Tony Yarrow's Investment View - August 2009

Written by Admin, 03 August 2009

Market's Heat Up - Weather Stays Cool

I suggested in my last blog that the stock market had entered a new uptrend in early March. The title, ‘torpor descending’ was meant to be ironic. Many commentators were saying that markets would ‘drift sideways and downwards over the summer’ reflecting the old saying that you should ‘sell in May and go away’.

But these days, markets rarely drift sideways. Most of the time, they are going up or down quite steeply, and currently the direction is steeply up. Last month I was expecting a ‘higher low’ on the UK stock market, which would confirm the uptrend, and hoping that it would be above the 4000 level on the UK stock market. In the event, the ‘higher low’ came at 4127 on Friday July 10th. Since then the market has risen above its previous high of 4506, made on June 1st, in the process chalking up that remarkable sequence of eleven consecutive up-days. So, as well as a ‘higher low’ we now have a ‘higher high’, another confirming feature of an up-trend. Also the latest upwards move was very fast, and as previously mentioned in this blog, the market tends to go faster in its primary direction than in the consolidating counter-trend moves. Last month’s hypothesis was that the stock market is going up. All the evidence of the last month tends to confirm this hypothesis. As far as the funds are concerned, we think that there is a good opportunity to make money in these markets, and that we should make the most of this opportunity while it exists.

The rest of this blog will consider the uptrend, how much further it might go, how the current second phase is different to the first one, and what might derail the otherwise positive outlook.


There are three useful pointers to value in the stock market, price-earnings (P/E) multiples, directors’ dealings, and the yield ratio.

The price-earnings multiple tells you how many years’ profits you are buying when you pay for a share.

The higher the number, the more expensive the share, and vice versa. At the moment, price-earnings multiples aren’t much help. Many companies’ profits have collapsed over the past year, which has pushed the P/E multiples up, but what really matters is what profits will look like in a year or two’s time, assuming that companies will survive the recession. Investors are only just starting to think that far ahead.


This one is far more useful. Directors are only going to invest substantial amounts of their own cash into their businesses if they think that the shares are cheap and that things are going to go well. For the last year the ratio of purchases to sales has been strongly positive, and it continues to be so. This last week, there were thirty-one purchases to five sales. Two weeks ago, it was thirty-seven to one. These numbers are highly supportive to the hypothesis that the market is still cheap, and will rise further.


The yield ratio compares the income you get if you invest £ 100 in shares, to the income you would receive if you invested the same amount in UK government stock ( gilts). Shares pay dividends, which tend to rise, and gilts pay an income which is fixed. All other things being equal, a rising income is preferable to a fixed one, which is why for almost the whole of the last fifty years, the across-the-board dividend yield on the stock market has been lower than the yield on gilts, and sometimes much lower. But for the last nine months up until a couple of weeks ago, it was the other way round, with shares paying more than gilts. This happened because in the economic paralysis which followed the banking crisis, investors preferred the security of gilt coupons to the uncertainty of dividends which could be cut or completely suspended.

Today, the yield ratio is 1.07, which means that gilts pay a bit more than shares. I believe that in today’s market, the ‘right’ level for this ratio is around 1.30.


The QE programme began in early March, and was designed to support the gilt market through a huge purchasing programme. Why would the Government want to print money in order to buy its own debt? Consider what might have happened if it didn’t. The Government is expected to have to issue around £   220bn of new gilts this year, to pay for the bank support programme, and finance the other costs associated with the recession, lower tax receipts, higher unemployment benefits, etc. There is a risk that its much higher debt level might seriously impair the government’s credit rating. The more of a credit risk a borrower is, the higher the interest rate a lender will charge. Should this situation develop, you would see failed gilt auctions, where the Debt Management Office, who issue gilts, would be left with unsold stock on their hands. The prices of gilts would fall in the market, causing the yields to rise, and new gilt issuance would have to be at higher interest rates in order to attract buyers, costing the Government yet more money in interest payments, and forcing them to borrow still more money to cover the interest payments on existing debt. A serious loss of confidence would almost certainly lead to a further fall in sterling. The situation could run out of control.

One side-effect of the above scenario would be to undermine the valuation of the stock market. Higher gilt yields make shares correspondingly more expensive. A sell-off in the stock market would follow almost inevitably, and we would reach the ‘equilibrium’ yield ratio of 1.3 by gilt yields rising, as a consequence of gilt prices going down, rather than by share yields falling, as a result of share prices going up.

Since the QE programme started in early March, the long gilt index has fallen by 8.8%, which means that prices have fallen by around 10%, ignoring the interest paid. Does this mean that QEhas failed? No-without it things could have been a lot worse. Without the commitment to stability implied in QE, the stock market rally might not have happened. And there has been a fair amount of switching from expensive gilts to cheap shares. Today, the Treasury 5% ’25 gilt pays 4.4%, which is attractive compared to a cash yield of 0.5%. Gilts have fallen, but prices have stabilised at what look like fairly comfortable levels.

Banks are now profitable again, and it looks as if they will soon begin to repay the Government loans. Unemployment is still rising, but doesn’t look like reaching the 3.5m level forecast a few months ago.

So, a collapse in confidence in UK Government finances is possible, but not inevitable, and is something we will be watching closely, because of its potential effect on the stock market.

On the positive side, we suspect that investors have under-estimated the potential for dividends to be increased from their current levels. Companies have cut dividends because their profits have collapsed, and because they have been anxious to preserve their cash-flows in an environment where the banks aren’t lending. Next year both these factors are likely to be much less significant. Rising dividends make shares cheaper relative to gilts, and would tend to prolong the stock market rally.


If you accept the hypothesis that the ‘fair value’ yield ratio is 1.3, and if the yields on both UK gilts and UK shares remain at today’s levels, then the UK stock market would have to rise to 5600, slightly below where it was before the Lehman’s bankruptcy last September. That is our ‘base case’. When might it get there? At a wild guess, sometime in the first quarter of next year.


The March-May rally concentrated on shares that investors had completely given up on-property, house builders, retailers, and smaller companies.

This one, which began on July 9th, has reverted to the ‘decoupling’ theme of 2007-8, the idea that the economies of China and others could carry on growing regardless of the problems of the indebted West. The formula is a simple one- in a low-growth world, growth is at a premium.  Growth=China=Commodities=Mining Companies. In China, the authorities have headed off recession through an aggressive infrastructure-building programme and by forcing the banks to lend - it seems that in China, unlike the UK, when the government tells banks to lend, they actually do. Result - the Chinese economy is now growing again.

But much of the lent money seems to have found its way into the property and stock markets, where it has re-ignited the bubble which burst a year ago. Since July 13th, China (MSCI China Capital Return)  is up 17.6% and India (Mumbai SE 100) up 17.1%, compared to the UK’s UK stock market, up 9.7% And in turn, UK stock market would have risen a good bit less had it not been for the dozen or so miners in the index, which are up by around 28% on average.

Now, there is no question that economic growth in most of Asia and Latin America is much faster than in the US and Europe, and it helps to be resource-rich like Brazil, and have lower debt levels, like many Asian countries. But the valuations are worrying. There was a brief opportunity to invest in the Far East and the mining sector at reasonable valuations earlier this year, which my funds missed, but now my strong instinct is to continue steering clear. As often happens when a particular theme dominates, others get left behind, and so it is that TB Wise Investment and TB Wise Income, though both have made progress in July, have lagged behind both the stock market and the peer group, especially TB Wise Investment-as discussed below. But there it is-we ignore our instincts at our peril. The funds are full of good assets at attractive prices, and it doesn’t feel comfortable joining the commodities merry-go-round just now. Interestingly, over the last two weeks, the prices of most ‘hard’ commodities (nickel, copper aluminium, etc) have risen strongly, while the Baltic Dry Index, which measures the cost of shipping these commodities round the world, has fallen 5%. From this it would appear that the rise in the prices of these commodities has been caused by speculative rather than physical demand.

The latest rally, then, has been a rather narrow one so far. From here, one of two things will happen. The rally will either broaden out, in which case the funds will do very nicely, or it will continue to concentrate in the same sectors, get ahead of itself, and there will be a correction. In the event of a correction, again one of two things may happen. Either investors will begin switching into the more rationally valued assets, in which case the funds would do nicely, or there might be a general sell-off, which is an eventuality for which I believe we are prepared. The most unpleasant outcome, and the hardest one to defend against, is the one where the overvalued asset ( miners/emerging markets) carries on roaring ahead, while investors sell the undervalued asset so as to gain more exposure to the ‘happening’ asset class-a re-run of the 1999 tech-bubble, in other words. Here the alternatives are either to invest in things you know are capable of losing you a lot of money, or watch your funds creep along in the wake of their peers, which is the more likely outcome.  The only consolation, if we are indeed in a 1999 re-run, is that a period of very strong performance for the funds follows the bursting of the bubble. But this is all speculation. For the moment, both funds are making reasonable progress.



Since my last blog (July 7th) TB Wise Investment is up 4.2%. During this period, the Active Managed Sector average is up 5.7%, and the UK stock market index is up 10.2%. Year to date, TB Wise Investment is up 16.7%, while the sector average is up 7.9% and UK stock market is up 6.8%.

In this rally the UK Smaller Companies sector (14% of TB Wise Investment) has risen very little, but has started moving in the last few days. There is a huge amount of value, especially among the very smallest UK companies listed on the Alternative Investment Market (the AIM) The AIM market overall would have to rise by around 90% to recover its early June 2008 level, and while there are companies on the AIM which are un-investable, there are some excellent ones too. Patience is likely to be rewarded in the end, in my view.

One of TB Wise’s biggest holdings, Ecofin Power & Water Opportunities Trust, has been raising cash in what looks like a rather clumsy way. They have issued a preference share, costing £ 1.00, and available only to existing investors. Each pref. can be cashed in on November 30th for an amount equivalent to the net asset value per share plus 1%, which would currently be around £ 1.68. This is free money, and TB Wise has bought £ 200,000 worth. However, so have other shareholders, many of whom have as a result been selling their ordinary shares, which has meant that the shares (7.5% of TB Wise ) have gone down slightly over the month, completely missing out on the rally.

Overall, few changes have been made in the past month. We have been increasing weightings in Europe, which looks very cheap, mainly through Jupiter European Opportunities Investment trust, managed by Alex Darwall, the long-term head of Europe at Jupiter.

Alex has an angle on China, by investing in the French luxury brands which Chinese consumers like. Valued on European multiples, rather than Chinese ones, and accessed through an investment trust on a 14.8% discount, this feels like a more elegant, and perhaps less risky approach than a full-frontal investment in the Chinese stock market.

I have for several years held all my pension money in TB Wise. In the last month, Judith and I have moved our ISA money into the fund as well.


TB Wise Income has done better this month than its older and larger sibling, up 5.6%, compared to the Active Managed Sector average (up 5.7%) and the UK stock market, up 10.2%. For the year to date, Wise Income is up 7.9%. Income appears to be coming into its own finally. Some of the individual holdings, such as Aviva, Land Securities, Legal & General & BT, deeply mistrusted by investors and as a result extremely cheap, have seemed to me to be that holy grail of value investors, shares into which the worst possible outcome has been priced. Since July 9th, these four shares have risen by 20.5%, 27.6%, 26.7% and 26.1% respectively. However, they are not in the portfolio for ever. Each share has a target price, and once the price has been achieved, they will be held until the upwards price momentum abates, and then sold, unless there is a good reason to revise the target.

While the mining sector rises higher, utility shares are being sold off, on the back of a review by OFWAT saying that the water companies must lower their prices. Once this sell-off has played out, there will be very good value in utilities, and attractive dividends, too. Utilities are also relatively recession-proof.


The better performance of the last few months makes us even more aware of the task that lies ahead of us to restore the funds to their pre-credit crunch levels, to say nothing of making progress beyond that. Our aim is to achieve these levels in as short a time as is practical, and with the minimum risk to capital in the process.

We are extremely grateful to all investors in our funds for the patience, restraint and good humour that you have shown in the investment conditions of the last two years, which are generally agreed to be the worst in living memory.

Please don’t hesitate to contact me or your usual adviser, if you’d like to discuss any point arising from this update.

Tony Yarrow

This blog contains the personal views of Tony Yarrow as at 3rd August, and does not constitute financial advice.

Tony manages TB Wise Investment and TB Wise Income.

The source of all the market data in this Blog is Lipper.