"Volatility is your friend" by Tony Yarrow

Written by Admin, 18 November 2011

VOLATILITY IS YOUR FRIEND - Blog - 18th November 2011

Tony's Seminar Presentation, Brief summary - If you go down to the woods today (meeting the bears); Crisis in Europe; What is the right amount of debt?; Catches 25 & 26; Markets in October & early November; Volatility is your friend; How the Wise Investment & Wise Income funds have performed; The Great Mall of China stands empty, Bling Dynasty ending?- Glaxeau Lafite Index; Interesting change of direction.


If you were unable to come to the Wise seminar, we were sorry to miss you, & hope to see you at future events. In case you missed it, my presentation was called ‘The Seductive Charm of the Consensus’. I made the point that most investors are momentum investors, expecting current conditions to continue. Things that are going up will go on going up, while things that are going down will carry on going down. For long periods of time this approach works well, but at major turning points it is disastrous. At market tops, commentators argue that whatever market they’re talking about will inevitably rise much higher, and at major lows they tend to argue that markets have much further to fall. There have been many excellent examples of this tendency in recent years.

I argued that we should try to cultivate the habit of looking at the current financial crisis as an event, like the Second World War, with a beginning, a middle and an end. This is in contrast to the media, where the crisis is always reported as something with no time-scale apart from the immediate future, in which things are about to get much worse. We need to try and understand where we are in this process, how far we are through it, in order to get a better idea of what the threats might be, and the opportunities. Some commentators, the bears, argue that we are still in the early stages of this crisis, with a great deal of pain ahead. The next section of this blog will be devoted to some of their views, and to thoughts arising from them.


In stock market parlance, ‘bears’ are people who expect share prices to fall. Recently, we have been researching the views of some of the most highly regarded members of that community. We take the bears’ views very seriously, even though we don’t always entirely agree with them. Here, I will look at one such bearish outlooks, and make some comments.

The US analysts Pring produced a piece called Secular Bear Market Update at the end of August. Having studied 200 years’ worth of data, Pring conclude that the average secular bear market (secular=the big nasty ones, lasting a long time) goes on for 23 years, during which time there are typically four or five recessions. The period begins with ridiculously high valuations, which take a generation to unwind. Inevitably, the market overshoots towards excessive cheapness, and the period ends in a mood of deep pessimism.

We are already in a secular bear market, which has lasted in this country for twelve years, and arguably for fourteen, and in Japan for twenty-two years. Pring are by no means alone in arguing that the current bear market will continue for a good many years longer.

Pring look at the Schiller P/E ratio. The P/E of a company is the relationship between its market value and a year’s profits. If a company worth £ 10m makes £1m profit in a year, then the P/E is ten, and over the long term P/E ratios tend to come in around 10-14 times, and in recent years have usually been higher in the US than the UK. On the whole, and with many caveats, a low P/E ratio is a measure of cheapness, while a company on a high P/E ratio is often seen as expensive. The Schiller P/E is thought to be a more accurate measure than the standard P/E ratio, as it averages earnings over the whole business cycle, rather than just looking at a single year. According to Pring, the Schiller P/E is still miles too high - it was 22.5 at the top, is 20.2 now, and normally falls to 7.5 at a secular bear market low.

Another measure they quoted is Tobin’s Q, which measures the relationship between the market value of a company (what you’d pay to buy all its shares) and the replacement value of its physical assets. Tobin’s Q reads 1.03 in the US today, but, they say, it typically falls to 0.30 at market bottoms.

Pring’s research also shows an inverse relationship between commodity prices and stock markets - stock markets tend to fall, as in the last decade, when commodity prices are rising, and to rise, as in the 80s and 90s, when commodity prices are falling. As they expect commodity prices to continue rising, then it follows that share prices should continue falling.

Personally, I didn’t find this analysis wholly convincing. You have to work quite hard to massage the data to fit into neat twenty-three year bear market cycles. Pring’s scary graph overlays the current bear market above the ‘typical’ 23-year one, with a high degree of correlation. The typical market fall in a secular bear market is 65% adjusted for inflation over 23 years, but the current one was already down 62% in March 2009 after just nine years, implying that the market had by then fallen by as much as it does in 23 years in the ‘typical’ cycle.

People often refer to the extreme over-valuation of the stock market in early 2000. Having worked through that time, I remember some comically extreme over-valuation, but alongside it there was also some genuine value. For example, the hand-held computer company Psion, was valued on a P/E ratio of 1500 times in March 2000. This one company on its own gave the index an above-average P/E ratio of 15 times - before you begin to consider the P/E ratios of the other 99 companies in the index. On the other hand, the highly profitable house builder Crest Nicholson was on a P/E multiple of four-and-a-half at the time, reflecting the fact that they had nothing to do with the internet, and so were of no interest to investors. The extreme valuation of a couple of sectors distorted the whole market, which may not have been in the aggregate any more than normally over-valued. Within a couple of years, Psion’s P/E ratio had fallen a very long way - the rebalancing in this case took far less than 23 years.

Tobin’s Q can be misleading. The data goes back 200 years, but even much more recently than that, heavy industry had a dominant position in the quoted market- ships, steel, railways, textiles and heavy manufacturing. Today these companies have been replaced by capital-light service and software industries, with almost no physical assets. When you consider the changing mix of companies in the market, it’s no surprise that Tobin’s Q is higher than in days of old.

To sum up, the idea of a secular bear market which we’re in the middle of needs to be borne in mind, but the time to be most concerned about the vulnerability of share prices is when they’re obviously expensive, which isn’t the case for much of the market at present.

If, at Easter 1998, you’d predicted that almost fourteen years later, the UK stock market would be 14% lower than it was then, it would have been taken as excessively gloomy, but that’s what has happened. And yet, during this ‘lost decade’, investors have not lacked for opportunity. The fact that this period of consolidation has happened makes another such period over the coming decade less, rather than more likely, in my view. It’s worth bearing in mind that if the relationship between the yield on UK government stock (gilts) & UK shares was the same as it was in early 2000, the UK stock market would now be around 13,200.


I was hoping to get away without mentioning Europe in this blog - you have either read a huge amount about it already, or else you aren’t interested. However, as the situation rushes onwards towards its inevitable climax, some comment is probably appropriate.

There is now a crisis of confidence, which is a combination of the fast-growing scale of the problems, and of the authorities’ apparent lack of the commitment and ability to tackle them in an effective way.

What happens when investors sell Italian bonds? When sellers outnumber buyers, the price goes down, and because payments are fixed, the income yield goes up. This higher rate becomes the new ‘market rate’ for Italian debt. All bonds are issued for a fixed term, so as existing bonds mature, the Italian government has to issue new ones at the higher rate in order to persuade investors to buy them. This increases the Italian government’s cost of borrowing, and, as more and more bonds are re-financed at the higher rate, eventually pushes it into insolvency. The process would take quite a few years to happen, as maturing stock was gradually replaced with new issues at the higher rate, but in the meanwhile higher bond yields have the effect of increasing pressure on the Italian government. The other effect is that existing holders of the bonds, mainly continental European banks, have lost money because their bonds are worth less. This puts pressure on their capital adequacy and pushes them towards insolvency. There is a temptation for them to sell some bonds before the price drops further, and that sale raises the yield higher, putting more pressure on the Italian government, and causing further losses for other holders of the bonds - a classic vicious circle, in other words.

Recently, events have begun to move very fast. The summit a couple of weeks ago was meant to draw a line under the sovereign debt crisis, and restore calm to the markets. I’ve summarised the main proposals, and why they didn’t have the desired effect of calming the markets, in footnote 1 below. In the last week the Greek and Italian governments have fallen, to be replaced by governments of ‘technocrats’ who understand how the euro regime works and are prepared to apply the necessary austerity measures, rather than just talking about it - but the markets are not reassured at all, and the vicious circle has accelerated. In the last couple of days, the selling pressure has extended from the weaker countries - Greece, Portugal, Italy and Spain - to ones previously seen as safe, ‘core’ European countries, including Holland and Finland.

What Europe lacks is a lender of last resort, a central bank such as the Fed in the US, or the Bank of England in the UK, which has the depth of resource to support the market to the extent that it needs to be supported, and prevent the contagion from spreading further. Whether this support comes from the European Central Bank (the E.C.B.) or another institution, it can only work with the full support of the Euro’s strongest member, Germany, and up to this point that support has not been forthcoming. I believe that the markets will continue to trash European government bond prices until they either receive sufficient support, backed by Germany, or the euro collapses. I believe that the former outcome is the more likely one, as explained below, and I expect it to happen sooner rather than later.

Please imagine for a moment that you’re a German citizen. You believe in a united Europe. Your country has been in the forefront of the movement towards European integration. And you have been a huge beneficiary of the euro. Germany has the largest and strongest economy in Europe, and should Germany leave the euro, her exports would immediately become greatly less affordable because of the strength of the deutschemark. The euro has kept German exports competitive, as anyone who sits in a traffic jam in Beijing, surrounded by Audis, BMWs and Mercedes, will appreciate. As a German, you object to the idea of printing money to help the weaker nations for two very good reasons. First, you don’t see why you should have to pay for the mistakes of your southern European neighbours, which you didn’t commit yourself. Second, your grandparents had their savings wiped out in the hyperinflation of the early 1920s, which was caused by your government printing money to pay for the First World War, and then afterwards to keep the economy afloat under the pressure of war reparations payments. Inflation caused by the excessive printing of money is most Germans’ worst nightmare.

The alternative is to watch the euro fall apart, when everyone knows you could have saved it. Then, you are on your own with the strong deutschemark. Your export industries will cease to be competitive, and you will suffer a severe recession. All the foreign banks and governments who owe money to your banks will find themselves owing a lot more in the new deutschemarks than they did in the old euros. They will default, and you will suffer a string of bank insolvencies. Finally, you will once again be the most unpopular nation, not just in Europe, but on the planet.

This is the dilemma that Germany faces at the moment. No wonder Angela Merkel talks about greater political union, and giving the measures that have already been passed enough time to work. But there isn’t enough time left. The US and Chinese governments are screaming at the European policy-makers to put an end to the chaos. The markets smell blood, and will force the issue through to a conclusion. It probably won’t take long.

When this happens, the markets will be able to turn their attention to other matters, such as the improvement in the US economy, and will move significantly higher. In the meanwhile, it could be pretty grim.

Further out, the question of the euro’s viability remains. My personal guess is that it isn’t viable in its current form. Currency union among the northern core group of hard-currency countries has worked for the last two decades, and will probably continue to do so. Nothing short of a miracle could keep Greece in the euro in the longer term. Where do you draw the line? Can Portugal, Spain and Ireland stay in? That depends on the political will and the actions of many millions of people over the next few years. Meanwhile, the crisis continues to dominate the headlines and the financial markets.


I ask this question, because a lot of commentators appear to be confused about it. There are really two different questions. When you ask ‘How much debt should you have if you want to get through life with the least amount of financial risk?’ then the answer must be ‘None’. If the question is ‘How much is the right amount of debt if you want to maximise your financial returns through your life?’, then the answer is ‘As much as possible at some times, and none at others.’ It’s good to borrow money when you are sure that you can comfortably service the interest under all possible circumstances, when you know you can repay the capital, and when the money you borrow is going to turn into a lot more money. It is good to borrow at times of high inflation, when the real value of your debt falls quickly at the same time as your income is rising, and the asset you’ve borrowed to buy is rising quickly in value. This was the case for anyone buying houses in the 1970s.

The problem with debt is, there are several variables, and they can all move against you together, for example when the interest rate you’re paying shoots up at the same time as the value of the asset you’re buying with the borrowed money collapses. The saying that ‘Debt is Danger’ is always true.

Attitudes to debt have changed in the last few years. In 2006, a fund manager described households in Eastern Europe to me as ‘under-geared’, meaning that they hadn’t borrowed enough money. This struck me as an odd idea then, and it seems even odder today, when people seem to think that the crisis won’t be over until the last penny of debt has been repaid. Attitudes to debt tend to be cyclical, like everything else. People eagerly borrow money at the top of the cycle, to buy assets which are about to fall in value. At the bottom, people shun debt at a time when it is at its least risky and potentially most profitable.

It’s never wrong not to borrow money.

Still, as investors, we look for opportunities. Today, companies which use debt are considered, quite rightly, as risky, and some will collapse under the weight of their debts, while many already have. It is worth looking out for good companies with low and manageable levels of debt, which are thrown by investors into the ‘indebted and risky’ basket with the hopeless cases, and valued accordingly.

CATCHES 25 & 26

If you read my last blog a couple of months ago, you may remember a couple of conundrums or ‘catches’ that seem to sum up the financial world we live in. Catch 23 states that when all investors want to invest in safe assets, those assets become so expensive that they stop being safe. Catch 24 states that nervous banks will only lend to low-risk borrowers - in other words, they’ll only consider lending to people who don’t need to borrow money. Here are a couple more. Catch 25 is about policy.

The crisis we are living through was caused by too much debt and not enough saving. The cure should therefore be more saving, and less borrowing. But policy has kept interest rates at record lows for the last three years, which encourages borrowers and discourages savers. In other words, Catch 25 says that the solution to the problem consists in encouraging the thing that caused the problem in the first place. This may be because there was, and still is so much debt, secured against such dubious assets, that had the situation remained unchecked, the number of simultaneous bankruptcies could have brought the whole financial system down. Interestingly, in Argentina in 2001, and in Iceland in 2008, collapse could not be prevented, and in both countries, after several years of intense economic pain, strong recoveries are taking place. What we are likely to see in the US and Europe is something more prolonged, with periodic crises. We are passing through one such crisis at the moment.

Catch 26, a favourite catch of Mr. Balls, the Shadow Chancellor, is that the measures governments take to reduce their budget deficits actually end up increasing them. So, you’re a government, and you’re spending far more money than is coming in. What can you do? You raise taxes, which increases your income, and you cut spending. Result, the deficit goes down. Or does it? You cut spending by making people redundant. They are then unemployed, and you have to pay them benefits. You raise taxes, which take out of people’s pockets the money that they would otherwise have spent, which would have gone round the economy, making profits which you could then have taxed. There is a point here, but it is illusory. There are better and worse ways of raising taxes. There are better and worse ways to cut spending (perhaps cut Trident, but keep the public libraries open?) It’s true that a certain level of austerity is counter-productive - it’s probably true that the level of austerity needed to bring Greece’s public debt down to manageable levels would cause an economic depression, social unrest, and end up being counter-productive. But Greece is an extreme case. There’s no doubt that the right response to ballooning public debt is the right amount of carefully-targeted tax rises and government spending cuts.


Markets continue to be affected by three main themes. The most urgent and high-profile one is the euro crisis. The second theme is the macro-economic numbers. Over the summer the world’s economies were all slowing down at the same time, and the US & the UK were at a standstill, which commentators predicted would develop into a double-dip recession. There is growing evidence that the US economy has turned the corner and is ‘accelerating into the fourth quarter’ as the FT notes today (Friday 18th November). China’s inflation has come down, and it appears that the monetary tightening phase may be over there. Worldwide, the economic growth numbers have improved in the last few weeks. Leading indicators are also looking more positive (more on this in Footnote 2). The third theme is the continuing strength of results among our investee companies. Agreed, company profits report on time passed, and they can deteriorate in an uncertain future. But the last year hasn’t been exactly rosy - economic growth numbers in the first half of this year were mildly positive, but had to be revised down afterwards. Also, the valuations of many companies already factor in a more pessimistic outcome. The first of our themes is a huge negative, the second and third are both positive, and may explain stock markets’ relative resilience over the past couple of months. Yesterday, (Thursday 18th) was a down-day, when investors concentrated on the first theme to the exclusion of the second. The FT commented ‘Wall Street looked increasingly nervous about the eurozone debt crisis as investors largely shrugged off further encouraging US economic data.’ On other days, though, the emphasis has been the other way round, with a more positive tone.


At nervous times, you get bargains. At very nervous times, you get screaming bargains. We’re pretty close to screaming bargain territory, if you ask me. But don’t ask me, ask Warren Buffett, the world’s most successful and best-loved investor, who has been investing his cash-pile in a big way over the last few months, and has recently taken a $10 billion stake in the computer giant IBM. Successful investors invest in quality assets, not in the prices of those assets. The good, long-term assets that we are interested in are more or less the same as they were four months ago, it’s only the prices that have changed with the views of the more short-term investors. The vast majority of Wise Investment’s clients understand this, and I am hugely grateful to you all for your patience, intelligence and good humour over the last few months. If we can stay the course, we will reap the rewards of the bargains that the market has been offering us.


It seems logical to measure performance from when the markets turned downwards in early July. Since that time, TB Wise Investment has fallen by around 5% more than the market, & Wise Income by around 2% more than the market, both funds giving back some of their outperformance of the previous two-and-a-half-years. This was disappointing, especially in view of the fact that I considered both funds to be cautiously positioned as we entered the sell-off phase. Many will remember that my funds underperformed in 2007-9 as well, which suggests that today’s market sees my investment style as high-risk, in the sense that when people want to reduce risk, they tend to sell things that the Wise funds own. This consideration is receiving serious thought, though it should also be said that weak performance in falling markets doesn’t always happen - both funds performed strongly during the Spring 2010 sell-off.


Many of our funds performed strongly in the first half of this year, and we took profits and raised cash, without which the fund would have performed even less well recently than it has. The cash was mostly invested towards the end of September, and all the purchases we made then are profitable to date, despite the recent market weakness. We raised around 6% cash earlier this week, which has again added value so far. Across the board, investment trust discounts have widened significantly, in other words the assets they hold have fallen in value by a lot less than the prices of the trusts that own the assets. A couple of weeks ago I worked out that the whole TB Wise Investment fund is at a discount of 14.3% to its net asset value, so if we could liquidate the Wise Investment fund and receive the market price for all its underlying assets, we would receive around 16.7% more than the current price of TB Wise Investment reflects. One might fairly ask whether it’s a good idea to own investment trusts in such uncertain times. The extra volatility through the discount movement is annoying to say the least, but as I see it, the trusts we own represent fantastic long-term value today.

One example is British Empire Securities, one of Wise Investment’s largest holdings. The fund has had the same fund manager, John Pennink for the last decade, with impressive results. It aims to buy undervalued assets, and does so mainly through investing in private wealth funds, mainly in Europe and Asia. One example is the Rothschilds’ private office, Paris St. Germain. The wealth funds mainly own blue-chip shares. Being a cautious fund manager, Pennink usually keeps 15-20% of the fund’s value in cash and government stock. Performance over the last decade has been excellent, with the trust’s net asset value per share up 166% during that time, and you might have thought that in the recent sell-off a more cautious fund would have held its value well. On the contrary, the fund has dropped 17% from its June high point, and is now staggeringly cheap. Its European assets are at an average discount of 38% to their net asset value, and the Asian assets at a 44% discount. The trust itself trades at a discount of 6.3%. We have added to this holding, and may add further if it falls from here.


Wise Income has received a fair amount of new money over the last few months, which has allowed us to top up holdings on weakness, and add to the dividend yield, which now stands at 6.4% net.

Wise Income’s largest holding at present is Standard Life Property Income. This fund has had a chequered history, going into 2007’s collapse with too much debt. Things have turned round since the appointment of Jason Baggaley as manager in June 2007. The current portfolio consists of 31 properties which are 95% let, compared to a national average of 91.4%. One of the voids was caused by a company going into administration, which is a hidden blessing as it allows for a value-enhancing change of use. The net asset value per share is 62.6p, compared to a share price of 54.25p, giving a discount cushion of around 13.5%. The dividend yield is 8.33%, which is fully covered by rental income. The fund looks very good value to me. Commercial property values are unlikely to rise over the next couple of years, but with a dividend yield above 8%, we are being paid to wait till they do. However, the share price was 70p in the summer, so disappointingly it has fallen by 22.5% over the last few months. The properties, the net asset value, the management, and the dividend payments haven’t changed, but now our cash buys a lot more dividend. We have been adding to this holding.

And there’s a little extra. The interest rate swap, an insurance taken out to protect the fund against rising interest rates, takes 5p from the net asset value. In two years’ time, the swap will expire worthless, adding 5p to the net asset value. At that point, unless anything else changes, the net asset value will be 67.6p, and the discount will be almost 20%.

How much further might it fall? We don’t know, but what we can say is that in five months the fund has gone from a somewhat optimistic premium valuation to a pessimistic one. There is obvious value at this level, but markets don’t always look at these things calmly.


Here’s a 30-second update on the Chinese economy. It has three main elements: industrial production and export, domestic consumption, and construction. Domestic consumption has been rising fast over the last few years but is still low at 35% of the total economy. Export is not growing so fast these days because of weak demand from the US and Europe. The gap is filled by construction, which is an astonishing 50% of economic activity, a number almost unprecedented anywhere in history. China needed a huge amount of infrastructure development, but the trend is very mature now. Michael Pettis, a noted expert on the Chinese economy, comments that ‘China long ago ran out of obvious investments that are economically viable’ - we are now onto roads, bridges and tower blocks that are likely to stand empty. China has a clear need to rebalance its economy towards domestic consumption, which is a central policy in the current five-year plan. But it’s easier said than done, because China’s policy through the last two decades has been to use low interest rates to provide industry with cheap finance, a policy whose flip-side is low returns to private investors, who need to save for their retirement, as there are virtually no state benefits. The risk to the Chinese economy is when the construction boom finally runs out of steam, and many of the loans which financed it go bad. Michael Pettis expects that China’s impressive double-digit growth will then slow to 3.0% per annum or less, which he expects within the next few years. We agree. We have been avoiding China as an investment for some time. When I wrote my blog on China at the beginning of last year ours was very much a minority view - now it is becoming more widely accepted.


The Glaxeau Lafite index tells you how many Glaxo shares you’d have to sell in order to buy a dozen-bottle case of Chateau Lafite 2000, a noted vintage. It’s been interesting over the last decade to watch the price of a speculative asset, the wine, soaring ahead of an investable asset such as Glaxo. Lafite is no ordinary wine, it is much loved among the wealthy Chinese, and it has been described as a favourite currency in which to bribe Chinese officials. However, in the last few months the GL index has changed direction. Not only is Glaxo going up, but Lafite has started going down. Exactly a year ago, cases of Lafite 2000 sold for £ 20,000. Today, the case is just £ 10,000, while Glaxo shares have risen to £ 13.87 from £ 12.57 a year ago. Thus the Glaxo Lafite index has fallen by over half from 1591 to 720 in the space of a year. The reason? One might say, sanity beginning to return. We hope for more of the same.

I hope you have found this blog interesting and useful, and as always, I would be interested in your comments and feedback.


Footnote 1

The resolutions at the most recent summit on the European crisis were:

1) Investors in Greek government debt would take a voluntary 50% ‘haircut’ - they would accept that the bonds were only worth half their face value, thus ensuring Greek solvency.

2) European banks to increase their capital ratios to 9% by June 2012.

3) The European Financial Stability Fund (EFSF) to be strengthened from 400 billion to a trillion euros.

The financier George Soros commented that this solution would last ‘from one day to three months’. In fact, it lasted about two days. The ‘haircut’ only applied to privately-owned Greek debt, around 40% of the total, making the haircut just 20%, which is well known to be inadequate. Also, banks are run for their shareholders and not for the general good, and their boards may veto such a voluntary agreement.

European banks appear to be meeting the increased capital requirement by lending even less than before, making the much-needed economic growth even less likely to happen.

In the event, it turned out that none of the countries who are signed up to the euro wanted to put any more money into the ESFS, which was recently reduced to buying its own bonds to support a new issue.

Footnote 2

The leading indicators I look at include directors’ dealings in the shares of their own companies, the relationship between government bond yields and corporate bond yields, and between government bond yields and share dividend yields, the VIX index, employment statistics and purchasing managers’ indices. Government bond yields in the UK and the US have been distorted by quantitative easing (QE), so ratios using them are less than usually reliable. The other indices show conditions either improving, or not getting any worse.