Angry men have been wreaking havoc across London. Fueled by aggression, fear, and a disregard for the long-term, they’ve been destroying value that’s taken years to build.

No, I’m not talking about the riots on the streets of Tottenham, Hackney, and Ealing, and the fires in Clapham, but rather the share traders that have sent the FTSE 100 index down around 20% from its high of the year – most of it in a record-breaking run of 100+ point declines.

Traders in suits and hoodlums in hoodies have more in common than just testosterone, however. Both justify running rampant on what seems like a convenient excuse, rather than any changed reality.

• At the heart of the London riots are ugly truths – poverty, racial tension, an alienated underclass, police bungling, and the death of a man with loved ones.

• At the heart of the stock market crash are ugly truths, too – the US deficit, the unprecedented downgrade of its AAA bonds, the contagion in Europe, unemployment, and a lack of political leadership.

Yet in both cases most of this was true last month, too.

Rather than rationally responding to new information, youths looting electronic stores and traders dumping holdings are behaving like animals.

Cheap, and getting cheaper

I can’t see any good reason for the FTSE 100 to be trading on single-digit current and forward P/Es, based on what’s emerged in the past week. It implies a change in earnings expectations from very strong growth next year to a sharp decline. The data doesn’t yet support that.

But take my opinion for what it’s worth. True, I was worried about the US downgrade, and I’ve been tilted much more defensively this year – but I was still absolutely overweight in equities. I was holding Unilever, Diageo and the like on valuation grounds, not because I saw a big correction was imminent, let alone a crash!

Even last week I quickly put my recently liberated cash back into equities. Needless to say, everything I bought has fallen further!

It reminds me of the old stock market joke: A long-term investment is a short-term trade gone wrong.

Equity income on sale

I am in this for the long-term, though, and if you are too then you’ll agree it’s hard not to salivate at some of the apparent bargains on offer.

The markets look utterly oversold, at least in the short-term. Yet once this kind of panic sets in anything is possible. You have to assume anything you buy now could fall a lot further.

If you’re looking for long-term income from quality shares, however, now looks a great time to buy. Even the FTSE 100 index will probably be yielding 4% on a forward basis by the time you read this, and its dividend-paying companies are generally in great shape. The 4% yield is more than a 1% spread over 10-year gilts – very high. Ideally, you’d buy a high yield portfolio and ignore the capital fluctuations.

Having said that, some of the real bargains appear to be at the more speculative end of the spectrum – small cap miners, little oil explorers, and the like.

What I suspect is happening here is both private investors and bigger leveraged funds are having to dump holdings to meet margin calls or as stop losses are triggered.

We’ll probably also discover in the months ahead that one or more big funds have completely failed, if history is any guide.

Some good reading to end a topsy-turvy week.

Well, it’s finally happened. As Chinese mandarins fingered their mountain of U.S. Treasuries by flickering LED light and we soundly slept beneath U.S. nuclear bombers patrolling our skies, the S&P agency downgraded U.S. debt.

The decline from AAA to AA+ puts the U.S. on a lower rating than the UK as well as Liechtenstein, and on a par with New Zealand.

S&P said in its press release (reprinted by the WSJ):

We lowered our long-term rating on the U.S. because we believe that the prolonged controversy over raising the statutory debt ceiling and the related fiscal policy debate indicate that further near-term progress containing the growth in public spending, especially on entitlements, or on reaching an agreement on raising revenues is less likely than we previously assumed and will remain a contentious and fitful process.

We also believe that the fiscal consolidation plan that Congress and the Administration agreed to this week falls short of the amount that we believe is necessary to stabilize the general government debt burden by the middle of the decade.

U.S. Treasury officials tried to head-off the downgrade by pointing out a $2 trillion error, amongst much else:

Treasury officials noticed a $2 trillion error in S&P’s math that delayed an announcement for several hours. S&P officials decided to move ahead, and after 8 p.m. they made their downgrade official.

From hedge fund traders buying Korean growth stocks to doomsters hunkering down with gold, everyone knew this was coming. For at least three years the question was been how best to respond to the deterioration of America’s finances, not whether it had happened.

As such, this should all be in the price. Indeed on Thursday I published a graph showing bond yields typically fall after a downgrade from AAA status, meaning bond prices rise as investors buy more of the downgraded debt!

There’s usually been a sell-off in such bonds beforehand, however. In this week’s market madness, U.S. bond yields had already shrunk in the flight to safety, pushing down yields.

There’s also the scary question of unintended consequences from the downgrade. Will the embarrassing shift to AA+ status also cause technical breaches in financial contracts? As I wrote last Saturday, some City insiders have considered the potential for a systemic event.

Downgraded portfolios, too

This blog doesn’t have the answer to a question on a million financial professionals’ lips. On the face of it though, the downgrade to U.S. debt looks ridiculous: This is the world’s reserve currency, from the world’s strongest nation, and nobody seriously fears Treasury holders won’t get paid.

True, some fear the U.S. will inflate its way out of debt – so you might get paid, but in much less valuable dollars. But according to S&P’s press release, its model scenarios put CPI inflation at 1.5% to 2%. So no Zimbabwean antics to blame there.

Even if the chances of a superpower that can print its own money not doing so to pay its debts seem close to zero, I don’t berate S&P for the downgrade. Whatever ratings agencies do, they’re kicked for it. Let’s remember it was U.S. politicians squabbling and posturing for their constituents and the chronic lack of both long-term thinking and honesty about the past that brought America to this juncture.

Another reason I’m not going to make any specific predictions: If I’d been more vague about my foreboding last weekend, I’d now be seen as a financial soothsayer!

The FTSE 100 fell 10% last week – one of the worst weekly performances of all-time – and the modest portfolio trimming I’d conducted beforehand was a pretty flimsy defense. My year-long defensive shift away from trackers pumped up on energy and cyclicals towards companies like Unilever and other income payers (together with more skeptical investment trusts like the Independent Investment Trust and others) served me well until Friday, when the levee broke, spreads widened, and my small cap and subscription shares cratered.

Regrets? Life’s too short, and selling out too expensive.

While it’s rare for me to be worried about the markets, churning your portfolio is a very costly insurance, even for more active investors like me, for whom bargain basement costs are intellectually sound but in practice fleeting.

A frictional cost of 2-3% or so may seem cheap compared to a crash, but markets don’t usually crash, and when they don’t the entire effort is simply an ill-judgement tax on your wealth.

There’s also the issue of when you buy back in. Most market timers miss the bottom.

Instead of regrets I’m glad to have the chance to buy more shares cheaply, especially at the more illiquid end of the spectrum. A focus on income helps, too.

If you’re young, then the markets hanging around at these levels for a few years will likely make you much richer in the long-run. The growing multiple of my portfolio against my annual disposable income is lessening that effect for me, but there’s always the dividends to reinvest and compound.

With the FTSE 100 on a current P/E of less than 10 and a forward P/E around 9, I don’t expect us to stay down here for long.

[continue reading…]

This is the second of a two-part series on summer shenanigans in the markets. Read part one first.

A fellow blogger and Monevator reader named Ermine recently noted that I have been much more nervous in the past few months (although I did a bit more actual selling back in August 2010).

Recently, I’ve been worried about the unintended consequences of US Treasuries losing their AAA status. I still am worried, and will be until it happens without consequence, although the very low yields on these bonds shows I’m in a minority. Most investors couldn’t give two hoots about a ratings downgrade.

As an aside, the following graph from Business Insider shows yields have actually tended to fall recently after downgrades from AAA ratings!

S&P downgrades: A very contrarian indicator, recently.

This doesn’t say S&P is wrong to downgrade – only that the market anticipates the rating change by selling off, and then buys once the deed is done. But the wider point is that downgrades haven’t been doomsday by any means. (Mind you, things might be different when it is the world’s reserve currency that gets downgraded).

Another reason UK and US government debt has done so well is sovereign default fears in Europe. In other words, it’s a beauty pageant among ugly sisters. Forget doomed Greek bonds and the like, I’d even rather buy our debt than German bunds. I think the Eurozone crisis will be resolved, but it will be at the expense of higher German interest rates as the pain is spread around a more closely-integrated Europe.

German bonds would surely be vulnerable in such a scenario.

Right problem, wrong time

The real irony is that the UK and US governments are so committed to debt reduction in the near-term, even as they can finance spending more cheaply than ever before.

I first wrote in November 2008 that while I’m no fan of paying taxes to pay for other people’s laziness, I am all for smart investment in infrastructure.

With the government able to borrow at well under 3%, that’s doubly true today.

Sean O’Grady wrote recently in The Independent that:

Right now, British business is sitting on a £60bn cash pile, some 4.5 per cent of GDP, too frightened to spend it on new kit because they don’t know what’s round the corner.

What’s more, business investment is in long-term decline, on a quarter-century view, and that is not promising. In the past decade or so it has been hidden by some substantial government investment, but that is now set to shrink sharply. According to the CBI’s latest forecast private sector investment is due to grow by an annual rate of about 9 per cent over the next year or two – if companies can summon up the gumption to do so, and on a low base.

But the really startling trend is in government fixed investment. While certain high-profile projects such as the fast link to Birmingham will be protected, many others, not least the Building Schools for the Future programme, have been cancelled. So government fixed investment is due to shrink by an annual rate of 10 per cent plus in the coming months.

It’s a similar situation in the US. But sadly, in both countries government spending on useful infrastructure has been pretty weak compared to spending on what the Americans call ‘entitlements’, which aren’t half so good for boosting productivity, and on tax cuts, which are probably neutral.

With GDP faltering, the resultant public backlash against government debt couldn’t have come at a worse time for making the case for governments spending more, even though in both the US and the UK it’s easy to think of massive job-creating projects that could boost our nations for years to come, from railways to windfarms to nuclear reactors.

It’s not hard to get a decent return on capital when you are borrowing at less than 3%!

Betting on a mid-cycle slowdown

The final twist therefore to the present situation is that even as the US moves towards reaching a resolution about its debt ceiling – and so potentially staves off a meltdown – equities are selling off because of a fear that the consequent reduction in US government spending will choke off global growth.

There are already jitters that more companies have started to miss earnings estimates, although personally I think that’s more due to a mid-cycle slowdown exacerbated by Japan’s earthquake. But as we saw in part one, US earnings are close to their previous peak. They are undeniably vulnerable to a setback.

I’ve even found myself researching strange indicators such as the share price of auction house Sotherby’s! The theory is it peaks before a recession, due to all the excess cash sloshing about. That particular rune has indeed looked a bit toppy, although I wouldn’t say it’s brought the hammer down yet.

But on balance, I’d still prefer to be overweight shares than anything else. I don’t think UK shares are fundamentally dear, and I think that stock markets will be a lot higher in 2020 than they are today. I also think equities offer better-priced inflation protection than most alternatives (though I prefer to keep cash in NS&I index-linked certificates).

According to Bloomberg, the FTSE 100 is on a current year P/E of just under 10, falling to less than 9 on next year’s estimated earnings. The famed single digit P/E ratings beloved of bears! Even the S&P 500 is on a reasonable looking 12.5, falling to 11 on next year’s estimates.

True, the US housing market and unemployment remain mired in the doldrums and the UK and much of Europe is struggling, but equally I’d say that makes today’s earnings more credible than say 2007, coming off such an unpromising backdrop.

Finally, I think that most trading in equities is currently done by hedge funds and the like at the margins. Private investors never truly came back to shares, and nor have institutions like pension funds. As such, any choppiness in share prices could turn on a dime: I don’t take these summer gyrations as profound indications of a change in sentiment.

One caveat: like hedge funds, I’ve been actively trading more than ever. My passive allocation has been at an all-time low point since early this year, as I’ve tried to position myself more defensively through globally-focused dividend paying shares like Diageo and Unilever, and seemingly mispriced securities like the Caledonia Trust. I’ve also realised about 4% from selling vulnerable or illiquid holdings, mainly to give myself a little war chest to cheer myself up if things turn really bleak!

It has all helped recently, but it obviously won’t protect my net worth in a rout. If we see one, it’ll be time to dust off the bear market survival guide again. As a 30-something I’d much rather take my chances with equities for the long-term than government bonds at 300-year old lows. If you’re 60 you might take a different view, although you should be thinking about rebalancing as you age, not as the market wobbles.

Just as I believe the UK government should be investing for the long-term given it can borrow so cheaply, I still believe these past years will eventually prove to have been a great time for us to build up an income for the future. If you’re looking to someday live off investments, bear markets are to be welcomed.

As ever though, the sensible thing to do is to buy a diversified portfolio, periodically rebalance, and not try to be too clever!

Readers, what do you think of the recent market wobbles? Let us know what you’re doing below (saying “nothing different” is entirely acceptable…)