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Weekend reading: Current asset valuations

Weekend reading

My view on the current valuation of different asset classes, followed by this week’s money links.

Last week I mentioned I’ve been selling down equities since late March. I hope I was clear this was an asset allocation decision, not a call on valuation.

Over 90% of my net worth was in shares, after I went ‘all in’ with my last reserves in March 2009.

That was the buy of the century, but 13 months on I don’t want to push my luck, given that I may want to buy a house in the next five years.

I still remain more than 75% invested in shares. By most measures, this is too high. But I still see equities (including REITs) as reasonable value and most other assets as expensive.

Please remember I’m just a chap on the Internet. I’ve had a good run in the past 18 months, pointing out on Monevator the government bond bubble, the opportunity in corporate bonds, and in commercial property.

But a different economic outcome would have made all those articles look dumb. If was right all the time, I’d have retired!

I was buying shares in early 2008, for instance, and I’m finally going to lose my holding in Jarvis – an old position I kept just to remind me of my potential for crap decisions – because it’s now in administration.

This then is a personal view given in the knowledge that asset valuation isn’t art or science so much as witchcraft. It is definitely not advice.

UK blue chip shares

The FTSE 100 is currently yielding 3.3%, on a P/E of just over 16. The All Share is more expensive, on a P/E of 17.5.

As this article points out, in April 2008, the FTSE 100 was also around today’s level at 5,800. The P/E was near 11 then. This shows how much earnings were clobbered by the recession.

Still, earnings have been growing strongly for 12 months and I expect this to continue. Most companies I look at are leaner, have spare cash, and even the dodgy banks are returning to profitability.

On Schiller-style cyclical basis, you need to expect earnings to grow strongly to call shares cheap. Otherwise they look fairly valued, according to Richard Beddard’s assessment of long-term PE, which has them on a PE of 15.

Beware of banking on P/E ratios. It’s very easy to forget the ‘E’ (the earnings) side of the ratio, and think shares are too expensive for years. Eventually the P/E drops and the hapless investor piles in, just as earnings collapse!

When I sold shares recently, I focused on early stage winners, especially the big miners. They are also exposed to the dollar, which I also lightened my exposure to – by selling HSBC, Pearson, and some of my FTSE 100 passive funds.

I’m not really predicting a huge rally for the pound. I just thought most of its decline against the dollar was now priced into UK shares. (Predicting currency moves is infamously tough).

Overall, I think the long-term case for shares is strong, after two decades of under-performance.

UK small caps

I still like these a lot, and have added to holdings in the Aberforth Smaller Companies and the Rights and Issues investment trusts, as well as a smattering of individual small caps.

The manager of Aberforth argues that his fund is the cheapest it’s been in 15 years, based on P/E levels, dividends, the discount, and the valuation gap with large caps. Rights and Issues is more geared towards UK capital spending, but it is finally coming good. (Horrible spread, mind).

US equities

Pretty much fair value if you think earnings can keep bouncing back, otherwise looking pricey. (For the currency issues for UK investors, see ‘overseas shares’ below).

Personally, I think earnings will keep growing, but the chart below (pointed out by Investor Junkie) shows the risks. It plots the P/E according to the Schiller method of evaluating over a ten-year cycle (so-called PE 10):

(Click to enlarge)

You can plot an up-to-date chart for yourself at the Multipl website.

I reluctantly sold my holding in Polar Capital’s technology trust to fund this year’s ISA allowance – I think technology could boom for years from here, and US tech stocks still look cheap.

The long-term case for US equities is strong, after two decades of under-performance versus bonds.

Overseas shares (in general)

Most of the developed markets moving in tandem over the medium term, although over the longer-term the US has done better in recent decades and Japan has stiffed.

This makes investing overseas as much a currency play as an asset diversification issue. Small changes in P/E or growth will be dwarfed in the short-term by big currency swings.

With the pound looking cheap versus the Euro, the dollar, and the ever-mighty Yen, I have repatriated some overseas exposure in the past couple of months, although I retain about 50% of it for diversification purposes.

Two markets deserve special mention:

  • Japan – By all accounts this is still really cheap on a price-to-book level, even if it has a crazy high P/E rating. After a two-decade bear market, Japan will eventually start growing again, but when? I consider it a special case in my asset allocation.
  • Emerging markets – I have a small holding in Templeton’s emerging market trust that has done very well. I should hold more, but I’m wary of emerging market mania. My main exposure to emerging markets is through blue chips like Diageo, and specialist asset managers like the City of London group.

UK commercial property

After a strong bounce in summer 2009, it’s gone nowhere for six months. I sold my holding in the IUKP ETF and rolled the money into very safe looking Daejan, a specialist property company, but I’ve already begun buying Land Securities with my spare cash!

On a ten-year view, I think the blue chip UK commercial property REITs (Land Securities, British Land, and a couple of others) are a cracking opportunity.

The value of commercial property plunged, but rents held up well through the recession. The companies took huge paper hits and had to sell property and raise money via rights issues, but this was mainly to protect their banking covenants. Laws that forced them to issue profits as dividends are being re-examined.

Land Securities has a decent yield. If the share price followed annual NAV upgrades by say 8% a year over the next 10 years, I think I could easily triple money invested here on a total return basis.

Commercial property also provides some welcome inflation hedging in a week where the CPI rate hit 3.5%! Inflation erodes the REITs’ debts.

It’s true the big REITs are trading at a premium to asset value. But remember I think the UK recovery is on track. I therefore expect more NAV upgrades.

Cash

Right, I need to speed up as this post is getting massive!

Cash to me looks ‘expensive’, in terms of the return and the inflation rate. The best cash savings account pays 2.8%, versus CPI inflation of 3.5% and RPI inflation of well over 4%.

In other words, money held in cash is losing value. I may look at National Savings inflation-proofed certificates with my newly-liberated cash, but the return over inflation is puny and we can’t bank on the BoE missing its target every month.

Government bonds

I watch the ten-year gilt like an adolescent boy who has discovered girls, but after a good move in 2009 it is now stubbornly stuck at around 4%.

This is very frustrating – government bonds are a truly useful asset class for diversification purposes.

To me though, 4% is not good enough. I suspect government bonds could be at the end of a 20-year bull market (everything ends eventually!) and it’s hard to judge how much QE and bank hoarding is holding the rate down.

If there’s a decision I may come to regret it’s not holding some government bonds. They are indispensable in a crisis, but for now I prefer cash.

Corporate bonds

In my view, the great opportunity in corporate bonds is over. Sure you can hunt around and find slightly riskier issues with slightly higher yields over government bonds, but these don’t reflect the risks.

Spreads have narrowed back to near pre-crisis levels, and since I think government bonds are expensive, corporate bonds don’t fare any better. I’m not at all interested in junk / high-yield bonds.

Gold and other commodities

You tell me! Gold looks expensive, seeing as the world didn’t end. I wish I’d bought copper and oil and the like in the panic of late 2008, but that’s essentially punting – unlike equities you can’t hold for an income until they come good.

If gold halved in price I’d probably add some for diversification, but it’s finger in the air stuff.

Other bits and pieces

There remain several interesting quirks in the market, such as PIBs yielding far above cash, Lloyds preference shares on near-12% yields (after a couple of years without payment) and still fairly heavily discounted private equity investment trusts.

Some Venture Capital Trusts still look cheap, though the 10% tax-free yields of 2009 have largely been priced away.

I continue to take small positions in some of these, but I don’t really write about them on Monevator, since they don’t have much to do with sensible long-term investing. They’re more like ‘varmit’ hunting from a helicopter in Vegas!

Stock Tickle was going to be the home for them, but that’s becoming more of a market news nibbles site. Decisions, decisions!

Monevator this week

I wrote about the benefits of interest only mortgages, gave Goldman a break, quoted Clarkson on pensions, and ran Jacob’s final post on how to retire early.

This as ever for dropping by. (Tell your friends! 🙂 )

Pick of the blog posts

Interesting money articles from the big boys

  • World recovery: Curb your enthusiasm – The Economist
  • It’s a bumpy recovery for the UK, too – The Motley Fool
  • Jeremy Grantham believes it’s all a bubble (PDF) – Zero Hedge
  • 29-year bull market for US bonds over? – Fixed Income Investor
  • Lessons from Argentina (not new, but see re: Greece) – Bond Vigilantes
  • Did porn cause the financial crisis? – The Atlantic
  • Sell in May trend has gone away – FT
  • Why private equity ITs are trading at big discounts – FT
  • The latest victims of ‘safe’ not-bond ‘bonds’ – Independent
  • 10 safer high income sources [but why no ITs?!] – The Telegraph
  • SEC fiddled with porn while Wall Street burned – The Telegraph
  • The trouble with premium bonds – The Telegraph
  • [What about fees?] Standard Life absolute return fund – Independent

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{ 16 comments… add one and remember nothing here is personal advice }
  • 1 Financial Samurai April 24, 2010, 1:51 pm

    What is your investing portfolio and retirement portfolio up this year may I ask mate?
    .-= Financial Samurai on: 5 Money Habits I Learned That Will Never Make Me Rich =-.

  • 2 RetirementInvestingToday April 24, 2010, 2:24 pm

    Great post as usual. Some good thoughts in there.

    I’m now 52.7% equities (so a lot less bullish than yourself) and my tactical asset allocation strategy has me gradually reducing this allocation given current market conditions. I postulated whether we were beginning to again start blowing asset bubbles here http://retirementinvestingtoday.blogspot.com/2010/04/are-we-back-to-blowing-asset-bubbles.html as in fact I have struggled to find anything of value out there.

    Using the PE10 method of asset valuation I don’t see US equities (or for that matter UK or Australia equities) at fair value but beginning to become pricey. For example I currently see the S&P 500 over valued by about 32%. Of course it’s been a lot more over valued than that in the past.

    I agree with you on cash. I can’t get a real return on my cash wherever I look. That’s why I have nearly 20% of my total assets currently invested in Index Linked Savings Certificates. They’re working well for me at the moment. I agree the return is tiny but at least it’s a real return. Remember they’re tax free also.

    Gold. To me it seems over valued when compared to trend lines and historic averages. However in real (inflation) terms in 1980 it reached $1,896 and in £1,064 respectively. I’m continuing to work towards a 5% allocation and bought some more this week. How would you have bought copper and oil? I tried buying commodities other than gold in the past but was eaten alive by contango. I’ve therefore made the strategic decision to only buy physically allocated gold as my commodities play. I also buy the ASX 200 as a psuedo commodities play.

    FinancialSamurai asks how much your portfolio is up this year. I’d be interested to know also. To play fair I’ll share. For Q1 I was up 6% which compares to my benchmark portfolio of 5.2%. So I’m happy YTD.
    .-= RetirementInvestingToday on: Minimising investment portfolio ‘fees and taxes’ not ‘fees or taxes’ =-.

  • 3 The Investor April 24, 2010, 2:55 pm

    Hi Sam! See last week’s post. I’ve doubled my net worth in 13 months, mainly but not entirely from portfolio performance.

    This year up just 5% or so, so far. I don’t spreadsheet it to death because I believe you lose the big picture staring at the margins.

    Incredible times which I don’t shout about because the market gave most of the gains and risk much of the rest! Could have gone a different way for many years if confidence hadn’t returned to markets. 🙂

    That said I did some smart stuff to outperform, rolling my US MBS investment trust gains into commercial property, and selling gilts early.

    I don’t microtrack my performance and don’t distinguish between pre and post retirement funds (basically it’s all a freedom fund! 😉 )

    I’d have to track carefully if I began posting all my trades here… I’m too lazy to! 😉

  • 4 The Investor April 24, 2010, 3:03 pm

    Hi RIT. Great comments. Re commodities I’d either have bought ETCs or oil exploration companies. I held soco for ages (finally sold on recent spike) but sold my other minnows in late 2007, too soon.

    I’m alert to the costs in ETCs but did well enough with AIGA a few years ago when I wanted exposure to soft commodities. I don’t really like holding them though, and would probably look again for a listed trust or similar.

    A great benefit of something like RIT Capital Partners is it does all this currency and commodity exposure for you. But less fun, and tiny yield.

    Who knows of US is overvalued – I wouldn’t argue with you, it’s not cheap and is dependent on strong earnings for a good while.

    I think we’re at or near the start of a new secular bull, but anything can happen over 5 years.

  • 5 The Investor April 24, 2010, 3:08 pm

    P.S. I have almost written that pensions vs ISAs article I promised. But your own evaluation has been at least as rigorous, tbh.

  • 6 OldPro April 24, 2010, 8:35 pm

    Lots to digest there old chap, jolly Sunday reading. Can’t say I disagree with you all told except if you’re going to buy a house then buy and grin and bare it.

    Good article from Smithers to add to your roundup with your love hate of the banks. On the motley fool of all places:

    http://www.fool.com/investing/general/2010/04/21/supporters-of-capitalism-should-read-this.aspx

    Sorry don’t know how to do the fancy link thing!

  • 7 The Investor April 24, 2010, 9:51 pm

    Thanks OldPro, Smithers is usually a good read.

    Here’s another link I’ve just added to the roundup, a PDF letter from bearish bubble-watching fund manager Jeremy Grantham.

    RIT, if you’re tagging along you should definitely read this PDF, he’s pretty bearish like you. I can see the argument, but I can also see green shoots everywhere, albeit watered by cheap money I agree.

  • 8 RetirementInvestingToday April 24, 2010, 10:52 pm

    Hi TI

    Thanks for the link. I’ll have a read.

    Maybe I came across more bearish than I should have. I am struggling to find value but the market has proven over and over that it can reach very high levels of exuberance. For example I gave the example of the S&P500 being over valued by 32%. I say this because the CAPE is currently sitting at 21.7 against it’s long term average 16.4. That said in 1999 it reached a high of 44.2 and in 2007 it reached 27.3. So there is plenty of upside potential when looking at recent events before big market adjustments.

    My investment strategy is largely mechanical with a strategic allocation but then a tactical portion associated with equity valuations using the cyclically adjusted PE (CAPE). I set my nominal allocation at CAPE’s of 16.4. If it’s above this level I hold proportionally less equities and vice versa. (I hope that made sense.) It’s this strategy that is forcing me to be light equities and not any cleverness based on crystal ball gazing. I use it because backtesting the CAPE against the S&P 500 shows a correlation of 0.78. Additionally I’ve also shown a few charts on my blog over the past few months showing historical future performance relative to CAPE valuations. This correlation and these charts are good enough for me to take the tactical allocation risk but of course everyone should always do their own research and make their own decisions.

    I agree with you that the recovery is based on cheap money and QE. We seem to be fixing the proble with more of the same problem. Wasn’t Alan Greenspan given a hard time recently for holding rates to low for to long. We seem to be doing exactly the same thing again. I can’t help feeling that the next bust when it comes is going to be pretty impressive.
    .-= RetirementInvestingToday on: Minimising investment portfolio ‘fees and taxes’ not ‘fees or taxes’ =-.

  • 9 Lemondy April 24, 2010, 11:39 pm

    Japan has been good this year. IT discounts are stabilizing and narrowing in the Japan sectors; the market has risen faster than the FTSE, and the pound has crashed. My best performer for the year so far here.

    I’m also finding it difficult to resist the temptation to bank the “free” fx gains. Must… trade… less. Finding ITs on “interesting” discounts is sending me into some exotic sectors which I’d probably be better off avoiding. Fun to research though.

    “I’ve doubled my net worth in 13 months”

    That must feel pretty awesome 😉 Good work out there.

  • 10 The Investor April 25, 2010, 9:01 pm

    Thanks for the detail RIT. Just for the record, I don’t think the recovery is ‘fake’, as such. I think it’s juiced to the gills, but I believe boom and bust, fear and greed, and so forth is endemic in capitalism.

    We probably should have suffered for a few years and lost a few more companies / jobs / entitlement programes, etc, however painful that would be in the short term. But the banking crisis meant the authorities felt the risks were just untenable this time (/terrified) hence the unprecented global response (of which China’s stimulus shouldn’t be underestimated, either).

    The question for me isn’t whether the recovery will take (I think it will) but what the legacy of a lack of good cleanse will be, and the cost of the remedial actions we took.

    You don’t get something for nothing with capitalism.

  • 11 The Investor April 25, 2010, 9:07 pm

    @Lemondy – Thanks, but it wasn’t me, it was The Grand Rally in Everything. Albeit, with some perhaps foolhardy cojones. And some luck with when I switched certain asset classes etc.

    In other words, I haven’t cracked the code and I can’t step-and-repeat for 2010. The Monevator hedge fund will have to wait.

    The other problem is we feel loss more than gain, and these gains have only taken me back to where I peaked in 2007.

    Still, obviously not complaining!

    Re: Trusts, yes, I came a-cropper with a couple of dubious ITs early in the meltdown (over-leveraged illiquid overseas property trusts). I only put a few hundred pounds in each though on a ‘Claridges or Bust’ basis. 😉

  • 12 Money Funk April 26, 2010, 7:07 pm

    Most of this is greek to me, but I very much enjoyed learning something in your cash analysis and how you are losing with cash in savings. I don’t seem to include CPI and RPI (which I had to look up) when considering savings. But makes for a good point.

    Did like your “adolescent boy who has discovered girls” in regards to bonds. 🙂
    .-= Money Funk on: The New High-Tech $100 Bill Edition =-.

  • 13 The Investor April 26, 2010, 9:10 pm

    @MF – Nobody starts knowing anything, we all pick it up along the way. 🙂

    The basic issue with inflation is to remember that every year your money has to grow by at least the rate of inflation to keep its ‘purchasing power’ (i.e. The stuff you can buy with your money remains unchanged).

    So if you start the year with $10,000 and inflation is 3% a year, you need to end the year with $10,300 to have the same purchasing power.

    Also remember tax. I’m not sure what US tax rates are, but let’s say it was 50% (just to make the maths easier, I realize it’s much less!)

    In this case, to keep up with inflation on your $10,000, you’d need to get an interest rate of at least 6% in a taxed account. You make $600 before tax, but 50% of your interest income is taken away in tax, so you end up with $300 income, or $10,300 again.

    Tax and inflation are critical factors, especially when returns are low (as are fees, of course).

    Glad you liked my teenage boy analogy! 😉

  • 14 Faustus April 27, 2010, 5:40 pm

    Very interesting – thanks for sharing these portfolio thoughts.

    I like the look of index-linked certs for holding medium-term cash – since these track RPI am I right in thinking these will benefit from any rises in VAT and mortgage interest rates, both of which are likely?

    Commercial property is a bit stagnant – I hold PHP which is very defensive and has a good yield, but may also move into British Land & Land Securities.

    Interesting ideas on overseas markets investing in relation to sterling. Presumably this means it is i) better to invest in a market where the local currency is likely to appreciate, generating higher sterling returns, and ii) better to invest overseas at times when sterling is overvalued. In the former case Japanese and Euro stocks look problematic, with suggestions that the yen and euro will have to depreciate as part of a debt reduction measures. Certainly the Euro looks overvalued against sterling at the moment.

  • 15 The Investor April 28, 2010, 9:50 am

    @Faustus — Glad you found them interesting. Yes, I always think in terms of currency when investing overseas in the developed markets, as discussed in my article on, er, investing overseas!

    Newspapers often write stuff like “The pound is really strong against the dollar, so you don’t want to buy US investments in case their value falls further” whereas we contrarians should really be thinking “Here’s a chance to get more US assets for my money and perhaps a dividend stream in dollars that will go up if/when the pound falls again”.

    Re: Commercial property, I keep trying to second guess what I’m missing. The debt was an issue this time last year, but has largely been refinanced. If you’re worried about deflation, you would want to avoid it. But is anyone seriously worried about that any more? (Roger Bootle, I guess).

  • 16 Sammy Launius @Asset Recovery July 23, 2010, 10:14 am

    Very good market insight and excellent post. I have learned that good ideas are common, where as good implementation is hard and rare. Wish you good luck.

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