9th November 2009
Michael Magnay, Senior Private Banker Cambridge, Kleinwort Benson
"Today, people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long term asset, one that pays virtually nothing and is certain to depreciate in value over time" Warren Buffett October 2008.
Bear markets end either in panic or in indifference. In the UK, the long 2000-2003 equity bear market ended in a panic with the market falling 12% in 7 trading days, as the FSA ordered a major life assurance company to reduce its weighting in equities. By contrast, the 1965-1982 period saw the Dow Jones Industrial Index trade between 500 and 1000 throughout the period. The actual bottom was in 1974, but in the early 1980s, with the market no higher than it was 18 years previously, there was complete indifference towards equities as investors had ceased to believe that they would make money from equity investment. In fact, the autumn of 1982 saw the beginning of 25 year bull market that would take the Dow Jones Index up by 18 times.
Thus, bull markets begin with investors in a state of either fear or apathy, depending on which type of bear market has come previously. Investors either fear losing money, preventing them from buying equities, or are apathetic as a long period of sideways trading means they have no expectation of generating positive returns. Almost by definition, investors (both professional and amateur) are at their most miserable at the beginning of a bull market, and are able to provide the many media outlets desperate for views with which to fill their pages and air-time, with erudite and convincing reasons why prices will not rise, usually related to a negative view of future economic developments.
Only twice have I seen stock market valuations as depressed as in March of this year, the first in 1987 and then in 2002/3. It has been my experience that every 7-15 years one gets an opportunity to invest at very attractive levels, and we have just witnessed such an occasion. A widespread collapse in asset prices coupled with paradigm-changing policy measures set the basis for the recovery which we have enjoyed thus far.
Within the space of three months, the glass has become very much half full as opposed to half empty. The "green shoots" are sprouting and have been recognised and understood by the markets. Trying to predict the turning points in markets as they occur is nigh on impossible, but it would now appear that March 2009 marked a major low of the type seen in 1987 and 2002/3. More interestingly for those corporates which have survived the traumas of 2008, they often now find themselves in a healthier position as their competitors have gone to the wall and they have reduced costs.
How have we taken advantage of the position we have found ourselves in this year? A combination of enormous monetary policy easing and liquidity provision and momentum reversal in markets and economies is actually bullish for almost all asset classes.
All analysis tells us that asset allocation explains the vast majority of investment returns and we have been asking ourselves how best to allocate monies in the fast moving investment world that confronts us today. A back to basics approach of trading liquid securities in the gilt, corporate bond and equity markets has generated encouraging returns. Currency trends have been less clear-cut in the current year, however a return to sterling from dollar assets has been beneficial over the last few months, although this has now played out. In addition, hedge funds have enjoyed a better year as the mispriced asset opportunities in this area leave very rich pickings for the survivors from last year’s carnage. We believe that 2009 marks a watershed in the development of the world economy , when for the first time, markets have seen China and Asia take the lead in pulling the world out of recession rather than the US this also supports our view of the commodity super-cycle and we expect this area to help drive returns within equity markets. We are playing China through Hong Kong based companies, in particular where we can enjoy Chinese levels of growth, coupled with US levels of interest rates. Finally, UK property looks to be near its lows, and the very high yields on offer, pay the investor if he has to wait for a pick-up in capital values and this serves to complement the particular opportunity which we see in the US residential mortgage-backed securities market.
Inflation remains my biggest fear in the medium term; Mr Bernanke articulated in 2002 how he could use the printing press to provide an infinite amount of US dollars. He has gone a long way towards that with the expansion of the Fed’s balance sheet over the last year. At present, commentators are concerned about the deflationary impact of the credit crunch, and this has led to extraordinary monetary policy easing. In due course the tide will turn, the huge amounts of liquidity in the system may find themselves taken up by the real economy, and inflation may begin to rise from the ashes, at which point cash will be, as Warren Buffet stated "a terrible long term asset".
This note is intended for information purposes only and does not take into account the investment objective, the financial situation, or the individual needs of any particular person. Investors should obtain independent advice based on their own particular circumstances before making investment decisions.