check out Exhibit 4 in Grantham's Q4 2010 quarterly letter. Basically, it's a chart that shows The South Seas Bubble of 1718 to 1721:

- Newton invests a small amount prior to the South Seas bubble - Newton exits happy in the early stages before the bubble really gets going having made some money - Newton sees his friends getting rich as the bubble does really get going - So Newton re-enters near the peak of the bubble with a lot of money Then, of course... - Newton exits broke after the stock then falls roughly back to where he had initially invested just a small amount of money Newton had the great good luck to get into the South Sea Bubble early. He made a really decent investment and a very quick killing, which mattered to him. It was enough to count. He then got out, and suffered the most painful experience that can happen in investing: he watched all of his friends getting disgustingly rich. He lost his cool and got back in, but to make up for lost time, he got back in with a whole lot more (some of it borrowed), nicely caught the decline, and was totally wiped out. And he is reported to have said something like, "I can calculate the movement of heavenly bodies but not the madness of men." NEWTON WAS 75 YEARS OLD WHEN HE MADE THESE INVESTMENT DECISIONS!!

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WHAT DRIVES SHARE PRICES?

(1) Company Intrinsic Value = Net present value of expected future cash flows discounted by companys weighted average cost of capital (2) Growth in the general Economy GDP Growth Approx 6% per annum nominal Approx 3% per annum real (3) Interest Rates Government ten year bond yields (4) Inflation sometimes a significant driver eg 10% pa 1982-1987 (5) Dividends Increases; unexpected falls (6) An index of optimism or expectations or optimism-pessimism waves (Sahni 1951) The largest influence of all factors on share prices? Sahnis analysis of London share prices 1918-1947 Dividends did not recover to the heights of the middle 20s but low interest rates and moderately buoyant expectations lifted share prices to a peak at the end of 1936 which was higher than that of 1929. The peak of optimism coincides unmistakably with the peak of prices which fell thereafter, despite the fact that dividends increased until as late as the third quarter of 1938. This price fall of 1937-39 however was not entirely a matter of pessimism; it was aided by a fall in consol prices. The accelerated rise of interest-rates after Munich seems indeed to have helped falling dividends to offset a minor increase in optimism. On the other hand, rising consol prices helped to mitigate the depressing effect of both falling dividends and increasing pessimism from the outbreak of war until nearly the end of 1940 Share prices rose fairly steadily from the end of 1940 until 1947. The main factor in 1941-42 appears to have been increasing optimism, though falling interest rates helped in 1941. From the beginning of 1943 rising dividends began to be an appreciable factor and continued so throughout the period under review. After the end of 1944, anticipation of the difficulties of demobilisation caused a marked decline in optimism extending for more than one year, but almost entirely offset, so far as its effect on share price was concerned, by the fall of interest rates consequent upon the cheap money policy. The marked turning point of share values in the second quarter of 1947 seems to have been a consequence of the rise of interest rates rather than any change in optimism (which has then been reviving for about or in dividends which continued to rise.

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AUSTRALIAN STOCK MARKET HISTORY 1875-2012

10.00 9.00 8.00 7.00 6.00 5.00 4.00 3.00 2.00 1.00 0.00 01- 01- 01- 01- 01- 01- 01- 01- 01- 30- 31Jan- Mar- May- Jul- Sep- Nov- Jan- Mar- May- Jun- Aug00 11 22 33 44 55 67 78 89 00 11 log index log trend

Based on Lamberton Index derivation Trend line growth rate of 5.28% pa (1900 to 1950)

Index Returns (Nominal) Excludes Dividends

FROM Index TO 1900 1920 1937 1950 2000 2012 1875 5.06 2.28% 3.37% 4.38% 4.27% 5.27% 5.04% 1900 8.89 1920 22.44 1937 72.2 1950 116.2 2000 3101.7

4.74% 5.82% 5.28% 6.03% 5.66%

5.82% 5.28% 6.03% 5.66%

3.73% 6.15% 5.59%

6.79% 5.98%

2.67%

Inflation Rate (CPI Index)

FROM Index TO 1900 1920 1937 1950 2000 2012 1875 5.06 1.00% 3.20% 1.50% 2.30% 4.10% 4.00% 1900 8.89 1920 22.44 1937 72.2 1950 116.2 2000 3101.7

3.20% 1.50% 2.30% 4.10% 3.96%

-0.10% 1.60% 4.30% 4.10%

2.10% 4.80% 3.63%

5.90% 5.17%

2.78%

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ASX SECULAR BULL AND BEAR MARKET CYCLES

As Goldilocks discovered there is more than one type of bear. Lets define these: GRIZZLY BEAR (OR BIG BAD WOLF?) We define this as a market crash where the index falls around 50% or more within a two year period. There have been four such crashes in ASX history: Bear Market Aug 29-Aug 31 Jan 73-Sep 74 Sep 87-Nov 87 Nov 07-Mar 09 Duration 24 months 20 months 2 months 16 months % Decline -46.2% -59.3% -50.0% -54.6%

PAPA BEAR No net gains over more than one decade from previous index peak. This is the classical secular bear and has typically lasted 13 to 15 years. There have been three such periods in ASX history commencing around 39 years or one generation apart: 1888 to 1903 (15 years) 1929 to 1942 (13 years) 1968 to 1982 (14 years) So if history holds, there is a good chance that the November 2007 ASX/S&P200 Index peak of 6800 may not be exceeded until 2020 to 2022! MAMA BEAR This typically five year cycle is the worst performing sub- period in terms of investment returns of the secular papa bear market. Generally the index bottom (as measured by 5 year rolling returns) occurs five years after the top as in 1937 to 1942 , 1969 to 1974, 1987 to 1992 (and 2007 to 2012?). During this period an investor who bought shares at the peak has suffered a loss of around 10% pa. BABY BEAR Since 1960 there were 14 bear markets (happening on average once every 3 years) with an average duration of nearly 12 months and an average fall in the All Ordinaries Index of almost one third from peak to trough. A baby bear is characterised by a 20% correction over a period of several months. Bear Market Sep 60-Nov 60 Feb 64-Jun 65 Jan 70-Nov 71 Jan 73-Sep 74 Aug 76-Nov 76 Feb 80-Mar 80 Nov 80-Jul 82 Sep 87-Nov 87 Duration 2 months 16 months 22 months 20 months 3 months 2 months 20 months 2 months % Decline -23.2% -20.0% -39.0% -59.3% -22.0% -20.2% -40.6% -50.0%

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Aug 89-Jan 91 May 92-Nov92 Feb 94-Feb 95 Sep 97-Oct 97 Mar 02-Mar 03 Nov 07-Mar 09 Average

15 months 6 months 12 months 1 month 12 months 16 months 10.6 months

-32.4% -20.3% -23.0% -21.0% -22.3% -54.6% -32.0%

MEAN REVERSION OF STOCK RETURNS

In the long run stock index returns are mean reverting. This is logically and mathematically intuitive since aggregate company values as represented by a developed market index cannot indefinitely grow faster than the overall economy, which nominally grows at 5% to 6% per annum.
15 Year Rolling Returns (Nominal) 18.0% 16.0% 14.0% 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% Jan-00 Jan-09 Jan-18 Jan-27 Jan-36 Jan-45 Jan-54 Jan-63 Jan-72 Jan-81 Jan-90 Jan-99 -2.0% Jan-08 RR 15YR GM

When 15 year rolling return exceeds 10% per annum as in 1969, 1987 and 2007 a 50% market crash has followed. When 15 year rolling return falls below 2%, it has historically marked an important market bottom and a great time to buy stocks. This occurred in 1903, 1942, 1974, 2002 and 2009.

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Real 15 Year Rolling Returns

10.0% 8.0% 6.0% 4.0% 2.0% 0.0% Jan-00 Jan-09 Jan-18 Jan-27 Jan-36 Jan-45 Jan-54 Jan-63 Jan-72 Jan-81 Jan-90 Jan-99 -2.0% -4.0% -6.0% -8.0% Jan-08 15 yr real RR GM (1.7%)

When 15 year real rolling return > 7%, major reversal (mean reversion) follows. eg 1937, 1968, 2007. This typically signals the peak of the optimism pessimism wave cycle. Major market bottoms have coincided with 15 year real rolling return falling below zero eg 1903, 1942,1974,1982,2003. Five year returns following these major market bottoms are exceptional.

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Not a Random Walk

40.0% 30.0% Future 5YR RR 20.0% 10.0% 0.0% -20.0% -10.0% 0.0% -10.0% -20.0% Past 5YR RR Series1

10.0%

20.0%

30.0%

40.0%

Above chart of past 5 year rolling returns vs future 5 year rolling returns shows that returns over medium term time frames are negatively auto-correlated at the extremities, ie investors buying at the end of a period of high negative rolling returns (say below 10% pa) are rewarded by outperformance in the following five years. Conversely an investor buying after a strongly performing 5 year period (say above 20% per annum) is likely to encounter a market crash within the following few years. This is best highlighted by examining 5 year rolling returns before the crash of October 1987, the largest in ASX history. In a period of two months, the ASX All Ordinaries Index fell by 50% from its peak including a one day fall of 24% on October 20th 2007

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5-Year Rolling Returns (Nominal)

40.0%

30.0%

20.0%

10.0%

0.0% Jan-00 Jan-06 Jan-12 Jan-18 Jan-24 Jan-30 Jan-36 Jan-42 Jan-48 Jan-54 Jan-60 Jan-66 Jan-72 Jan-78 Jan-84 Jan-90 Jan-96 Jan-02 Jan-08

-10.0%

-20.0%

As can be seen above, the crash of October 1987 was preceded by the largest 5 year run-up in stock prices in ASX history. The market rose by 342% (quadrupled) between September 1982 and September 1987, representing a CAGR of 34.7%. The five-year period from the September 1987 peak to September 1992 proved to be one of the worst performing in ASX history delivering an annual return of 7.6% per annum. The market bottomed two months later in November 1992 and commenced a 15 year bull run that peaked on November 1st 2007. The index increased by 364% over this period, delivering a rolling annual return of 10.8% and setting the stage for the next bear market Historically major market bottoms have occurred when the 5 year rolling return fell below -7.5% per annum. These occurred in August 1931 (bottom after 1929 crash) March 1942 (bottom after 1929 -1942 secular bear market), September 1974 (bottom after 1973/74 crash), September 1992 (bottom after 1987 crash) and June 2012 (bottom after 2008/9 crash?)

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ELLIOTT WAVES AND FRACTALS

The Elliott Wave Principle is a form of technical analysis that some traders use to analyze financial market cycles and forecast market trends by identifying extremes in investor psychology, highs and lows in prices, and other collective factors. Ralph Elliott discovered the underlying social principles and developed the analytical tools in the 1930s. He proposed that market prices unfold in specific patterns, called Elliott waves.

The Elliott Wave Principle posits that collective investor psychology, or crowd psychology, moves between optimism and pessimism in natural sequences. These mood swings create patterns evidenced in the price movements of markets at every degree of trend or time scale. The structures Elliott described also meet the common definition of a fractal (selfsimilar patterns appearing at every degree of scale. Elliott wave practitioners say that just as naturally-occurring fractals often expand and grow more complex over time, the model shows that collective human psychology develops in natural patterns, via buying and selling decisions reflected in market prices: "It's as though we are somehow programmed by mathematics. Seashell, galaxy, snowflake or human: we're all bound by the same order. In 1963, Benoit Mandelbrot discovered cotton prices time series exhibited a fractal structure. Again, all charts look the same. In the case of cotton I found all

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the price variations followed the same statistical properies for days over a few decades and for months over eighty years. All the lines were equally wiggly Didier Sornette, UCLA Physicist applied maths and physics to anlysing stock market crashes He found that the underlying cause can be found months and even years before -- in the build-up of cooperative speculation. Sornette analysed historical precedents, from the decade-long "tulip mania" in the Netherlands that began in 1585, a time of great prosperity, and wilted suddenly in 1637, to the South Sea Bubble that ended with the first huge market crash in England in 1720, to the bubbles and crashes that occurred every decade in the 19th century, to the Great Crash of October 1929 and Black Monday in October 1987. He analyzes herd behavior and the crowd effect, speculative bubbles, and precursory patterns before large crashes, as well as the major crashes that have occurred on the world's major stock markets. Sornette concludes that most explanations other than "cooperative selforganisation" fail to account for the subtle bubbles by which markets lay the foundation for catastrophe. Sornette said "Collective behavior theory predicts robust signatures of speculative phases of financial markets, both in accelerating bubbles, as well as decelerating 'antibubbles, "These precursory patterns have been documented for essentially all crashes on developed as well as emergent stock markets." The charts of rolling returns for the ASX indices display a fractal structure and similarity to Elliott waves.

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MARKET CRASH PREDICTORS

(1) Pogos Rolling Returns Indicator A stock market crash is likely when 15 year nominal rolling return > 10% 15 year real rolling return > 7% 5 year nominal rolling return > 20%

This is mathematically intuitive Suppose Index starts at 1000 At growth of 5.5% pa GDP rate for 15 years it will grow to 2232 At growth of 10% pa in bull market for 15 years it will grow to 4177. A 50% correction will take it back to long term trend line. (2) Buffett Market Capitalisation to GNP Indicator This indicator has been described by Warren Buffet as "probably the best single measure of where valuations stand at any given moment." It compares the total price of all publicly traded companies to GNP. This metric can also be thought of as an economy wide price to sales ratio. Buffett said For me, the message of that chart is this: If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200% as it did in 1999 and a part of 2000 you are playing with fire. In October 2007 ASX market cap to GNP ratio hit 150% In July 2012, ASX market cap to GNP ratio is approx 86% (3) Ziemba bond yield to earnings Indicator William Ziemba found that when long bond interest rates (30 year bonds) get too high relative to stock returns as measured by the earnings over price yield method (inverse of P/E ratio) then there almost always is a crash. The tipping point is when the bond yield gets to 4% above the earnings yield, eg if 30 year bond is at 9% with P/E at 20 (earnings yield of 5%)

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CONCLUSIONS & INVESTMENT IMPLICATIONS

In the long run, the stockmarket is broadly predictable (just like the weather). It is likely to grow around a trend line of around 5% per annum in nominal terms. Human behavior will create above trend growth bubbles or cycles and these will be followed by crashes. At 4150 on the ASX/S&P200 Index, the market is within 10% of a historical low that have marked the low points of previous bear markets. The Index is likely to spend the next four years within a trading range of 4000 to 5000, and could be back near 4000 in 2016 after a periodic 20% correction. With no net capital growth over such a cycle, the only source of returns to investors will be dividends. Selling call options and put options in this type of market can add significant incremental returns to investment portfolios The 2007 index high of 6800 may not be exceeded until 2022 at which time the market may commence a five year bull run ending (of course) in the crash of 2027. Ten year government bond yields which have hit three-hundred year lows in UK and US may be in one of the greatest speculative bubbles in history. Financial planners should rethink exposing their clients to Balanced Funds.

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NOMINAL Duration 2 months 16 months % Decline -23.20% -20.00% 5 10.9% -1.4% 10 4.9% 5.8%

Start

Finish 15 6.5% 4.8%

Bear Market Sep 60-Nov 60 Feb 64-Jun 65

Jul-68 22 months 20 months 3 months 2 months 20 months 2 months 15 months 6 months 12 months 1 month 12 months 16 months 9 months 10.6 months 8.6% 11.2% 6.9% 17.9% 0.6% 34 months 60 month 19 months 9 months -46.20% -32.00% -33.50% -16.30% 9.6% 18.9% 11.3% 0.6% -23.00% -21.00% -22.30% -54.60% -16.40% -32.00% 11.6% 1.8% 7.9% 9.8% 4.3% 12.3% 11.8% 4.9% 10.8% 5.3% -39.00% -59.30% -22.00% -20.20% -40.60% -50.00% -32.40% -20.30%

Jun-72

Jan 70-Nov 71 Jan 73-Sep 74 Aug 76-Nov 76 Feb 80-Mar 80 Nov 80-Jul 82 Sep 87-Nov 87 Aug 89-Jan 91 May 92-Nov92

5 13.9% 9.9% 12.9% 12.1% 11.7% 1.7% 20.1% 21.7% 34.7% 18.6% -1.6% 5.9% -13.0% 0.2% 17.3% 8.7% 19.1% 19.8% 2.1% -7.6% 2.7% 12.0% 0.3% -0.4% -3.7%

10 7.4% 9.5% 11.0% 6.9% 7.6% 4.6% 3.6% 7.6% 22.4% 15.1% 12.6%

15 8.2% 6.9% 10.1% 9.2% 7.9% 3.5% 6.5% 8.5% 12.4% 14.8% 11.9%

Appendix 1 - Australian Bear Markets, 1960 2010

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9.6% 5.6% 8.7% 4.3%

Sep-92

Feb 94-Feb 95 Sep 97-Oct 97 Mar 02-Mar 03 Nov 07-Mar 09 Feb-11-Sep-11 Average

3.4% -2.2% 3.0% 3.0% 1.6% 14.7% 10.3% 10.9% 11.6% 9.1% 6.9% 5.3% 1.2% 3.2%

5.9% -0.4% 2.3% 6.1% 4.1% 7.8% 12.8% 10.9% 11.5% 7.8% 11.2% 4.8% 3.0% 4.2%

Feb-29-Aug-31 Mar-37-Mar-42 May-51 Dec-52 Feb-2011 -Sep 2011

6.2% 7.1% 5.7% 5.3%

-7.5% -7.4% 7.5% -3.7%

0.4% 4.9% 3.7% 3.2%

2.5% 1.1% 2.1% 4.2%

REAL Duration 2 months 16 months -5.5% % Decline -23.20% -20.00% 5 10 15 5

Start

Finish 10 1.3% 15 0.4%

Bear Market Sep 60-Nov 60 Feb 64-Jun 65

Jul-68

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12 months 1 month 12 months 16 months 10.6 months 9 months -16.30% -23.00% -21.00% -22.30% -54.60% -32.00% 1.9% 6.9% 3.4% 14.9% 4.7% -3.0% 4.3% 7.0% -2.1% -10.2% 1.5% 0.1%

Jan 70-Nov 71 Jan 73-Sep 74 Aug 76-Nov 76 Feb 80-Mar 80 Nov 80-Jul 82 Sep 87-Nov 87 Aug 89-Jan 91 May 92-Nov92

22 months 20 months 3 months 2 months 20 months 2 months 15 months 6 months

-39.00% -59.30% -22.00% -20.20% -40.60% -50.00% -32.40% -20.30%

4.8% 10.2% 9.2% 3.0% -3.8% 11.3% 12.8% 22.3% 8.9% -8.5% 5.4% 6.5% 1.5% 7.9%

4.5% 8.4% 4.1% 4.0% -1.1% -4.0% -0.3% 11.2% 4.6% 4.8%

2.0% 7.6% 6.3% 4.3% -2.0% -1.3% 0.6% 2.1% 5.8% 4.1%

3.8% -16.6% -5.2% 8.8% -0.2% 8.4% -4.2% -5.0% -3.3% 7.4% -2.7% -3.1%

1.1% -6.3% -2.5% -4.5% -6.7% 4.4% -1.9% 3.1% 2.7% -1.5% 2.2% -1.5%

3.3% -4.5% -3.2% -1.7% -4.4% -1.9% 1.5% 3.2% 1.5% 6.2% 1.7% 0.2%

Feb 94-Feb 95 Sep 97-Oct 97 Mar 02-Mar 03 Nov 07-Mar 09 Average

Feb-2011 -Sep 2011 Jun-12

2.6% 1.2%

-6.3%

0.4%

1.4%