Live long and Prosper

I hope that readers will be familiar with the character of Mr Spock, Starfleet’s first officer on the bridge of the USS Enterprise in the hit TV series Star Trek. As any “Trekkie” will tell you, Mr Spock, with his pointy ears, pudding bowl haircut and split fingered salute originated from the planet Vulcan. As the story goes his father was a Vulcan but his mother was one of us, a human. The trademark of this fictional character was his logical perspective and a remarkable detachment from human emotions, such as fear and greed. With these attributes Spock would certainly make a STAR fund manager.

It is often said that the financial markets are driven by logic over the long term but by human emotion in the short term. Indeed to quote Benjamin Graham, considered to be the first proponent of value investing, “the owner of equity stocks should regard them first and foremost as conferring part ownership of a business. With that perspective in mind, the stock owner should not be too concerned with erratic fluctuations in stock prices, since in the short term the stock market behaves like a voting machine, but in the long term it acts like a weighing machine.”

Graham believed that true value in the long term would be reflected in the share price. But fear and greed can push prices to extremes in either direction in the short term. Typically market commentators justify these short term fluctuations with fundamental economic analysis. However, the truth is that more often than not, short term fluctuations are driven by there being more buyers than sellers, or vice versa all acting on a tide of human emotion. This can often lead investors to make rash decisions that can result in mistakes and portfolio losses.

A study of financial market history suggests that prices will tend to move in long term trends, more commonly referred to as bull and bear markets. With access to long term data these trends can easily be identified; over time we can essentially drawn straight trend lines from trough to peak or from peak to trough. But as we know markets do not rise or fall in straight lines. Instead they will fluctuate around their trend lines or “fair value,” driven by human emotion. When prices become detached from their fair value and shares are either over bought or oversold, market participants look to pull them back into line. This process is referred to as mean reversion.

Mean reversion is one of the most powerful forces in investment management. Markets are in essence like a pendulum, they will swing backwards and forwards at varying speeds but will in the end revert back to the centre. The theory sounds fine in principle but in practice investors need to establish where their mean lies before they can profit from a reversion to it. Share prices could look cheap relative to the mean of the last decade but expensive compared to the mean of the last fifty years. The process of mean reversion can be applied to share prices within an asset class and can also be used to evaluate the relative attractions of one asset class over another, for example bonds versus equities.

So where are we today? The equity markets have been trending upwards over the last eight months, a dramatic switch from the downward trend we witnessed previous to that. The current trend is driven by the actions of governments and their central banks that have been willing to do whatever it takes to reflate the economy and fight deflation. Their actions have been unprecedented. We have seen extremely low interest rates and a massive amount of quantitative easing. Short term this kind of shock treatment has been constructive for asset prices, but there is a fear that these policies may be destructive in the long run. Already there is talk of the next bubble being created in a similar fashion to the Tech, Housing and Credit bubbles of the last decade.

Over a period of time history teaches us that nearly all changes of trend are preceded by a change in monetary policy, whether that be easing or tightening. A bull market has usually been preceded by a slashing of interest rates and a bear market by a hike in interest rates. It is important to note that there is always a time lag for policy to take effect. The end of the Tech bubble was brought about as central banks drained excess liquidity from the markets as fears of Y2K abated. Whereas the additional liquidity and cutting of interest rates post 9/11 triggered a bull market in 2003 which lasted until late October 2007. Interestingly, the first hike in UK base rates was in October 2003 with further gradual rises over the next four years as the Bank of England looked to slowly drain liquidity from the economy. Eventually this policy of slowing withdrawing liquidity led initially to a housing bubble, then a credit bubble, and finally the recent crisis which threatened the very fabric of capitalism.

Policy today is extremely easy with record low interest rates and the authorities in the major developed economies prepared to print more money if required. This side of a General Election in the UK I would not expect to see a change in a policy. A policy which is looking to reflate the economy, create jobs and grow the economy. Despite the fact that the recent economic growth numbers showed that the UK remained in a recession, I would expect to see official confirmation of a recovery in the near future. This was a major blow for the government, especially when there are signs of recovery elsewhere in the world.

There is no sign today that either of the two central banks at the heart of the global credit crisis, the US and UK, are considering monetary tightening. Indeed Ben Bernanke, Chairman of US Federal Reserve and counterpart to Mervin King Governor of the Bank of England, has studied and lectured on the mistakes made during the Great Depression of 1930’s and by the Japanese in the 1990’s. His stance has been that on both occasions the authorities were too slow to supply liquidity to markets and too quick to end that strategy. This suggests that he is hardly likely to start tightening policy after just a single quarter of growth; especially whist unemployment continues to rise.

There is, and will continue to be plenty of talk about what would be an appropriate exit strategy. Whether these central banks actually do have a plan this time is another matter. After all they have faced this situation before and have to date been fairly unsuccessful in their efforts to remove excess liquidity without destabilising the economy in some way. And to be fair there are some critical milestones in this process: first, quantitative easing would need to end. Then the process of when and how to raise interest rates without causing an imbalance would begin. And underlying all this is the threat of an inflation shock led by a spike in commodity prices to contend with.

For now an environment of low interest rates and low inflation will continue to support equities after a year that has seen asset classes like corporate bonds delivering equity like returns with a fraction of the volatility. However, be aware that equities have rallied 50% from their lows and currently look ahead of themselves as measured by short term daily moving averages. So expect to occasionally see, as we witnessed in October, short term mean reversions. But, whilst no longer at bargain prices, equities are not far from fair value in terms of long historical price earnings ratios. Whilst I would not suggest that the current term trend can “boldly go when no man has been before,” we are unlikely to see a change in the long term trend whilst monetary policy continues to remain loose.

John Husselbee
17th November 2009

Property: Back to the first rung of the ladder

Over the years investing in commercial property has been seen as essential to providing diversification for an investment portfolio. This is an asset class that has traditionally provided investors with a good level of income and the potential for capital gains with relatively low volatility. However, for investors in UK commercial property it has been quite a different story over the last two years as capital values have almost halved since the peak of the market in mid 2007. With signs appearing that the global economy is now recovering, the outlook for property is now improving. Many believe that the property market is fast approaching the low point for this cycle. So is now the right time to start rebuilding property weightings in multi asset portfolios?

Investment in commercial property for most private investors is achieved via listed securities such as REITs (Real Estate Investment Trusts), property shares and closed ended funds. These provide investors not only with access to this asset class but also short term liquidity. Over the long term listed assets should deliver returns that are correlated to those an investor might expect from a direct investment in commercial property. However, short term, liquidity considerations may cause listed assets to act and behave in the same manner as the broader equity market and the share price of these vehicles may become significantly dislocated from the value of the underlying properties held within them. The global financial crisis in the last quarter of 2008 caused investors to dump all risk assets including listed property securities and we witnessed just such a dislocation, the average closed ended fund fell from a small premium in January 2007 to a 40% discount by December 2008 as investors scrambled for liquidity at any cost.

It certainly has been a torrid time for investors in commercial property but there is now reason for renewed optimism. Firstly, as a result of the significant falls in capital values the yield on commercial property has now risen to previous peaks. The yield now compares very favourably to the 10 Year UK Gilt yield, a key valuation measure for property investment. Historically, as the chart below shows, the yield on commercial property has traded at a 2% income premium over gilts. Inevitably gilt yields will have to rise as the Government seeks to fund the growing national debt, however, with property currently yielding around 8% and gilts ranging between 3.25% to 3.75%, this income premium is currently twice the long term average.

Source: Clavis Walden, IPD UK Monthly Index to 31st July 2009.

Another reason for optimism is the correlation of commercial property values with the growth of the economy. The daily news on the economic recovery continues to improve with nearly all of the major economies approaching the end of a short, sharp recession. Governments and their Central Banks have provided unprecedented levels of monetary and fiscal stimulus to stave off a downward deflationary spiral. Their goal of avoiding a deep depression is showing signs of being achievable and they appear to remain committed to a loose policy to defeat deflation and sustain the recovery. The chart below shows that historically the best time to invest in commercial property has been just as the recession is ending, a period when yields are peaking and investor sentiment is beginning to turn.

However this optimism should be tempered by a level of caution. Whilst we maybe close to or, at the bottom of the capital value cycle for property, the rental value cycle may still have further to fall. In a recession rental values typically decline as insolvencies rise, leases expire without renewal and break clauses are enacted. Furthermore, in this cycle landlords are being forced to lower rents on some properties to attract new tenants to occupy empty buildings which have had their relief from rates dramatically cut. Property specialists tell us that whilst the rate of decline in rental values has slowed, the vacancy rate could continue to rise.

The belief that we have reached the bottom of the capital cycle is based upon the assumption that the economy will continue to improve. As we have already mentioned, the UK Economy has been saved from Armageddon by unprecedented amounts of monetary and fiscal stimulus. There is now an expectation that the economy will resume growth in the next few quarters but this will come at a considerable cost. Government spending has increased and our nation debt, through the introduction of Quantitative Easing, has literally exploded. The traditional way to reduce the Nation’s real debt burden has been to inflate the economy and devalue the currency. This in turn will lead to sluggish economic growth over the next five years and the effect will be a slow recovery in property capital values. A final concern is of course the lack of bank lending. All of that being said, the potential upside that commercial property can offer investors at the moment does seem to outweigh the downside risks I have outlined above.

The recent buyers of commercial property have been overseas investors. They have been tempted by a capital correction in the UK that has been far greater than anywhere else in the developed world. These depressed valuations coupled with Sterling weakness have seen a whole host of international buyers knocking at the doors of UK property managers. The obligatory upward only rental review clause together with longer leases can create quasi bond type investment assuming the properties are let to quality tenants. There has also been renewed interest from UK institutions wanting to re-enter this asset class seeking to benefit from the wide yield premium over gilts. But as yet there is little evidence to suggest the retail investor is buying.

As investor sentiment has improved so has the trading environment and more importantly the liquidity conditions. Listed property securities have rallied strongly in line with the broader equity markets showing the same level of correlation that they did on the downside. The dislocation between share price and the underlying capital value is rapidly disappeared. The chart shows how the market weighted AIC UK Property sector has moved in terms of both share price and NAV (net asset value.) Share prices have bounced reflecting a sea change in sentiment whereas NAVs or capital values have merely stabilised. This bounce in share price is to be expected short term given that this sector has, over recent years, been more volatile and shown little correlation to direct commercial property. However, longer term we do expect the AIC UK Property sector to revert to displaying similar characteristics to those of the commercial property asset class once more.

Open ended funds, the traditional destination for most retail monies, have seen redemptions slow this year and the managers of these funds are no longer forced sellers looking for liquidity to pay exiting unitholders. We recently reviewed those funds ranked in the IMA Property Sector over two time periods: the period covering the fall from peak to trough of the cycle and the period covering the recovery to date. We discovered a clear division of returns between those funds invested in listed securities and non sterling assets versus those funds wholly invested in direct property.

Over the long term, property tends to be invested in for income rather than capital growth. Indeed, it is generally accepted that the majority of the long term gains are attributable to income rather than capital gains. It is hard to imagine that capital values can fall much further in a developed economy such as the UK, therefore, looking ahead the return on property will be dominated by income with a starting yield of around 8% but little capital gain in this rather sluggish economic growth environment. To maximise returns it is therefore important that private investors should review how they can most efficiently invest in this asset class. The introduction of REITs in January 2007 gave smaller investors a more tax efficient vehicle to access commercial property. REITs focus on property assets and do not pay capital gains nor income tax on the proviso that the majority of income generated is paid out to shareholders who then pay tax on their dividends. More recently we have seen the introduction of PAIFs (Property Authorised Investment Funds) which levels the playing field in terms of tax efficiency for open ended funds. Our understanding is that many existing open ended funds will consider converting to this more tax efficient structure.

So, we believe commercial property values are close to or at the bottom of the cycle. The change in investor sentiment is rapidly closing the distance between listed property securities and direct property assets. Those that fell the hardest in price have, generally speaking, recovered the quickest as liquidity conditions have improved over the last six months. What investors must ensure is that they select the right vehicle and the right manager to maximise their returns in the next stage of the cycle as there will be considerable dispersion of returns between the winners and the losers. Gearing which was the enemy of returns in a falling market will now magnify the gains in a rising market. There is an expectation that capital values will begin to rise and a vast amount of money has already been raised ready to invest in this asset class. We do not expect to see a rapid rise in capital values but investors should be attracted by the total return potential, driven predominantly by the yield, which significantly exceeds the current yield on government bonds and cash.

John Husselbee
5th October 2009

Tax and Cut

Autumn has arrived, bringing with it the start of a very interesting party conference season. With the General Election less than a year away the Labour Party will gather in Brighton later this month to plan how to win a fourth term in government after what has been quite an extraordinary year. The country has experienced the worst financial crisis since the Great Depression. A crisis which led to a near collapse of the UK banking system, took us into a severe recession and caused a sharp rise in unemployment. The Government’s remedy has been to flood the economy with liquidity in an attempt to stave off deflation and reflate our flagging economy. We saw interest rates slashed to historic lows last October, our banks effectively being nationalised and in the Spring the introduction of Quantitative Easing - printing money. These unprecedented measures are now beginning to stimulate the desired green shoots of recovery. There will, however, be a heavy price to pay for a sustained recovery. We have already seen the pound being devalued and should fully expect to see inflation longer term as the National Debt builds. To balance the Nation’s books the taxpayer will be footing the bill with tax rises and cost cutting. Indeed, we have already seen this start:

• fuel duty has been increased by 2 pence per litre as of 1 September 2009, and will increase by 1 penny per litre in real terms each year from 2010 to 2013.

• the thirteen month reduction in VAT will end 31st December 2009 and then will return to the previous rate of 17.5%.

• from April 2010, an additional rate of income tax of 50 per cent will apply to income over £150,000 and the income tax personal allowance will be restricted for those with incomes of over £100,000.

• from April 2011, tax relief on pension contributions will be restricted for those with incomes over £150,000 and tapered down until it is 20 per cent.

If raising taxes is unpopular, then there is more to be lost on cutting public spending. According to this year’s Budget total public spending is expected to be around £671.4 billion this year, around £10,900 for every man, woman and child in the UK. The chart below shows how the budget is spent, with half of the money used to fund unemployment benefit and the National Health Service. It is unlikely that these two departments will suffer too much from cost cutting
with education and defence being the more obvious targets. There is already talk, in the weekend newspapers, of the Government’s plans to save £2 billion on education. It will not be long now before the Government begins to spell out exactly what cuts and savings they plan to make.

Whilst the governing Labour Party is looking to convince us that they deserve a fourth consecutive term in office, the Conservative Party will be seeking to regain the majority they lost in 1997. They will meet in early October in Manchester to plan how they will convince voters of their manifesto to replace the governing party. But this is a manifesto which will surely be unable to avoid increasing taxes and cutting public spending. For their part The Liberal Democrats will gather in Bournemouth and they too have been talking tax hikes and bold cuts. They will be hoping to take votes from both sides in the next General Election. Whilst they would, of course, ideally want to form the next government, a more realistic outcome would be to hold the balance of power in a hung parliament.

Whatever the outcome of the next election, there is no doubt that voters in the UK must now accept increasing taxes and cutting public spending as inevitable. The Party that wins will be the one that can convince the electorate that they are the most capable of making the right choices to sustain an economic recovery. This is a similar campaign to 1992 when the economy was in a
recession and against all odds the Conservative Government under the leadership of John Major managed to retain power. This time round trust and confidence will be the key factors determining who takes the keys to No. 10. The MPs expense scandal tarnished the reputation of parties on both sides of the House. Whilst Party leaders urged their members to put right any wrong doing, the integrity of our politicians was delivered a severe blow. There have already been many casualties and no doubt there will be many more when MPs stand for re-election next year.

The next general election must be held on or before Thursday 3rd June 2010, with the present parliament expiring at midnight on 10th May 2010. Local elections take place on 6th May 2010 and some have suggested that the general election may also be held on this day. The best outcome for the economy would be a majority allowing tough choices to be made in the early term of a new government. The worst outcome, and one commentators are beginning to talk about, is a hung parliament which could potentially have a disastrous effect on the British economy.

The outcome of the next election will shortly become a concern for investors. Stockmarkets are forward looking and will be impacted as investors fears increase about what will happen in the future. The rally in the market which started in early March was based upon the perceived outcome of the recovery plan rather than any real green shoots. This rally gathered momentum with the concerted efforts of governments and central banks around the world, as well as the announcement that a policy of Quantitative Easing was to be introduced. It is unlikely that the authorities will begin to withdraw the liquidity supporting the global financial markets anytime soon. To do so too early would risk the recovery and prolong this recession.

The most visible measure of liquidity is interest rates. We believe interest rates will remain low for some time. This might be a delight for those with mortgages and high levels of debt in employment but is bad news for savers. They are still being forced into risk assets as they seek greater returns than they can achieve on their cash deposits. The excess premium yield on corporate bonds compared to ten year gilts remains attractive. Perhaps the “once in a generation” value that we saw in corporate bonds at the beginning of the year has now started to disappear but there is still plenty of value to be found at this stage of the credit default cycle. With the lack of willingness by banks to lend, many companies are turning to the bond markets
to raise cash. Most bond fund managers we have spoken to lately are increasing their exposure to the high yield market as the default cycle starts to peak. In this sector the key to generating superior returns, in the future, will lie in picking the right credits and having the right tools to reduce maturity and interest rate risk. For us this is best found through strategic bond funds that can employ a flexible approach.

Aside from the credit markets, UK equities are also offering a generous yield premium to ten year gilts. Whilst there is some uncertainty over dividends, there is the potential for capital growth. The more secure dividends are to be found in the larger companies, however, there is a danger that the market ignores these income stocks in favour of growth. Whilst, the economy is showing signs of a recovery, future growth will be muted as households, corporates and the government reduce debt. Companies have recently improved profits, but this has been more as a result of cost cutting as opposed to growth of revenues. Unemployment and consumer confidence always lag in a recovery and we see no reason why it should be any different this time. If this is the case, then growth companies which can outpace the economy, will be the favoured ones. In this type of market buyers focus on growth rather than valuation. In this environment value managers will underperform.

This focus on growth has also been highlighted by the difference in the equity returns from Developed and Developing Markets. The West has been constrained by increasing debt and the prospect of higher taxes and fiscal tightening. On the other hand, Developing Markets, particularly those found in Asia Pacific and Latin American regions remain in a stronger fiscal position as they are able to fund future growth through savings. This division looks set to widen further as we witness the gradual wealth transfer from West to East. The next ten years will see this trend accelerate as the least indebted nations maintain their growth path. Our current preference is for the BRIC countries (Brazil, Russia, India & China) which have strong momentum in growth and maturing economies. These are also the countries which Goldman Sachs believe will have the biggest impact on the global economy in the future due to their strong population growth coupled with their open markets.

The continued growth in Developing Market economies also supports commodity markets, but at the same time weakens the US dollar. The thirst for energy and industrial metals will drive prices higher in the long run. The oil price has risen to the US$70 level which is less than half its
price last summer. The increasing burden of debt and the fact that US investors are now looking for better value overseas is weakening the US dollar. A gradual slide in the US Dollar will suit the authorities as it will reduce their debt and encourage exports. However, with the consensus forecasting that interest rates will stay lower for longer, there is a danger that the US Dollar will become the carry trade currency as the Japanese Yen was in the last bull market. This weakness, coupled with the long term fear of inflation has promoted Gold as a serious alternative for those wishing to diversify away from holding US dollar assets.

In my experience as an investor for over twenty years, there are many times where you have to hunt for opportunities, but this is not the case in today’s markets. Central banks and governments have stated that they are maintaining their loose monetary and fiscal policy stance to insure that the recovery is sustained. Withdrawing liquidity gracefully when the economy is back on track is only a future concern rather than an immediate problem. All this is very supportive for risk rather than risk free assets. We do not wish to imply that it will be plain sailing from here on out as there are still many clouds on the horizon, but it is fair to say that we can see a silver lining. It is quite understandable that for many investors, just a year on from the beginning of the credit crisis, their main thoughts are still on how to avoid losing another 10%. For us, it is about thinking about where we can make the next 10%!

John Husselbee
21st September 2009

Telegraph TV

This week, Robert Miller meets John Husselbee from North Investment Partners to discuss a new fund which allows investors to maximise their returns, while raising money for the Prince's Trust.

Invest and Give is a new kind of investment fund which allows investors to maximise their returns, but at the same time, raise money for youth charity, the Prince's Trust, which was set up the Prince of Wales in 1976 to help disadvantaged youngsters.

Donations are calculated as a percentage of your investment and are automatically made on your behalf. And as Mr Husselbee explains, although Invest and Give has a charitable angle, it is first and foremost an investment fund, which sits in the balanced managed sector, thereby offering a diversified portfolio, but also the opportunity to give money to a good cause.

Here is the link: http://www.telegraph.co.uk/finance/financevideo/?bcpid=3469232001&bctid=31919185001

Show me the Money!

Jerry Maguire was the 1996 American film starring Tom Cruise which remains popular today largely due to its memorable quotes. In the film, Cruise plays Maguire, a sports agent who is attempting, with limited success, to secure a major contract for his American Football playing client, Rod Tidwell (Cuba Gooding, Jr.) During a telephone update on his contract negotiations the exchange gets somewhat heated and culminates in a frustrated Tidwell shouting repeatedly at Maguire “Show me the Money!”

After three months of an extraordinary turnaround in equity markets, investors are now yelling “Show me the Green Shoots” at the market in a similar style to Tidwell. Although, it now seems pretty unlikely that the world economy will experience a recession of the magnitude of the Great Depression, the recent rallies in credit, equity and commodity markets have stalled signalling that buyers are currently exhausted and maybe not quite so optimistic about the future. The concept of “less bad” can only carry markets so far. The strong gains in the second quarter of this year have served to return valuations closer to fair value from the worse case scenario. From here on in, it would seem that the markets are now demanding firm fundamental evidence of the economic recovery.

So does this current stall represent a pause or a sign that markets will turn back and we will see the next leg down in this bear market? In terms of valuation, equity prices and credit spreads are now at levels usually associated with a recession rather than a slump or a depression. In terms of the fundamentals there are signs of improvement in the global economy, most notably in China, the rest of Emerging Asia and the resource markets. Elsewhere, economic recovery is definitely more subdued and perhaps rather suspect supported by the helping hand of governments. The mass of liquidity created by both monetary and fiscal stimulus has been the key to avoiding a depression up until now; however, this has all come at a cost. It will be critical to the recovery that governments continue with a loose money policy for as long as required but then tighten again before inflationary pressures reassert. This formidable task, in the opinion of bond markets, is asking too much of government officials and government bond yields have consequently been rising in recent weeks.

For now it appears appropriate to be cautiously optimistic about the economic recovery. As we have often said statistical and economic data releases have a tendency to be backward looking, generally because of the time needed to collate, verify and then release data. For a more forward looking view, surveys are often used, although sentiment indicators should usually be interpreted as a contrarian view. For example, survey data about new orders in the US is currently showing an up turn which in the past has tended to correlate to a positive change in employment figures. This is a positive sign after last year’s collapse in demand, which saw companies quickly de-stock and shed labour. New orders should translate into increases in industrial production, further employment, rises in both corporate and personal income as well as a recovery in consumer demand. Of course, there is the danger always remains that the consumer will prefer to save rather than spend.

We believe that these markets will continue to be driven by fear as investors weigh up the fear of being in the market versus the fear of being out of it. It would not be a surprise to see the markets move sideways whilst investors continue to grapple with their emotions. On my desk I have, in recent weeks, collated economic research which can evenly be distributed between the bull and bear case. The arguments put down by both sides are fairly well balanced. This crisis was caused by the scarcity of credit and this is gradually improving day by day through effective government policy. As we have already said a number of surveys are showing signs that the fundamental data is improving. However, this is countered by concerns that economic growth will disappoint next year and markets are now trading at or near fair value.

The strategy in a market that moves sideways is not as clear as the one adopted in a trending up market. The cyclical driven equity rally has created opportunities for managers to carry out a tactical summer rotation in their portfolios. The rise back to more realistic valuations has been achieved and we believe the key to future returns will be relative value so stock selection will be vital. Small and mid cap stocks have outperformed their large cap counterparts, to switch now to large caps may provide the best relative returns in these volatile markets. We will now use periods of weakness to build our equity exposure once again. We favour the growth markets of Emerging Asia and resources for the long term. Finally, there are no early signs of inflation as unemployment continues to rise coupled with the recent declining commodity prices. Therefore, printing money will continue to support the corporate bond market for the present. Whilst, we have seen vast amounts of money flow into this asset class and effective de-leveraging in the sector, we remain bullish on this asset class.

John Husselbee
14th July 2009

Citywire Video 24th June 2009

The Exchange Traded Fund (ETF) market is a rapidly growing industry. I have used ETFs in managing portfolios for many years to access equities and other asset classes including, gold, oil & property. This interview recorded recently discusses why I and other industry colleagues are such big fans of this market.

Heads or tails?

In stark contrast to the beginning of the year, when stock markets wouldn't stop falling, we are now seeing the opposite. It seems like only yesterday that we were fearing a banking collapse, the end of capitalism as we know it and the prospect of becoming the sequel to the Great Depression of 1930's. Peoples’ perceptions about the depth and severity of this recession seem to change on the flip of a coin at the moment. One minute the economy is free falling, the next it is skyrocketing towards recovery. The impact on investor sentiment has been marked. There has been a complete change from deep pessimism to hope and optimism. No doubt largely brought about by the massive amount of stimulus by governments and banks around the world to fight recession and deflation.

The recent stock market rally does seem somewhat at odds with the current health of the economy. The debate continues on about whether we are really seeing green shoots or are they just dandelions, very pretty, but at the end of the day, just weeds. Yes, it is true that more companies are reporting better than expected profits this year but this has been achieved mainly through cutting the work force and other costs. Shareholders are very supportive of companies following a lean strategy into the next economic upturn, as it will certainly be beneficial to them. However, to believe that the future upturn will be as robust as it has been over the past ten years would be foolish given the burden of rising unemployment, greater debt and an increasing savings rate. Companies in the future will just have to learn how to make money in an economy which merely trots rather than gallops.

To us though, the bigger issue is the UK’s credit rating. Last month the credit ratings agency, Standard & Poor’s, announced they had downgraded the UK's credit outlook to negative from stable. This comes at a time when the political system is in tatters. The disclosure of MPs’ expense claims for second homes, cleaning, food allowances and specialist plumbing have seriously dented their integrity and outraged the voting public. Furthermore the current government maybe in office but they seem to be losing their power. Some say a change of leadership is now required but there is yet to be a serious challenger to Gordon Brown. The potential damage to the UK’s finances and reputation is real. The cost of losing AAA credit rating would be a higher yield, an even bigger penalty to the UK’s taxpayers. Normally this would put pressure on sterling but the truth is that most G10 countries are experiencing challenges of their own in this global fight against recession and deflation.

Looking ahead, the worse may well be behind us but there is no official confirmation that this recession is over. Much of the future lower economic growth may well be reflected in current prices. It is all too easy for investors to get dragged into the day to day short term thinking of a trader when they are constantly bombarded with financial news. However, more than ever, it is essential that investors keep in mind their longer time horizon and this will inevitably drive the construction of portfolios with an equity bias. In terms of valuing equities long term, the Price Earnings Ratio (PER) has historically been a good guide. The chart above plots the starting PER against the annualised real return over the following ten years. Today it shows good value, with the current PER being around 8 to 9 it could be an attractive entry point for investors. So if we are in a position to expect double digit returns from equities, what about bonds? A basic approach to estimating the future return of bonds is to look at the current yield of a ten year gilt. That would show a return of a little over 3.0% if held to maturity without protection against inflation.

This is a fast changing investment environment and will we continue to see more opportunities and challenges to come. We believe the best opportunities will be found in the economies of Asia and other Emerging Markets which can recover faster than the debt laden western economies. Commodities can resume their long term bull market thanks to the growing middle class and infrastructure spend in these developing countries. A weak economic environment together with low inflation and quantitative easing is supportive for gilts but the government's balance sheet is weak and further issuance would be a concern. Corporate bonds look more attractive, with spreads pricing in much of the bad news. Indeed, with equities beginning to look a little overbought at present, we are reviewing whether to take some profits and rotate more into this less risky asset class. We continue to weigh up how best to invest our managed portfolios in the months ahead and wrestle with the decision of when to buy and when to wait for a better opportunity.

John Husselbee
North
9th June 2009

Citywire Video 13th May 2009

I have posted an interview with Richard Harris of Citywire. We discuss multi asset, multi manager investing and I use my favourite football analogy.

Funny Money

From my inbox this week....

A Simple Lesson in Economics

In a small town on the South Coast of France, holiday season is in fullswing but it is raining, so there is not too much business happening. Everyone is heavily in debt. Luckily, a rich Russian tourist arrives in the foyer of the small localhotel. He asks for a room and puts a Euro100 note on the reception counter,takes a key and goes to inspect the room located up the stairs on the third floor.

The hotel owner takes the banknote in a hurry and rushes to his meatsupplier to whom he owes E100. The butcher takes the money and races to his supplier to pay his debt. The wholesaler rushes to the farmer to pay E100 for pigs he purchased some time ago. The farmer triumphantly gives the E100 note to a local prostitute whogave him her services on credit. The prostitute goes quickly to the hotel, as she was owing the hotel for her hourly room use to entertain clients.

At that very moment, the rich Russian comes down to reception and informs the hotel owner that the proposed room is unsatisfactory and takes his E100 back and departs. There was no profit or income. But everyone no longer has any debt and the small townspeople look optimistically towards their future.

COULD THIS BE THE SOLUTION TO THE GLOBAL FINANCIAL CRISIS ?

And this cartoon from Daily Express.....

I hope you enjoyed this post in a time when investors are torn between the glass being half full or half empty. In the meantime, the "we're not bust" rally continues on from the lows of early March. Let's see what this week will bring.

John Husselbee

10th May 2009

Ladies and Gentlemen, please stay in your seats

In the past, we have used the airplane analogy to describe our role as your investment manager. We, like a pilot, are responsible for safely flying you on your long haul investment journey. In our cockpit, we have numerous instruments and indicators that provide us with information to help us gauge the market conditions we are facing now and what may lie ahead. As recent history highlights we can experience periods of severe turbulence and it is then that we will ask you, our passengers, to return to your seats and fasten your belts until it subsides. But turbulent conditions don’t last forever, nor do bear markets.

It is in the nature of financial markets to always look forward and investors continually hunt for that elusive market low. There is no flight path, map nor directions available to guide us to this destination. To date this quest has been a frustrating one, the low we discovered in November last year proved to be a false dawn by the beginning of March as markets plunged to new depths. Since then markets have continued to show a recovery. So again the question is – have we seen the bottom of this current bear market?

As investors we have experienced both volatile and ranging markets in the past six months as the mood swings from pessimism to optimism regarding the length and depth of the global economic slowdown. The slowdown that began in the US has now spread across developed economies to the rest of the World. In a bear market we expect to see false dawns and there have been plenty. These markets favour the skills of the day trader rather than the longer term investor. The winning strategy has been to sell short the market after any significant rise. This was the case with the post Christmas rally which was beaten down by the barrage of short sellers in the New Year. The continuous scroll of bleak economic and corporate news has made this trade profitable perhaps until now – but this may be about to change. For despite any obvious improvement in the fundamentals those short sellers are being squeezed out of the market – has the bear trap been sprung?

To sustain a genuine rally from here and ignite the next bull market, the congregation of long term equity investors will need a restored faith in a future of economic growth and financial stability. Governments and central banks worldwide need to restore our trust and confidence in the financial markets. The recent meeting of G20 leaders in London took us another leg along the way to achieving these goals. For some commentators this gathering was merely a photo opportunity which was long on hot air and short on substance because the agreed financial packages and joint statements were negotiated by those who arrived in advance of our World leaders. But the real objective of the G20 meeting was to show the world a picture of global leaders working together to solve a global crisis. This is the most serious global slowdown seen since World War Two. Co-operation amongst World leaders and their central banks in the global reflation trade remains vital. The economic landscape of the World continues to change as the engine for growth moves from West to East. The extension of the original G7 to G20 supports this picture of global co-operation and unity. However, as no one size fits all, each country will chose their own combination of monetary and fiscal stimulus bespoke to their own economic needs. The danger is that this could lead us down the path of protectionism which could hinder the current policy of global co-operation. To date whilst there have a few minor incidents, the policy of open discussion currently being adopted has avoided any disastrous individual policy decisions.

It is the banking system in the West that has required most care and attention from governments and central banks. In the UK, the exercise to clean up the banks’ balance sheets has leaned heavily on the generosity of the Government in the absence of any other private capital being made available to them. It is the Government who hold the last creditable cheque book and have the ability to print money in an operation known as “Quantitative Easing”. There has been much talk here about the possibility of nationalisation which is the British taxpayers taking ownership of the banks. In our view, and we feel this was best summed up in a recent market review carried out by Scottish Widows Investment Partnership, “in the land of the free (market), nationalising banks, like the wearing of white socks and dress trousers, is to be avoided at all costs.” But without taking the nationalisation route the challenge this Government faces is a significant one: to put significant sums of cash into the banks without taking ownership, and whilst still protecting taxpayers interests. As yet they have not succeeded with this challenge.

So we are in the midst of economic recession and more importantly for equity investors we also remain in an earnings recession. However there are some early signs that things are beginning to stabilize in the economy. Much of the bad news is already discounted by markets with what is the biggest reflation trade in history now in play. And we must remember that there is a stage in any earnings cycle where prices can rise even though profits continue to fall. Current buyers would argue that we have reached this stage; we are in an environment of very low interest rates, much lower commodity prices and are experiencing a period of unprecedented monetary and fiscal stimulus. And it seems the market supports their view point having rallied week after week since early March. But it is the sustainability of that rally that is questioned, particularly by those who have maintained high cash weightings. The choice facing investors is a tough one: either be “long and wrong” or stay in cash and miss the market rally. To chase a rally too hard at this stage and get hit by a 20% fall would be extremely painful after the last six months.

We would caution investors not to chase these markets too hard until there are clear signs that the fundamentals have stabilised. Expectations are that the economy will begin to show signs of a mild recovery later in the year. The summer will hopefully bring better news, the housing market is stabilising, the rate of unemployment is slowing and credit markets are functioning closer to normality. The lack of transparency in the banks is still a major concern and we continue to monitor closely for signs of an improvement here. In our cockpit the instruments gauging economic fundamentals are still erratic whilst we appreciate that other indicators measuring confidence and conviction portray a different story. So although confidence and therefore share prices have risen recently just for now, Ladies and Gentlemen, stay in your seats until we turn off the seat belt signs.


John Husselbee
North
20th April 2009

It's Official

Last week government figures confirmed that the UK is indeed officially now in a recession for the first time since 1991. The economy shrank by 1.5% in the last quarter, the second consecutive quarter of decline which is generally accepted by all as a recession. This confirmation seems to rather contradict the spot of political gardening Baroness Vadera was doing the previous week. The green fingered Baroness, in a television interview on ITV, spoke about seeing the ‘green shoots’ in the economy. Her cautious optimism was clearly rather embarrassing for the Government as the economic data continues to deteriorate. It seems gardening has long been a popular pastime for Ministers, I remember Norman Lamont making similar comments as Chancellor during the last recession.

Of course, official confirmation that we are in a recession is hardly a shock. The evidence is all around us with businesses closing and unemployment rising every day. This crisis started in the financial sector and has swept out across the broader economy. Just take a look at the High Street, the downturn has hit the shops like a flu epidemic. As we know, flu takes its toll on the old, young and the weak. We have seen Darwinism in progress as famous names have disappeared from our High Street. First Woolworths and more recently Zavvi have fallen into administration. And others elsewhere are suffering too. In the car industry prices have fallen sharply on both new and used cars, indeed one car dealer is offering a “buy one get one free” deal!

The real shock in all this is the magnitude and speed of the downturn. Even Mervyn King, the Governor of the Bank of England, in his speech in Nottingham last week referred to the economy having "fallen off a cliff." He sited the failure of the investment bank, Lehman Brothers, four months ago, as the point in time that marked the beginning of the collapse of confidence in the world’s banking system. This then led to an unprecedented and synchronised downturn in business and consumer confidence around the world.

But there has and continues to be a really concerted effort to prevent this recession from deepening into a depression similar to the one that Japan experienced in the 1990’s ‘the Lost Decade’ as it is referred to. Interest rates in the UK have been slashed to 1.5% and there has been a series of bank bailouts to cut the cost of lending and allow both businesses and households access to credit once more. Is this working? Well it is far from an easy task - banks are being asked to repair their balance sheets so this means they must hoard the cash. At the same they are being told to lend to their customers but to the frustration of the Government they are not doing so enough. And this is the same Government that has taken stakes in many major banks using taxpayers’ money.

One suggestion being made is to clear the decks and take public ownership of the banks, to nationalise them. It is certainly true that the Government can afford to take a long term view and by doing this could remove the bad assets and provide capital to the markets. However, this is politics getting in the way. To nationalise the Banks in the UK could undermine the fabrication of Capitalism and could bring an end to New Labour with a shift towards Socialism. It is important in a free market economy that there are allocators of capital beyond the Government and the banks play a key role in this. Furthermore, it is likely that if this Government takes ownership of the banks now, then a future Conservative government would of course privatise them for profit and to extend their period of government.

I believe we have several more steps to take before nationalisation and, from his speech, Mervyn King, seems to agree. The conventional instrument maybe interest rates, however, he spoke about considering ‘a range of unconventional measures.’ There is quantitative easing. Mr King described how the Bank of England would look to purchase a range of financial assets from the banks in order to expand their reserves and allow lending to function once more in both the corporate and household sectors. Some critics have argued that as a nation we have spent our way into trouble, so surely it is hardly a good idea that we try and spend our way out of it.

That said some of the other measures that have been taken by the Government have been aimed at encouraging consumers to go out and do exactly that - spend more. But will this work? The temporary reduction in VAT from 17.5% to 15% was dwarfed, to a large degree, by the large discounting by most UK Retailers and confidence amongst consumers remains low even though the cost of living has fallen with reduced mortgage payments, petrol prices and energy bills. House prices have fallen and people will gauge their net worth relevant to this benchmark. The biggest fear is unemployment and despite the encouragement to spend many consumers may in fact prefer to save.

So where do we invest amongst all of this? Well to answer that, it is worth considering the behaviour of investors in a recession. A survey undertaken by YouGov Alpha illustrates how and when the consumer tightens his/her discretionary belt. When times are tough people become more frugal, a nation full of bargain hunters. The supermarkets have already noticed their customers opting for less expensive food in their ‘value’ range. Indulgence is avoided as people become more prudent in their shopping habits. There will be winners and losers in this environment. Whilst demand will contract for many, for some providers there is less competition. In fund management separating the wheat from the chaff is the role of the stockpickers, there are number of quality UK fund managers that we, at North have identified who I believe have the ability and experience to excel in these markets.

Source: The Alpha Bulletin, Issue 6 YouGov Alpha

I am also keeping a close eye on where the Government and the Bank of England will be directing their capital. When they provided funds to the Banks, the beneficiary was the UK Gilt market. Yields in this market may now be fairly unattractive but there may still be room for further capital gains. If quantitative easing were to occur, then according to Mr King, the Bank of England would consider buying corporate bonds. These would of course be purchased at the higher quality end of the spectrum where the spreads have risen considerably over gilts as a result of the credit crisis. In our portfolios, where appropriate, we now have a significant weighting in quality corporate bond funds managed by some of the leading investment managers.

If you know where to look there will be plenty of opportunity to make money in these markets. The behaviour habits of investors will of course change. Savers will begin to consider whether their deposit account, offering a very paltry rate of interest, is really the best place for their assets. They will look to find other ways of obtaining a relatively safe and reliable income. I very much doubt that they will be interested in returning to the highly complex and leveraged products that we saw so many of in the last few years and which led to this crisis in the first place. A move into more risky assets may well be required but so is the necessity to keep the approach simple. If this is, as I believe, the case, then quality corporate bond and UK equity funds should benefit.

John Husselbee
26th January 2009

Keep following the Fundamentals

It was George Soros, the trader that made a fortune betting against the British Pound in 1992, who once said “short term volatility is greatest at turning points and diminishes as a trend becomes established…” Volatility remains a key feature of today’s financial markets with investors not knowing whether to squeeze the trigger or pull the plug. The market’s daily ups and downs are not driven by fundamental factors but rather by emotion. The VIX, the Volatility Index, is the gauge most widely accepted as the best indication of investor’s risk appetite. It measures the market’s expectation of short term volatility of S&P 500 Index. Commonly referred to as the index of fear and greed, it provides scale of ‘fear’ from zero to hundred. On average, it hovers around 20 or below. This is the level where investors are considered to be relatively confident about the future. Throughout this recent credit crisis we have seen this indicator reach record heights of 80 and above.

As the pendulum of fear and greed swings, it allows the extremities to be reached as investors become too optimistic in bull markets and too pessimistic in bear markets. As the markets go through cycles so too does investor behaviour. This is illustrated by the investor psychology cycle diagram below which was produced by South African based RMB Unit Trusts.


Before trying to establish what stage of the cycle most investors find themselves in this current market situation, let’s consider each of the stages.

Contempt: According to the cycle, a bull market typically starts when a market is at a low and investors scorn stocks.

Doubt and suspicion: Investors try to decide whether what they have left should be invested in a safe haven such as a money market fund. They have burnt their fingers with stocks and often vow never to invest again.

Caution: The market then gradually starts showing signs of recovery. Most investors remain cautious, but value investors began to scoop up the bargains.

Confidence: As stock prices rise, investors’ feeling of mistrust changes to confidence and ultimately to enthusiasm. Most investors start buying their stocks at this stage.

Enthusiasm: During the enthusiasm stage, prudent investors are already starting to take profits and get out of the stock market, because they realise that the bull market is coming to an end.

Greed and conviction: Investors’ enthusiasm is followed by greed, which is often accompanied by numerous IPOs on the stock market.
Indifference: Investors look beyond unsustainably high price-earnings ratios.

Dismissal: As the market declines, investors show a lack of interest that quickly turns to dismissal.

Denial: Then they reach the denial stage where they regularly affirm their belief that the market definitely cannot fall any further.

Fear, panic and contempt: Concern starts to take a hold and fear, panic and despair soon follow. Investors again start scorning the market and once again they vow never to invest in stocks again.

In order to determine where we are in the equity market cycle, it is important to understand where investors are in this psychological cycle. I would argue that we are on the left hand side of the cycle, but where exactly is a matter of personal judgement. I believe that it is likely that investors currently fall into the area of “Doubt & Suspicion.” It is my opinion that the later cycle stages of the right hand side of this chart have already been seen back in September and October. This is when we saw mass deleveraging. Monies have now been temporarily parked on the sidelines in cash and short dated government bonds, which are offering very little in return.

This simple analysis may help with the obsession amongst investors and market commentators to call the bottom of the market. Falling energy and food prices mean that inflation is no longer a concern and all efforts can focus on promoting growth. The massive amount of monetary and fiscal stimulus that central banks and governments have provided to date is clearly designed to restore confidence as quickly as possible. The markets want to see firm evidence of these measures beginning to work fast but it will take time. We would not expect to see signs of a recovery until later next year and a return to economic growth in 2010. However in the long term we believe equity markets to be a discounting mechanism. Studies have shown that in past recessions equities have started to recover, even whilst economic news is still worsening, around six months before the official end of a recession.

Only time will tell whether we are dealing with a typical investor psychology cycle or not and what the next stage of the cycle for investors will be. However, in order to be a successful investor, it is important to distance yourself from the ‘herd’ mentality and to make objective decisions based on the fundamentals. To quote Warren Buffet “Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.”


John Husselbee
2nd December 2008