A Warning on Stock Investment

We all rely heavily on the stock market with a significant chunk of our wealth reliant on it, particularly through our pension.

Pension Scheme Dangers

What typically happens is we go through our working lives making monthly contributions into our pension (defined contribution plan) in the crazy and naive hope that miraculously the market will keep on rising and we can enjoy annual average investment yields of 8 or 9%. Welcome to the real world everyone, in reality this doesn’t happen! What does happen is we have periods when markets will lose you money and long periods when you will make money. How these patterns are determined is whether you buy-in when the markets are under or over-valued.

Beware- Overvalued Stock Markets

At the moment, based on a number of indicators markets are most definately over-valued! So what does that mean for our annual average returns over the coming 10 or 20 years…well they are unlikely to be very good and will result in a disappointing retirement pot. This knowledge has come from a fascinating book I have just been reading called “Unexpected Returns” by Ed Easterling.

http://www.crestmontresearch.com/stock-matrix-options/

Please follow this link to an amazing chart which shows a matrix of annual stock market returns since 1900 over whatever holding period you choose. Please study the matrix, it reveals some fascinating insights. In particular, if you invest into overvalued markets (ie. when price to earnings ratios are above 20), it shows how long you will have to hold your stocks for before you will a achieve a decent positive return. For example, if you invested in the early 1930′s you would need to have held that investment for 20 years to see a positive average return, scary! We now appear to be in an environment when price to earning ratios are very high, it may well take at least ten years to enjoy a decent return.

Now, all of this is not to say that stock market investing is a bad idea, it is just important to buy-in when markets are undervalued, therefore giving yourself a high chance of achieving a decent return over a 10 or 20 year period. At the moment some European markets look cheap, especially Italy, Spain and Germany where worries about the Eurozone may have been over done. In fact, I was reading that at the moment these markets have not been this cheap compared to US equities since the 1970′s! Other markets worth investigating would be my old favourite Japan, but avoid the US!

Asset Allocation for 2013

The investment environment is incredibly difficult to negotiate at the present time.

  • Will all of this money printing result in inflation or deflation?
  • As economies round the world struggle will economies depreciate their currencies to boost exports. Is it a race to the bottom?
  • What is the outlook for stocks. Have we seen major highs for the year or will Bernanke QE3 ( QE infinity) still boost asset prices.
  • What of property? Will the interest rates ever start rising stopping the housing market in its tracks?
  • Will prime London house prices stop increasing? What is driving this seemingly bizarre phenomena going against the grain of the rest of the UK property market?
  • What of precious metals? Will gold hit new highs at some in the next 12 months, consolidate or start to decline?
  • Will China have a hard landing? What will be the impact on commodity prices, exchange rates?

As you can see there is an endless stream of questions which no-one knows the answer too. In this sort of environment it makes sense to hold a reasonably diversified portfolio across asset classes: cash, commodities/ precious metals, stocks and property. A 25% allocation, as suggested by the great Marc Faber, seems reasonable.

One asset class to avoid however is bonds, in particular government bonds. There has been a 20 year bull market in bonds which must be nearing the end. Bond prices have been bid up to crazy levels. It seems crazy that companies are happy to lock up their funds for 4 years investing in government bonds of countries like Germany, Switzerland and the UK for a return less than inflation. It just does not seem logical.

There is a rule of thumb which applies to bonds, that if you hold a bond with a ten year term, a 1% increase in the yield of a bond will result in the bond price reducing by 10%. Just be very careful because you don’t want to be on the wrong side of the market when the sovereign bond market eventually blows up. Check your defined contribution pension schemes as a significant majority of you will be holding some funds in government bonds in your pension funds which you need to exit.

In terms of stocks, look for value. Japanese stocks look cheap at the moment and have done for a while, but the market will turn one day and Japanese stocks will provide you with a great return. Hold some dividend payers, the usual names in the FTSE 100 are BP, British American Tobacco, Shell, Scottish and Southern and within the FTSE 250 there are some great non-life insurers that have been battered down along with the banks but provide awesome dividend yields.

Have a look at some of the gold mining majors. As in the 1970′s when inflation took off, the gold miners went up like they were on steroids. Gold miners are currently cheap versus the price of gold ie. they have not followed the gold price up as strongly. They are slowly catching up but at the moment are still available for reasonable value.

Hold a bit of cash. We do not know whether we will face armageddon in the next year but we know there is a significant chance that stock prices will fall. If this occurs, by holding cash it enables us to pick up any bargains which may arise. Make sure all of this cash is not held in sterling though. It’s easy enough to open Dollar, Swiss Franc, Norwegian Krone accounts for a small monthly fee, right here in the UK.

Sorry, it has been a while since I last posted. I have so much to get down on paper but this serves as a quick introduction to the many questions and thoughts swirling round my mind at the present time.

As ever good luck with building your investment portfolio. Happy investing and good luck on your path to financial independence!

 

We are living in extraordinary times

I think it is very important that we remind ourselves from time to time that we are living in extraordinary times. Never before has the Bank of England base rate been as low as it is today. And this exceptionally loose monetary policy is being used in many Western countries.

As you can see from the chart above showing the bank base rate going back to 1694, the previous low was 2%, yet we are currently at 0.5%. This is unprecedented and shows the desperation of the Bank of England to stimulate the economy in what can only be described as a severe financial mess.

The chart clearly shows that the natural level of base rates is around the 5% mark. Normally the base rate is greater than the rate of inflation to encourage prudence and saving but at the moment it is definately not. Historically bank base rates have been around 3.5% above inflation and therefore we can conclude that interest rates, assuming CPI inflation of around 4.5%, should be around the 8% mark!! This would therefore mean that mortgage rates should be 10%, think of the carnage that would be caused if this was the case!

When the Bank of England eventually starts raising the base rate, and they will have to one day, that’s when we will finally see the correction in UK house prices which has been long talked about. And when this correction occurs, that is when some astute investors will pick up some absolute bargains in UK property which will set up them brilliantly for a life of financial independence. I hope I am bold enough to take advantage!

As an aside the gross yield, rent received over price paid for the property, back in the mid 90′s when the property market last bottomed was 9-9.5%. This was in an inflation environment of 1.5% though so the real yield was around the 7.5-8% mark. These days the gross yield is 7.5% but this is on a background of inflation around the 4.5% mark so a real yield of 3%. When real yields get back up to 7.5% mark that will be a reasonable guide to the housing market bottoming out.

Why Government Cuts Are Necessary

All around us there is a lot of opposition to the government cuts which the UK government and other Western Economies are currently pushing through. These cuts are very important to maintain economic strength though and we have to endure some significant short term pain for long term gain. Let me explain.

Focus on the UK Government

The UK government is currently running a massive annual budget deficit, indeed at the end of 2009 the public borrowing requirement was 11.5% of GDP. This means the government is spending vastly more than it receives in tax revenues each year. In addition the UK already has government debt which is forecast to be 94% of GDP by the end of 2011. Each year the UK is adding to its debt pile and as the debt pile gets larger and larger it becomes more and more difficult to service. If the UK continues as it is doing there will become a time when its borrowing won’t even cover the interest payments on its debt. Then, of course, the UK economy is in a world of trouble, and economic armageddon is on the horizon.

If at the end of 2011, as forecasts suggest, the UK government debt stands at 94% of GDP this will clearly not be sustainable. Even more concerning is that the proposed cuts in government spending will only shave 1.3% off the annual budget deficit each year from 2011 and 2015. This means our debt to GDP ratio will keep going up and up. In a decade’s time, forecasts from the Bank of International Settlements suggest our debt to GDP ratio could between 150 and 200%!

What does this mean?

Sooner or later the bond buyers of the world will wake up and realise that it is not a wise investment lending money to a government which is so indebted for such a poor yield. When this event comes, it will mean only one thing, the UK will be forced to raise interest rates so that it can offer a better return on its bonds to incentivise investors to fund its debts. Of course, raising interest rates will be mean that the economy will grind to a halt again as it will hit all the UK homeowners on variable rate mortgages. This, of course, could result in a further bout of quantitative easing which would be very much inflationary.

What can countries do when they have too much debt?

Well they have 3 choices, which are all pretty bad.

1. They can inflate it away
2. They can default on their debt obligations
3. They can devalue their currency- making their debts worth less in foreign currencies.

At the moment the UK appears to be using a combination of 1 and 3. UK CPI inflation is more than double the Bank of England’s 2% target, it currently stands at 4.5%. The pound is far weaker than it was only a few years ago. Back in 2007 a pound bought you $2.10, that figure now stands at $1.65. Likewise in 2007 a pound bought you 2.49 Swiss Francs, today it only buys you 1.5. Oh well, at least all this might mean a boost to the Cornwall tourist industry!

What does this all mean for UK investors?

Prepare for inflation. Invest in real assets- commodities, precious metals and real estate. It might be sensible to diversify the currency of your asset holdings too. As I have said before, look for strong currencies with well run governments. The Swiss Franc and Norwegian Krone look good bets to me.