A question about the demo high-yield portfolio (HYP) I set up back in May 2011:

“I found the portfolio for income you did for your blog and have been following your website since but as far as I can tell you haven’t told us any trades since then.

I think it would be better if you told us what trades you are doing for this portfolio (and what is your overall trading strategy / aim).

Thanks and understood if you don’t want to disclose your strategy /  trades for privacy reasons.”

A simple query, with a simple answer: I haven’t done any trades in the portfolio.

All 20 of the shares I initially chose remain in place today.

This isn’t sheer laziness on my part (although my inner editor should have thought a bit harder about whether a demo portfolio that wasn’t traded would make for gripping blog fodder!)

Rather, the idea of this sort of HYP – into which I invested £5,000 of my own money to ‘keep it real’ as the kids used to say – is that you enjoy the dividend income, while leaving your shares to do the business.

If there is a trading strategy, it’s pretty straightforward…

Don’t trade!

Doing nothing is not nothing doing

People get hung up on seeking the best investments, beating the market, avoiding blow-ups, and maximizing their dividend income.

Never mind that every one of those aims – to “beat” and to be “best” – will prove impossible for most people.

It wasn’t always like this. In the old days, a wealthy gentleman or lady about town held a clutch of blue chip shares (and bonds) for income, and scarcely had any idea there was a market that they could fail to beat.

There were no index trackers to make things even simpler, but equally there was no CNBC to tell them they had to get out of Monkey Brain Holdings by teatime or they were toast. They might have reviewed their holdings with their accountant or banker if they should come into more money – or perhaps at family milestone, such as a coming of age or a death – but that was about it.

Obviously things could and sometimes did go wrong. But often enough, over the long-term, it seems to have gone right, too. And I think the approach still has some merit today, especially for those who distrust the paradoxes inherent in index tracking.1

I obviously didn’t notice this alone. Motley Fool UK writer Stephen Bland, for example, is just one of several writers to make a similar point. He’s done it best in his pieces about a fictional dowager called Doris, who enjoyed her dividend income oblivious to the huge wodge of shares that provided it.

Bland optimistically calls such HYPs ‘eternity’ portfolios.

Perhaps he eats a lot of vitamins. I wouldn’t dare expect my portfolio or its owner to live forever without a trade. But I wouldn’t wait up.

Practical reasons not to trade shares

Besides striking a blow for old-fashioned rentierism, there are other reasons why I don’t have a trading strategy for my demo HYP:

• Research suggests the more you trade, the worse your returns. By reducing my opportunities to make boneheaded decisions, I’ll hopefully increase the chances of success.

• I’ve also no plans to trade because the demo portfolio can’t afford it. I set it up with £2-a-pop dealing fees in a Halifax Sharebuilder account. However it costs £11.95 to sell a share. That’s a huge amount compared to the £250 invested in each company, making dealing very expensive.2 (Any comparison between the cheap price of entry to Sharebuilder and the tactics of your local drug dealer would probably be libelous, so I’ll say nothing more.)

• I also have no trading strategy because I’ll make it up on the hoof. In my view, once you’ve decided to go to the dark side and buy individual shares rather than passive funds, you must do it your way. I believe active investment is at best an art not a science (at worst it’s an illusion) so no firm rules.

Others take a different tack. Rules that work for some people include:

• Sell a shareholding if the dividend is cut.
• Sell half of a shareholding if its share price doubles.
• Reduce a holding if it becomes greater than 10% of the total.
• Reduce if its annual dividend stream is more than 10% of the total.

But not here.

Why I will end up trading in the portfolio

Ideally I won’t ever trade these shares. The total dividend payout will increase faster than inflation, and by 2020 we’ll be as shocked at how well things have turned out as any parent when their grumpy, smelly teenage boy turns up in his 20s with a nice new girlfriend and a haircut.

In reality, something will need to be done sooner or later.

A company will be taken over. I’ll need to reinvest the proceeds if it’s a cash offer, or possibly sell the shares if it’s a dividend-threatening merger. There will be rights issues, too, and maybe demergers. And while I’ve no rules, I may sell a shareholding if a company cuts its dividend or – more controversially – if I judge it’s likely to.

In addition, I will probably not ignore diversification, even if Doris does.

The danger with very long-term buy-and-hold is that one or more companies does particularly well. It then dwarfs the rest of the portfolio, which increases the risk. A related danger is that the dividend income stream from a particular company become a very large percentage of the total, leaving your income stream vulnerable to one bad blow.

When (not if) this skewing happens, it will be tempting to reduce the outsized holdings.

This is a tricky area. In long-standing buy-and-hold portfolios, it’s often a few big winners that deliver most of the returns. If you start trimming them too soon, you risk a mediocre outcome.

On the other hand, old portfolios that are never pruned can become fantastically lop-sided or top-heavy (as well as making their owners look like geniuses if you put too much weight into why they first picked a big winner in the first place).

The typical dabbler in shares asks if they should sell because a share has gone up 20%. In veteran buy-and-hold portfolios, you might find one that’s gone up 2,000%.

There are emotional factors to keep in mind, too, especially as this mini-portfolio is meant to be being run as if it was a significant-sized one – perhaps the bulk of somebody’s equity investments.

While it might be mathematically sensible to run your winners, in practice few people can handle having most of their money in 2-4 companies, with the rest of their holdings tagging along like gulls following a trawler.

Onwards and hopefully upwards

Remember that this demo HYP portfolio is meant to explore (for me as much as anyone else) the ups and downs of holding blue chip shares for income.

I’m not claiming to have a secret method for picking the best 20 shares you could want on any particular Thursday. And I am certainly not saying that buying and holding blue chips for income will beat the market.

I used real-money to keep it realistic, and because I’m curious as to how it will turn out. Do note though that while there are similarities – I like dividends, and I don’t trade most of my portfolio much – this demo HYP is not even close to a mirror of my own wider investments.

Finally, because somebody always asks, I should say again I’m not reinvesting the dividends – see my previous post on why I’m withdrawing the income.

Right, back to the metaphorical hammock!

1. I am not saying they are right to find index funds distasteful. I am saying I have met many people who do, and I have failed to convince them otherwise. [↩]
2. If I ever do trade I will possibly rebate most of the dealing fee with new money. This is meant to be a scaled-down model of a more practically-sized portfolio after all. We will see. [↩]

RIT is back with his latest roundup of movements in the key asset classes over the past three months. Remember that RIT also runs his own website, Retirement Investing Today, which is well worth visiting.

A belated Happy New Year to all Monevator readers! Our latest look at the ups and downs in the markets comes to you a few days later than usual. We decided to wait for the US Fiscal Cliff issue to be resolved before firing up our data-crunching supercomputers1, so we could present you with the most up-to-date information.

There have certainly been some large market moves in the recent period.

For example, the average price increase of the ten stock markets that we track is 6.6% quarter-on-quarter. In contrast US and China company earnings look to be flat, and they’re seemingly falling in the UK.

Indeed I personally find little evidence to justify these latest stock market moves. Is it just general bullishness on the promise of tomorrow?

Here are some data points to watch out for in our run through below.

• The S&P 500 rose 4% last week, after the US Government effectively deferred the Fiscal Cliff issue. This pretty much maintained status quo, but is the US just storing up problems for later? The Moodys rating agency says that additional steps to lower the ballooning budget deficit will be required. Standard and Poors goes one step further, stating the deal has done nothing to put the finances of the US on a more sustainable footing.

• The Chinese stock market has seen a big rally. Presumably the Fiscal Cliff decision gives investors more confidence that Americans can continue to buy Chinese goods at their present rate. Also, shares in listed Chinese property companies saw an increase on the back of belief that urbanisation initiatives will drive up demand for urban homes. A strong Chinese manufacturing survey may have helped, too.

• We seem to be in a Mexican standoff with UK house prices. Mortgage rates are low and going nowhere fast. The government’s ‘Funding for Lending’ scheme is likely to be influencing these rates, keeping house repayments affordable and so preventing any rush to sell by stretched home owners. In contrast, UK workers are seeing their earnings rise at below the rate of inflation. New buyers can’t afford the prices that sellers are demanding, and sellers don’t need to sell. It all adds up to low transaction volumes.

Please remember, I don’t know everything that’s going on in the markets (in fact I know very little) so if you know of any other macro effects that have occurred over the last quarter or are likely to affect the next quarter, please do share them with Monevator readers below.

Disclaimer: I must point out that what follows is not a recommendation to buy or sell anything, and is for educational purposes only. I am just an Average Joe and I am certainly not a Financial Planner.

Your first time with this data? Please refer back to the first article in this series for full details on what assets we track, and how and why.

International equities

Our first data drop is stock market information for ten key countries2.

The countries highlighted are the ten biggest by gross domestic product (GDP). They also represent the countries that a reader following a typical asset allocation strategy will probably allocate funds towards.

Here’s our snapshot of the state-of-play with each country:

The prices shown in the table are the FTSE Global Equity Index Series for each respective country.3 The prices in the table are all in US Dollars, which enables like-for-like comparisons across the different countries without having to worry about exchange rates between them.

The Price to Earnings Ratio (P/E Ratio) and Dividend Yield for each country is as published by the Financial Times and sourced from Thomson Reuters. Note that these values relate only to a sample of stocks, albeit covering at least 75% of each country’s market capitalisation.

Here’s a few interesting snippets:

• Best performer: Price wise, China is the best performer quarter-on-quarter, rising 19.2%.

• Worst performer: Canada takes this honour, with quarter-on-quarter prices only rising 0.5%.

A positive quarter for anyone invested in equities, then, with all the stock markets we track seeing nominal price rises.

• P/E rating: The advances in the Chinese market have pushed its P/E multiple sharply higher – it’s up 19.4% on the quarter. As both the stock market and the P/E rating have advanced by roughly the same level, we can deduce that Chinese company earnings have not grown at all. Italy meanwhile has seen its P/E fall 7.1% quarter-on-quarter, which could imply this market has got cheaper.

• Dividend yields: If you are saving for the long term, whether it be retirement or some other long term goal, dividends matter. Italy no longer boasts the largest dividend yield, with this honour now going to Russia at 4.1%. China saw its dividend yield fall 19.0% on the quarter, reflecting the rise in that market, which tells us there was pretty much no increase in the total dividend amount paid out compared to the last quarter.

Remember that – all other things being equal – falling prices increase dividend yields. Rising yields aren’t necessarily good news for existing holders, since they usually indicate prices have fallen, especially over the short-term. A higher yield might indicate a more attractive entry point for new money, however.

Longer term equity trends

To see how our ten countries are performing price wise over the longer term, we use what we call the Country Real Share Price Index.

We take the FTSE Global Equity Price for each country, adjust it for the devaluation of currency through inflation, and reset all of the respective indices to 100 at the start of 2008.

Here’s how the countries have performed over the five years since then, in inflation-adjusted terms:

The graph reveals that in real inflation-adjusted terms, not one of the countries tracked has seen prices reach new real highs since 2008. The US is now close though at 96.5. Italy is languishing at 37.5.

Spotlight on UK and US equities

I couldn’t talk about share prices without looking at the cyclically-adjusted P/E ratio (aka PE10 or CAPE). If you’re unfamiliar with these terms, you can read about the cyclically-adjusted P/E ratio elsewhere on Monevator.

Below I show charts that detail the CAPE4, the P/E, and the real, inflation-adjusted prices for the FTSE 1005 and the S&P 5006.

Some thoughts:

• Today the S&P 500’s P/E (working with some estimates) is at 16.8 and the CAPE is at 21.9. This compares to the CAPE long run average of 16.5 since 1881. This could suggest the S&P500 is overvalued by 33%, which is up on last quarter’s overvaluation estimate of 31%. (Alternatively, the market may turn out to be correctly anticipating a surge in earnings growth in the near future).

• The FTSE 100 P/E is 11.9 and the CAPE is 12.6. Averaging the CAPE since 1993 reveals a figure of 19.1. This could suggest the FTSE100 is undervalued by 34%. (Alternatively, the market may turn out to be correctly anticipating that UK earnings growth is set to stall in the near future).

I use the CAPE as a valuation metric for both of these markets and to make my investment decisions. Others are more cynical about the usefulness of the CAPE, however, so do your own research and make your mind up.

House prices

A house is probably the largest single purchase that most Monevator readers will ever make. It’s therefore worth looking at what is happening to prices.

For this roundup I calculate the average of the Nationwide and Halifax house price indices, as follows:

If you don’t already own a home, then the quarterly news continues to be good – prices are going nowhere. (They actually fell a whopping £30!) Annually prices are down 0.5%.

The next house price chart shows a longer-term view of this Nationwide-Halifax average. I adjust for the effects of inflation, to show a true historical perspective:

In real terms housing continues to fall, with prices now back to approximately October 2002 levels.

In my opinion these nominal and real falls are good news, as I believe the market is still overvalued.

I’m sure the majority of the British public don’t necessarily agree with me on this! But if this trend continues (or even better accelerates) we might one day see the market return to normality, with sensible transaction volumes and a free market that is not dependent on the government propping it up with the likes of its current Funding for Lending scheme.

Commodities

Few private investors trade commodities directly. However commodity prices will still affect you, and maybe your investments.

With that in mind, I’ve selected five commodities to regularly review. They were chosen based on them being the top five constituents of the ETF Securities All Commodities ETF, which aims to track the Dow Jones-UBS Commodity Index.7

Quarter-on-quarter we see natural gas up a large 24.7%. I’m not surprised at this, given how natural gas prices have previously lagged the other commodity price increases that we track. In fact you will see below that inflation-adjusted natural gas prices are essentially the same as in January 2000, whereas other commodities are up by a factor of 4.5.

My preferred commodity for investment purposes is gold, not because I’m a gold bug but because I don’t want to worry about contango or backwardation and I don’t own (and don’t want to pay someone to own) a tanker, silo, or large warehouse. Gold is down 1.0% year on year.

Real commodity price trends

Much as I did with equities, I have created a Real Commodity Price Index that we can track over the long term.

This graph looks at commodities priced in US dollars, is corrected for inflation so we can see real price changes, and resets the basket of five commodities to the start of 2000.

Gold continues to be the star performer, up 444%. As mentioned above the underperformer is natural gas. It is now at least above par, though, at 108.

Wrap up

So that concludes our latest roundup – a lot of data, which I hope gives you an insight into the market’s trials and tribulations over the previous quarter.

As always it would be great (and motivating) to receive your comments below.

Finally, as I always say on my own blog, please Do Your Own Research.

For more of RIT’s analysis of stock markets, house prices, interest rates, and much more, visit his website at Retirement Investing Today.

1. Note: Joke! [↩]
2. Country equity data was taken as of the first possible working day of each month except for January 2013, which was taken on 3 January 2013. [↩]
3. Published by the Financial Times and sourced from FTSE International Limited. [↩]
4. Latest prices for the two CAPEs presented are the 04 January 2013 market closes. [↩]
5. UK CAPE uses CPI with December 2012 and January 2013 estimated. [↩]
6. US CPI data for December 2012 and January 2013 is estimated. [↩]
7. The data itself comes from the International Monetary Fund. [↩]

Good reads from around the Web.

I first feared signs of a UK and US government bond bubble back in December 2008, writing:

With these crazy yields on government debt it’s getting too expensive to be a bear.

I believe the West can avoid deflation, and so I’m buying cheap equities, not expensive government debt.

At the time UK 10-year gilt yields had recently fallen below 3%, and short-term US treasury yields had briefly turned negative, which meant investors in them were effectively paying the government to hold their money.

I saw this pile into bonds as a sign of the extreme gloom and panic in the market, and worried that it would unwind with costly consequences. Equities looked much more attractive.

A good call? Not exactly.

As regularly readers will know, I have no problem admitting my own mistakes. But this was a case of half-right, but at least half wrong.

Equities have indeed done very well since December 2008. If you’d put your money into a UK FTSE 100 tracker and reinvested dividends at the time of my post, you’d now be more than 60% up.

I was right, too, that investors were clearly ultra-fearful (which was exactly why we had a great opportunity to profit from the stock market).

But there’s no denying I was wrong about those low bond yields being unsustainable. Money has kept piling into bonds of all shapes and durations for the past five years. The initial bond mania turned into a mass exodus from equities, driving yields ever lower.

As this graph from the Fixed Income Investor site shows, UK government bond yields approached 1.5% in late 2012.

It’s a small consolation that nobody reading this in the UK has never known such tiny long bond yields, and virtually nobody would have thought them even possible a decade ago.

Just another reminder of how hard it is to fathom the markets.

That was then, this is now

As we start 2013, there’s a lot of renewed chatter – and even fear – that this great bond bubble could finally be about to burst.

A sharp move up in yields last week in the wake of the US fiscal cliff resolution is being seen as a catalyst for this long-awaited unwinding.

There’s good reason to expect yields to rise, and hence bond prices fall. Ten-year gilt yields of less than 2 to 3% make little sense in an environment where inflation is running ahead of that. Unless we go into another big recession or even a depression – and hence see deflation – then sooner or later people will get fed up with the value of their bond holdings being eroded in real terms.

As a consequence, The New York Times is one of many outlets reporting that the bond craze could run its course this year:

“Mathematically, it’s next to impossible to get the kind of returns on bonds you’ve seen over the last few years,” said Kate Moore, the chief global equity strategist at Bank of America.

When the turn does ultimately come, it is likely to cause pain for at least some of the people who have been investing in bonds in recent years.

“You don’t want to be the last one out the door when the trends turn,” said Rebecca H. Patterson, the chief investment strategist at Bessemer Trust. “All good things come to an end and we want to make sure we’re in front of it.”

An article on a blog called Mutual Fund Observer puts these fears more colourfully:

We’ve been listening to REM’s It’s the End of the World (as we know it) and thinking about copyrighting some useful terms for the year ahead.

You know that Bondpocalypse and Bondmageddon are both getting programmed into the pundits’ vocabulary.

[We also suggest] Bondtastrophe and Bondaster.

It’s this kind of fear that has prompted Telegraph writer Ian Cowie to take what he says is the biggest bet of his life:

Contrary to the conventional wisdom that people should raise their exposure to supposedly low-risk bonds and reduce shareholdings as they get older, I did the opposite and sold all the bonds in my company pension to buy shares.

Now that’s an ultra-risky move, and not one that many advisers would recommend.

I don’t own any government bonds, but I’ve got 25-30 years ahead of me (touch wood!) before I’ll likely be required to live on my savings.

I could ride out another savage bear market. Could Mr Cowie?

How to deal with the bond bubble

That said, I do feel for you if you’re in your later years and you’re trying to decide what to do in the face of these extreme markets.

Anyone retiring since the mid-noughties has already had to decide whether to turn their pension pot into an incredibly low-yielding lifetime annuity.

Now the next round of retirees face the possibility of their retirement pots being cut down to size, if and when those low yields finally reverse.

However it’s important to remember a few things.

• Firstly, most long-term pension savers would have already benefited from the rise in bond prices over the past few years. You can’t really enjoy the proceeds of a bubble and then cry foul when it bursts.

• Secondly, even this kind of seemingly extreme bond bubble is not the same as an equity bubble. We have looked before on Monevator at the consequences of a crash (see the links below). While you wouldn’t exactly order one for yourself and a double helping for the lady, it’s very hard for a bond crash to be as catastrophic for an individual as an equity slump.

• Finally, most Monevator readers probably only have 5-40% in government bonds. A 20% holding in bonds falling by a quarter is still a 15% holding in bonds – and it would very likely come with a stronger rise in your equity holdings. Meanwhile your bonds are protecting you from bigger downside risks, like a 60% fall in the stock market.

What am I doing? Right now I prefer cash to bonds when it comes to cushioning my portfolio. But deciding between them is not a risk you have to take.

Remember cash and bonds are not the same thing.

Perhaps the biggest risk of the bond bubble bursting is a disorderly market that sees institutions and others scrambling for the door at once. Given that Central Banks have been mighty buyers of bonds due to QE, any sudden unwinding could get very messy.

But you and I don’t have any good way of knowing how likely that is, or even what we should do about it.

Staying diversified, rebalancing as necessary, and not trying to be clever is likely to prove the best approach for most in the long-term.

More reading from Monevator on bonds and the potential burst:

• Should passive investors dump their government bond funds?
• How would you really fair in a bond market crash?
• At what yield are government bonds actually worth buying?

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