Climbing A Wall Of Worry
This month’s thoughts are dedicated to the world’s worriers, an elite club of which I am a long-term member. Recently, the economic and investment news have been surprisingly good. The fact that there appears to be less to worry about than before is in itself a cause for worry.
The worriers’ case goes like this - the recovery has been brought about by a huge, unprecedented stimulus. Money has been created on a previously unheard-of scale. Once this stimulus has worked its way through the system, all the old problems will remain - private individuals massively indebted, banks carrying huge and increasing levels of bad debt, overvalued houses - together with some new ones - highly indebted governments and much higher unemployment. That’s when the final leg of the downturn will begin, with a sharp economic downturn and big falls in asset prices.
There is plenty of support for this view. A piece of research in front of me compares the combined level of fiscal (tax) and monetary stimulus applied to the US economy in each of the thirteen recessions since 1929. Surprisingly, the data shows that the current recession so far has been one of the smaller ones. The 1.8% fall in real (inflation-adjusted) GDP so far compares to falls of 2.6% (‘81-2), 3.1% (’73-5), 3.2% (’57-8), 2.7% (‘53’4) and a whopping 27.0% (’29-’33).
It appears that the US authorities have become increasingly intolerant of recessions. This is clear from the level of stimulus that has been progressively applied to the economy with each successive recession. It is well known that at the beginning of the Great Depression, the authorities tightened monetary policy, raising interest rates, which was precisely the wrong thing to do, and made certain that the depression would be deeper and longer than it would otherwise have been. During the Great Depression, the value of the combined tax-plus-money stimulus applied to the US economy was 30.7% of GDP (the country’s annual turnover).
Here are the numbers for succeeding recessions-
We know now, with the benefit of hindsight, that the US economy was over-stimulated in the aftermath of the tech-bust in 2000-1. The result was the bubble in asset prices which has been unwinding over the last couple of years. There must be at least a strong possibility that the extraordinary stimulus we have seen in the last year may turn out to have been excessive, and may lead to even more extreme bubbles in the future.
It isn’t hard to see why the financial markets have rallied so much in such a short time. One by one, unexpectedly, the world’s economies are emerging from recession, and everywhere there is a sense of normality returning. Companies that needed to repair their finances have done so, and those that didn’t need to are prospering. The stock market is still pretty cheap relative to history (UK stock market has just reached 5,000, a level it first attained in August 1997) and the authorities have more or less promised that cash yields will continue to be very low for another year or two at least, which means that the income yields on other assets such as corporate bonds, shares and property will continue to be attractive.
On the other hand, rises of 40% plus in a six-month period are most unusual. The questions for all worriers are… How much further can this rally continue? When will it end and how can we tell? Is it too late to buy now? Is it already time to sell?
For what it’s worth, and after much pondering, my view is - I have to keep reminding myself of this - that we are operating in an environment which contains some previously unknown features. Now more than ever, we must let the facts speak for themselves, rather than imposing our view of what ‘should’ happen. The reason why so many commentators missed the start of this rally was because they believed that such a thing couldn’t happen in the dire conditions at the beginning of this year. But from the beginning, this rally has shown every sign of being substantial, and continues to do so. It has shown no signs of waning at all. The up-legs have been steep, and the pullbacks have been short and shallow. The toe of this particular elephant was revealed in March and April, and it was massive. Now we have seen the whole leg, and part of the body, which have been in proportion to the toe.
In late July and August, you may have read in the press about how the rally had no solid basis. Once the influential money managers returned from their summer breaks in early September, we were told, the market would soon return to more sober levels. This view struck me at the time as delightfully naïve. In the 1860’s perhaps, one can imagine these demi-gods, with huge handlebar moustaches and blue hooped bathing costumes, strutting from the bathing machine to the sea and back, before returning to Paris to clean up in the markets. In the twenty-first century, even the smallest fund manager, such as myself, carries a smart phone and can access the world’s markets, and e-mails, just about anywhere, and does. The big-hitters know exactly what’s happening at all times, didn’t sell shares in August, and still haven’t.
Conclusion - don’t be surprised if the stock market rally goes on further than you expect. Remember - the money you make in a rally that ‘shouldn’t’ be happening is every bit as spendable as if the rally was ‘justified by the fundamentals’.
Valuations are a worry, but valuations can change quickly. We value companies on multiples of their earnings. Moving out of a deep recession, earnings can rise quickly, and valuations will drop unless the share prices keep pace with the earnings upgrades.
During this rally, the dividend yield ratio and directors’ share dealings have been clear indicators of the value in the market. (For an explanation, please refer to last month’s blog). Both are supportive still, though a little less so than last month. The yield ratio is 1.18, much higher than the 0.73 seen at the bottom in early March, but below the 1.25-1.75 long-term ‘normal’ range. If dividends yields start to rise, the yield ratio will drop back unless share prices rise further. It would be unusual for a major rally to end with yields below their long-term normal range, so this number is likely to continue rising.
More directors are buying shares in their companies than are selling, but the ratio has dropped back from the extreme levels (all buyers, no sellers) of the past year. These indicators are saying that the stock market is still good value, but not as ridiculously so as earlier on.
END OF THE SECOND PHASE
I’m guessing that we are near the top of the second phase of this rally, which could go on for another few weeks, maybe less. A rally in smaller companies is a sign of a maturing market, and a powerful one is evident in all markets - from which Wise Investment and Wise Income are both benefitting. Also, financial journalists, who have been negative on the market all year, have started turning positive, which is another sign of a maturing market.
In this rally, investors have concentrated on the theme of ‘recovery’. The shares of companies which can continue to be profitable regardless of the economic cycle are now at an extreme level of undervaluation, and it seems inevitable that their value must be realised in the next stage of the rally, if not before. As the current phase draws to a close, which looks near but not imminent, I plan to take profits on those assets which appear to have risen too far - about 20% of both Wise Investment and Wise Income, recycling the resulting cash in due course into the deeply undervalued assets which do still exist.
TB WISE INVESTMENT
Having outperformed the market in the first rally (March to May) and the subsequent pull-back (May to July) TB Wise has lagged the market in the second leg of the rally which began on July 9th. The price has risen 13.9%, compared to the UK stock market, up 20.2%. The IMA Active sector average is up 14.2% over this period. The reason is that four of the fund’s biggest holdings are unfashionable in this phase. HG Capital is cautious and is seen to be holding too much cash. Ecofin Power & Water Opportunites Trust invests in ‘boring’ utilities. Invesco Perpetual invests in large ‘defensive’ companies which would continue to be profitable, even if the recession resumes, but don’t fit the recovery theme. British Empire Securities invests in ‘deep value’ and has begun to raise cash in anticipation of the end of this phase of the rally. None of the above catches the fashionable theme, but there is quality there, and value, and we can wait patiently for the market to rotate - as it surely will. Other equally good funds like TR Property, up 32% during this phase of the rally, are being reduced on valuation grounds. A wonderful fund which I hope to return to in due course.
TB WISE INCOME
Wise Income has fared well in the second phase of the rally - up 19.2% since July 9th. As anticipated, investors have begun to appreciate the value of higher yields in an environment where cash and government stock pay almost nothing. It looks right to take profits in the near future on the most spectacular performers, and look for value elsewhere. Pleasingly, the stream of dividend cuts has dried up, at least for the moment.
Since the rally began on March 9th, both funds are up by around 47%, including reinvested dividends. UK stock market is up around 38%, and the IMA Active Managed Sector average up 30%
Your support of the Wise funds continues to be greatly appreciated by us. It is good to see some of the horrific losses of 2007-8 recouped, but we are not complacent, and remain cautious, but optimistic.
Before ending, let’s just return to the questions all worriers are asking.
How much further can this rally go? Quite a long way, but we are near the end of this phase of it.
When will it end and how can we tell? There is no certain way, but we find the ratios discussed above useful.
Is it too late to buy? Is it time to sell? Looks a good time to be selling cyclicals, and a good time to be buying quality.
If you have any comments or queries arising from this article, please contact me or your usual adviser.
I hope to see you at our Investment Seminar next month, or otherwise speak soon.
This blog contains the personal views of Tony Yarrow as at 15th September 2009, and does not constitute financial advice.
Tony manages TB Wise Investment and TB Wise Income.