Not So Bad, In Fact

A bleak week for the euro - or the week in which the political leadership of the Eurozone finally came to terms with harsh reality and faced up to the fact that its grand monetary union project cannot survive in its present form? The last few days have been full of drama. Nobody can say for certain where events will go next, but my money is, as it has been for some time, on the second interpretation.

It may take a few months before it comes to pass, but we have passed the point where Greece can credibly stay in the euro, even if it wants to - and passed the point also where the rest of Europe can afford to go on indulging its southern neighbour. There are bigger problem countries to rescue, and using all its firepower to try and save the weakest link has become an expensive folly. Mr Papandreou, it may well turn out, has inadvertently saved the rest of Europe from a much worse fate.

By extension, therefore, the current stalemate is potentially a good outcome both for the Eurozone and those whose economies - including the UK and US, who depend on its continued health. It is certainly good news for investors in the long run. Of course the risk of financial contagion remains. Many of Europe's banks are undercapitalised and cannot easily afford to write off their (foolish) exposure to Greek debt. But that problem is one that can be solved with positive remedial action: keeping the Eurozone intact in its present form cannot.

It is worth bearing in mind that leaders of all the main economies have their own agendas; what worries most of them is the short term trouble that a disorderly default by Greece, or a wider fragmentation of the Eurozone, will cause in their own backyard. It is hard to see how any of them will avoid paying a price in the polls for a second period of serious economic dislocation, like the one that followed the collapse of Lehmans in 2008. The longer term benefits for the world economy and for investors are not such high priorities. Yet the hard truth is that investors should applaud anything that halts the Eurozone juggernaut before it runs the world economy into the ground.

Market Comment January 8th 2010

Dr Sushil Wadhwani, the former member of the UK Monetary Policy Committee, now running his own hedge fund firm, had some interesting observations on the outlook for inflation and markets in an article in the Financial Times. He highlighted the fact that market opinion about the threat of inflation/deflation is likely to oscillate from one side to another for some time, a theme that I have also highlighted before.

In his experience central bankers are puzzled by the "inflation angst" that concern investors, as all they see are the downside risks to inflation, including growing unemployment and falling core inflation in many countries. As Dubai and Greece have demonstrated, many over-indebted borrowers have yet to adjust to the new climate, “a feature that typically holds back growth and inflation for several years after the bursting of a bubble”.

The current inflation/deflation debate is “a textbook illustration of the true uncertainty that confronts investors”, Wadhwani says. The truth is that the outlook for inflation is unknown. As Keynes observed: "The outstanding fact is the extreme precariousness of the basis of knowledge on which our estimates of prospective yield have to be made."

This has important implications for investors. As policymakers tread a tightrope while facing significant upside and downside risks to inflation, they will have to be exceptionally skilful and lucky to avoid none of these risks materialising. That means the probability of "price stability" in the developed world over the next five years is lower than it has been for some time.

“Looking ahead" concludes Wadhwani "we would expect financial markets to act in a schizophrenic fashion, alternating between worrying about deflation and inflation risks”. This is what occurred in Japan during the last decade, where the oscillations in bond yields were considerable. The 10-year yield fell from about 1.5 per cent in early 2002 to 0.5 per cent in mid-2003, before jumping back to almost 2.0 per cent over the following year. By the nature of bond prices, small changes in yields when yields are already very low can produce spectacular price movements, up and down.

In Wadhwani’s opinion, macroeconomic uncertainty is likely to be corrosive of the medium-term performance of equity markets. Since 1915, the US stock market has, on average, fared much better during periods of price stability than during either "inflation" or "deflation" episodes. In this period “the Dow Jones Industrial Average delivered average monthly rises of 0.86 per cent in times of stability, compared with 0.05 per cent a month with inflation above 5 per cent and minus 0.03 per cent during periods of significant deflation (with prices falling by more than 2.5 per cent per year)”.

"In an environment where markets are likely to oscillate between different views of inflation and macroeconomic uncertainty is likely to erode medium-term performance, we would suggest that medium-term allocations to equities should be below normal. Indeed, this should be an environment where, on average, some "alternative" strategies should outperform, as a more agile investment approach that switches allocations with the ebbs and flows of inflation expectations could be profitable".

Comment: It seems entirely plausible to me that the markets will indeed perform as Wadhwani suggests, and therefore that flexible thinking may be needed to ride the volatile but sideways trending market movements that this implies. He also makes the point that in the short-term, the next few months are highly likely to produce “an intensifying inflation scare", with economic growth likely to be higher than forecast – the point that Bill Miller and others have also been making.

Market Comment January 7th 2010

Japanese equities have been the great disappointment of the last 20 years, repeatedly confounding the hopes of those who have looked for an enduring recovery from the relentless downward trend in stock market valuation. What cannot be disputed is that the market is now incontrovertibly cheap on most conventional valuation measures. These comments are from the specialist fund managers Morant Wright in their latest monthly report. (I own shares in one of their funds, their Japanese income investment trust).

£ Returns	Month	2009	Since Inception (23rd May 2003)
‘A’ Shares	+1.8%	-6.5%	+74.6%
‘B’ Shares	+1.8%	-6.0%	+80.3%
TOPIX	+3.3%	-7.2%	+40.7%
Nikkei 225	+7.9%	+4.6%	+65.1%

Sources: Bloomberg and Capita Financial Managers Performance given for accumulation shares

The stock market ended the year on a very positive note with TOPIX up 8.1% in December and the rise in the Nikkei being well into double figures. For the year the capitalisation weighted TOPIX was up 5.6% but the Nikkei rose over 19%, a staggering divergence. This anomaly arises because the Nikkei index gives a greater weighting to highly priced stocks such as various technology names and notably Fast Retailing, which now represents over 6% of the index.

Currency moves were again significant as the yen weakened more than 4% against sterling in December and nearly 14% for the full year following the yen’s extreme rise in 2008.
Currently the economy remains weak with third quarter real GDP revised down dramatically to an annualised rate of 1.3% from the previous estimate of 4.8%. The main reason for the revision was private capital expenditure which now comprises the lowest share of GDP since 1984.

However, a new ¥7.2tn stimulus package was announced early in the month. The emphasis is on job creation and environmental industries through which it is hoped that any risk of a double dip recession will be avoided. In addition, the government unveiled a record budget of ¥92.3tn and also a longer term goal to generate average nominal growth of 3% p.a. over the coming decade.

Responding to government pressure to tackle deflation, the Bank of Japan called an emergency meeting and concluded that it will lend another ¥10tn in order to lower 3 month interest rates. Perhaps more significantly it has subsequently clarified its inflation aims by saying that it will no longer tolerate deflation. This suggests that further measures could be taken to stimulate monetary growth.

Apart from JAL, which continues its fight to avoid bankruptcy, company news was quite upbeat with, for instance, Japan Wool Textile and Noritz both announcing upward revisions for the full year. JAPEX also announced that it has won the rights to co-develop a significant new oilfield in Iraq. Mitsui Sumitomo, Aioi and Nissay Dowa received shareholder approval for their merger, which will now take place in April.

Restructuring also continues to be a strong theme with Nisshinbo and Yamato Holdings both announcing additional efforts to cut costs. Elsewhere M&A activity continues with Volkswagen taking a 20% stake in Suzuki and House Foods buying a stake in a Vietnamese food company. A small MBO was also announced at more than double the share price prior to the news.

As the Financial Times’s last Lex column of the year prophesied, somewhat light-heartedly, the coming decade could be the one where Japanese investors re-embrace equities – a prediction we naturally hope is right! Certainly if deflation can be eradicated then equities will become more attractive. The risks are probably more than priced in as our portfolio trades well below book value and many of our companies have significant cash reserves.

Comment: You can see the recent divergence between the Nikkei and the Topix quite clearly in the chart. These differentials tend to work their way out over time, but the Nikkei has never been the most representative index. Japan continues to lag well behind the performance of the US and other stock markets since the market turned in March 2009.

Market Comment January 6th 2010

Whatever the prospects for the world economy, the UK faces some particularly unpleasant problems. Not the least of these is the need to cut back the public sector, which has manifestly been allowed to run out of control in the last few years, both in terms of numbers employed and cost.  Doug McWilliams, of the Centre for Economic and Business Research, highlights the growing disparity between the pay experience of the public and private sectors in this note.

The official figures for the public sector pay bill (estimated by multiplying the average earnings index for the public sector by the employment numbers) show the public sector pay bill up by 12.5% in the two years to September 2009. This seemed unexpectedly high so we have looked carefully to see if the figures are distorted. It turns out that they are by the inclusion of Lloyds Bank and RBS employees. To get an accurate idea of what has been happening on a like for like basis the number of public sector employees in September 2009 needs to be adjusted down by 220,000, which brings the public sector pay bill increase down to 8.4%.

Meanwhile, the private sector pay bill (again adjusted to take out the distortion from the reclassification of Lloyds and RBS), which essentially creates the tax base to finance the public sector, has risen by only 1.8% over the same period.

Driving the rising relative cost of public sector employment aretwo factors. Employment in the public sector has been rising while that in the private sector has been declining. But in addition, public sector pay rose 3.9% in the year to September 2008 versus a private sector rise of 3.0% and by 2.9% in the year to September 2009 versus a private sector rise of 0.9%.

There is plenty of scope for legitimate argument over the right speed at which fiscal consolidation in the UK should take place, though a serious currency crisis could take this argument out of the hands of the economists.

But with income tax thresholds frozen in April, income tax rates set to rise in April 2010, employers’ and employees’ national insurance contribution rates set to rise in April 2011 and with above inflation rises in council tax projected, an excessive public sector pay bill cannot now be justified on Keynesian grounds. Any justification for the scale of the increase in public sector pay bills has to be based on a view that it makes sense to take resources away from the private sector to give to the public sector.

Had the public sector pay bill risen in line with the private sector pay bill over the past two years, £11 billion would have been saved in public spending, which would have made the entire rise in income tax and national insurance contributions in 2010 and 2011 unnecessary.

Comment: With the UK general election due to be held by May 2010 at the latest, a period of pre-election nervousness in the UK markets seems a virtual certainty. The prospect of a hung parliament, and a new government  forced to horse trade every initiative, is not one that inspires confidence. While a majority Conservative government would be the markets’ preferred outcome, there remain nagging doubts as to whether David Cameron has the necessary drive and support to  force through the changes in the public sector that will be necessary.

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Another big worry that will be preoccupying markets this year is the risk of sovereign debt default. Here is a timely comment on the subject from Jim Leaviss, head of the bond team at M&G.

Over the past couple of weeks, the cost of buying protection to insure against a default by the UK government has risen to exceed the cost of insuring a basket of European investment grade companies.  The chart shows that 5 year Credit Default Swaps (CDS) for the UK sovereign are currently at 83bps per year, compared with 72 bps for the investment grade companies, which are all lower rated than Her Majesty's government and unlike the UK, the last time I looked weren't allowed to print bank notes to repay their debt.  So it doesn't look right.  But noises about a downgrade of the UK continue, and the plans from both the government and the opposition to reduce the debt remain unconvincing.

 

 

 

 

 

 

 

 

 

 

 

 

Elsewhere we've had sovereign debt scares in Dubai and in Greece, and yesterday in Iceland the President exceptionally overruled the legislature and stopped a payment to the UK and the Netherlands of £3.4 billion to cover money lost by savers in the Icelandic banks.  Fitch downgraded Iceland to BB+ yesterday, although the bigger agencies still have the country in investment grade, but only just.  Iceland CDS now trades at 470 bps. 

The decision by the Icelandic people isn't surprising, as the payment amounts to around £10,000 per person - a massive burden.  I can't imagine that UK voters would agree to make such a payment to a foreign government should the table be turned, and the Icelandic economy is in a worse state than ours.  An article in today's Irish Independent by David McWilliams is therefore a little worrying, as it probably does reflect the popular view that default is a better option that a strong credit rating or than having to wear a hair-shirt for a decade. 

Ireland has entered into significant austerity measures (including large pay cuts for civil servants) in order to restore the nation's finances.  McWilliams concludes "Iceland proves there is an alternative - are any (Irish) politicians, from the President down, prepared to listen?".  2010 could be a year of angry populations and wobbly governments.

Comment:  Sovereign default by a developed country is not something that investors have spent a lot of time worrying over much about in the last few years, so if you are a worried, this is definitely one to add to the list.  The central issue raised by the Icelandic situation is also one of political will and political legitimacy. Who pays to get us all out of this mess?

Market Comment January 5th 2010

Bill Miller, the Chairman and CIO of Legg Mason Capital Management, believes the market is underestimating potential US GDP growth in 2010. Indeed, he thinks a major restocking of inventories will help drive a recovery in the US that will see the stock market rise by up to 20% this year. The fall in industrial output seen in the US has far exceeded the actual drop in demand, the shortfall having been made up from inventories. He expects to see a rapid restocking by US companies that will stimulate a sharp rise in economic growth over several quarters.

This is a (mildly edited) extract from his latest published view:

While the consensus view is for a 2.6% GDP rise in 2010, and the Federal Reserve has predicted 2.7%, Miller says there is a good chance that economic growth will exceed these estimates, possibly reaching as high as 8%. A rise in the stock market of up to 20% on the back of this recovery would not be beyond the realms of possibility.

US stocks are delivering earnings that are consistently above expectations and Miller points to the fact that since 1871 there have been 14, 10-year periods when stock market returns have been negative, including the last 10 years. In every one of the previous 13, the subsequent 10-year returns have exceeded 10% after inflation, or much higher than the long-term average real return of 6.66% and more than double the return of government bonds.

So every time stocks have performed poorly for 10 years, they have performed better than average for the next 10 years and have beaten bonds every time by an average of two to one. Miller’s view is that equities are extremely undervalued versus bonds, yet investors continue to favour bonds over equities.

Miller believes technology and financials are the two sectors most likely to benefit from any upturn, and has positioned his portfolio to reflect this. Technology is the portfolio’s largest weighting due to the strength of corporate balance sheets and the number of companies delivering record earnings.  Holdings include: IBM, Cisco, Microsoft and Hewlett Packard.

His second biggest weighting is in financials. Miller believes that financials are at their most liquid since the 1930s and those companies left after the fallout of the last two years are well placed to exploit substantial market share, while the banks are looking increasingly healthier, having reported their losses to be half or less than that predicted in their stress tests.

Mega-cap stocks are best-placed to exploit growth in emerging markets in coming years, especially those that carry favoured big brand names, Miller says. Their non-US earnings mean that they will grow faster than their smaller counterparts while rising consumer demand in China, which the Chinese government is encouraging, will also provide some support for the dollar if it translates into higher demand for US exports.

Comment: if the US economy grows by 8% this year, it will confound the entire profession of economists. While he is not everyone’s favourite cup of tea (and certainly no blushing violet), I have always found  Bill Miller an interesting and innovative thinker about markets, which is why he will always remain on my professional investor watch list, despite his traumatic fall from grace during the financial crisis. His point about bonds and equities is that despite the stock market’s sharp rise in 2009, inflows into bond funds massively outweighed those into equity funds.

Colin McLean, the founder of the Scottish fund management group SVM, and one of the fund managers featured in my book Money Makers, highlights some themes for investors to consider over the next ten years.

The scarcity of resources globally including food, metals and oil is likely to be a continuing trend over the next decade as demand from developing economies grows.  The vibrant economies of the Far East and other emerging markets will continue to outpace the West and a large part of the coming decade will see the UK and US battling enormous fiscal deficits, with the EU only slightly better placed.

A key factor in the faster growth of many developing economies will be their stronger financial sectors.  The credit boom in Western economies typically was not replicated in emerging markets and banks in those emerging markets were more conservative, leveraging to much lower levels than in the West.  Conservative banking was a challenge for emerging economies in the first decade of this century, but should prove to be a strength over the next ten years.

Commodities closely linked to global growth, such as copper and platinum should do well. Oil and gas exploration businesses should also pay off longer term, particularly those drilling successfully in Africa.  Gold should maintain its value if inflation grows and may play a part in the new global reserve currency that could emerge in the coming years.

Many UK companies have significant overseas earnings – particularly industrial and engineering businesses with a focus on infrastructure work and mining services.  Many British groups could be attractive targets for overseas predators, particularly if the Pound remains low.  The trend of loss of ownership of British national treasures could accelerate. There will be risks in chasing the environmental trend but the decade will see many more nuclear power stations built around the world. There will also be some opportunities in technology as demand for wireless chips grows.

Comment: Nothing very startling or original here, but the emphasis on resources and the Far East is very much in line with the strategic themes that form the basis of my own current thinking.

Markets: The equity markets got off to a powerful start yesterday, with rises in nearly all the major markets. Gold was also a notable feature, rising more than 2%. Nothing yet to disprove the Miller hypothesis so far, in any event.   This is the S&P 500 index over a three year period with 50 and 200 day moving averages, and the relative strength indicator.

This is the gold chart on the same basis. If the trend in gold is still higher, as I believe it is, this looks a good trading opportunity, as the metals all look oversold.

Market Comment January 4th 2010

A note on the fallibility of forecasts. In an entertaining piece for the Chicago Herald Tribune, Paul Greenberg highlights some of the most obviously, immediately wrong predictions of the last year.  He picks out George Soros for his warning on February 20 2009: "The economy went into freefall and is still falling and we don't know where the bottom will be until we get there and there's no sign that we are anywhere near a bottom."

Yet only a month later, the markets had turned and Soros was to hand to declare that the "the collapse of the financial system" had been averted and the economy was recovering. The biggest mistake of a year ago, we know now (though some of us fortunately foresaw it), was to mistake a global financial panic for a return of the Great Depression. Not that the economic out-turn has been good; far from it.

In his annual survey of economic forecasts two weeks ago, the always excellent David Smith in the Sunday Times discovered that not one of the mainstream forecasters whose predictions he monitored a year ago got anywhere near the actual outcomes for GDP, inflation and interest rates. The best prediction for GDP in the UK was minus 3.2%: the actual outcome (at least until the figures are subsequently revised) was minus 4.75%.

It is a timely reminder not to read too much into the waves of predictions now filling the financial pages. One of my firmest convictions after many years in the game is that short term investment decisions should never be based solely on economic analysis. The data is too ropey and in any event is swamped by market sentiment and investor behaviour. Valuation, momentum and technical analysis are much better guides to short term movements in the markets. Your thinking needs to stay flexible, as it always has done for Soros himself.

So I don’t automatically place that much credence on the kind of gloomy assessments coming out of the economics profession at the moment. This story from Reuters, which quotes such luminaries of the profession as Martin Feldstein and Kenneth Rogoff, is a typical example. It is not that the gloomier members of the profession can’t be right. It is just that the track record of economists provides no justification for placing undue reliance on it.

Longer term projections are another thing. In my most recent column for the Financial Times I highlight the way that Sir John Templeton liked to make forecasts, which might be summed up as: make them big, and make them years ahead. In 1980 he took a stab at predicting where the  Dow Jones index, then around 800, would be in 2020, 40 years ahead. On my calculations his forecast (the Dow at 16,000) is still very much on track. In part because of his Christian faith, Templeton was an optimist and a firm believer in the long term power of equities.

His investment philosophy was brilliantly summed up in just three words: “Buy cheap stocks”. To his mind, that simple approach dealt neatly with both asset allocation (if stocks aren’t cheap, don’t buy them) and stockpicking (the only stocks you can own with confidence are those that are cheap on valuation grounds).  The biggest risk during periodic market downturns is to forget these simple rules of thumb.

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This is from the Wall Street Journal on the so-called January effect, the apparent historical fact that the way stocks perform in January is a significant indicator of the way they perform over the rest of the year.

"Historically, the first few trading days of January have been among the strongest for stock performance, because this is when individuals and pension plans add big chunks of new money to retirement accounts. Whether people follow their normal pattern and pump money into stocks in January can be a sign of the market's prospects for the coming weeks, and even for the entire year".

"If stocks rise in January, they often finish the year strongly. If stocks are weak during this normally propitious time, stocks tend to do poorly. January was weak in both 2008 and 2009. In 2008, the Dow Jones Industrial Average fell another 30% in the following 11 months, marking one of the worst stock-market years on record. In 2009, the January decline was followed by an 18% plunge to a 12-year low in March. Only after that pain did stocks roar back. This time, stocks already have gotten off to a disappointing start".

"In normal years, investors try to front-run the expected January rise, and they bid stocks higher in late December. Since 1900, the Dow has risen a median 1% in the last five trading days of December, according to Ned Davis Research, more than four times the median rise for five-day periods in general. In the five final trading days of this December, however, the Dow actually fell 0.37%".

"Now, investors are worrying about whether the December weakness will carry through into January. If so, it could augur poorly for 2010, or at least for the first months. "Strong years for equities normally show investment-buying early, with great upside momentum in January; most bad years start with down Januarys," notes Phil Roth, chief technical market analyst at New York brokerage house Miller Tabak + Co., in a report on January's importance.

"What analysts would like to see now is a strong January rally on heavy volume, suggesting investors are pouring new money into U.S. stocks. During much of the Dow's big post-March rally, trading volume has been below-average, suggesting that many investors remain skeptical of U.S. stocks. If volume remains low in January, it would be a further indication of investor doubt".

It didn’t work that way in 2009, which began terribly and finished strongly. My own opening hypothesis for the markets in 2010 is that there is further to go in the rally, but that we are also overdue a significant correction at some point. While January will set a tone for the early part of the year’s market action, just as with macro-economic forecasts, the January effect is not something on which any serious investor will want to rely.

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As a firm believer in what Jack Bogle calls the CMH (the costs matter hypothesis), my view has always been that index funds, low cost ETFs and investment trusts are the preferred instruments for sensible investors, which is why they make up the bulk of my own portfolio. It is only in exceptional cases that the performance of unit trusts and other managed funds can justify their higher fees.

As for hedge funds, I have always been a sceptic, not because there aren’t some exceptional investors running hedge funds, but because their fees are so high that it makes it inevitable that they are run for the benefit of the managers first and the investors a distant second. At the same time the misalignment of interest between manager and investor makes them vulnerable to excessive risk-taking.

As will always be the case in a powerful market rally, because of their inbuilt gearing to general market movements, investment trusts were the place to be in 2009. The end year figures for investment trust performance, as compiled by the broking firm Close Winterflood, emphasise how good returns were, as underlying performance was boosted by a significant narrowing of discounts as the financial crisis receded from the first quarter onwards.

Here are a couple of standout examples from my own holdings. SR Europe, a European investment trust run by the hedge fund managers Sloane Robinson (why pay them hedge fund fees when you can get their expertise more cheaply?): NAV up 43%, share price up 51%, FTSE Europe index up 22%. Morant Wright Japan Income NAV up 20%, share price up 49%, Japanese market (TSE first section) minus 7%.

Of course the discounts on these and many other trusts had widened during the crisis, so some of these gains are merely catching up after their earlier above-market declines. But it remains the case that as long as you are prepared to live with the volatility, over the long haul the best investment trusts, with their low management fees and specialist skills, plus ability to borrow, are an excellent and efficient way to capture market returns.

It was notable how the improvement in discounts and share price performance tailed off in the last quarter of 2009. This might suggest that we are in for an early period of consolidation in the markets this year. However there was a special factor in the form of a large Norwegian investment institution selling all its investment trust holdings, for reasons that remain unclear, and this affected the price of a number of the larger investment trusts
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Investment Prejudices

For anyone who follows investment markets for any length of time, certain fundamental beliefs (and prejudices) inevitably accumulate over the years. Mine include the following:

1. Low cost passively managed funds are the initial benchmark against which investors of all kind need to measure their achievements. With the advent of ETFs, the available universe of passively managed funds has expanded dramatically.

2. There are a few exceptional fund managers whose talents are worth paying for (if you can find them - and I look a lot). The other 95% are not: invariably you can achieve the same results at a lower cost.

3. However good, no professional can ever outperform in all years and all market conditions - strategic market timing and asset switching calls are ultimately the investor's own specific responsibility.

4. It is better to make a few good decisions each year than a lot of bad ones, as turnover kills performance. It also absorbs too much of the investor's precious time.

5. You need to keep yourself well-informed and (even better) well-read in financial history and behaviourial theory to have a chance of outperforming the market. But paradoxically that does not mean that you need to know a lot about everything to succeed: knowing what is important and binning the rest is the key.

6. While market timing is widely believed to be an unprofitable investment approach, in practice the smartest investors always seem to have a view of some kind about where the markets are heading. In my experience you cannot totally divorce a topdown and a bottom up approach.