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!

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…)

This is the first part of a two-part article on the summer swoon in the markets. Today I consider the inherent contradiction between strong bond and share prices. Tomorrow we’ll look at the fallout.

I try not write too much about the market’s gyrations. For a start, most readers are best off ignoring the noise and dripping money into passive index funds. There’s plenty of importing things to learn about investing, but what’s making the headlines on CNBC is rarely among them.

Also, it’s easy to be wrong when you make economic or market predictions. Being wrong is bad enough when you lose money. It’s doubly hard being wrong in public!

The thing is, I have been an investing genius since March 2009.

Unfortunately, most other people have been, too. Shares, bonds, oil, London property, gold – you name it, it’s nearly all gone up.

We can’t all be right, can we?

Congratulations! You’re a winner!

Regular readers will know I’ve been near-fully invested in equities since 2009. And unlike others who laughed at anyone bullish on shares until the bounceback was well underway and they claimed to be buying, I was consistent – happily posting that the market could be set for a decade of 20%-plus returns in May 2009, for instance.

I got a few things wrong but the main things right, and more than doubled my net worth in under two years. Not bad (try compounding it!) but not very difficult when the FTSE 100 itself rose 73% (before dividends) over the period, and investors like me with a small cap or emerging market tilt did better.

It’s been a genius making machine! And I was barely invested in the supersonic stuff, like oil explorers or gold. Some people have done far better, and can brag of being even cleverer.

But bull markets make everyone look smart – especially this recent market, where you didn’t even have to be very right to make money. While most invested in equities will have done well, the weird thing is so has almost everyone else, provided they dared to tiptoe out of cash.

In particular, US and UK government bonds have generally been a great investment. Corporate bonds, too.

The strength of government bonds has been a constant source of amazement – and reassurance – to me. You see, while the conventional view is that low government bond yields signal recessions, I’ve understood the low yields of the past two years as reflecting investor paranoia, ongoing ultra-low interest rates, and government largesse. All have correctly signaled good times for shares.

The fear part of the equation was certainly evident in late 2008, when US Treasury yields actually went briefly negative – one of my rare good calls on bonds. Otherwise, I’ve waited in vain for a good time to buy gilts, looking for a yield of 5% as far back as November 2009, which seems a reasonable call in retrospect given how RPI inflation has climbed above that level recently.

You’d usually expect bond investors to sell on the prospect of an ongoing negative real yield, to drive bond yields higher to compensate. But that hasn’t happened. In fact, gilt prices stopped falling and started rising, to the extent that the ten-year yield recently fell to 2.76%.

Two point seven six per cent! I can hardly believe it even when I spell it out. It’s a record low.

To buy gilts on such a snail-scraping yield, you need to believe inflation will be tamed, pronto, and that economic growth will be lacklustre, or else you’ll need to buy them for some other reason.

Asset allocation across a diversified portfolio is a good other reason. Bearish despondency isn’t. Speculation by active traders such as hedge funds – about the only money moving the markets nowadays – is another likely cause.

Bonds on a bull run

Of course, you might be buying gilts because you’re the Bank of England implementing quantitative easing. Or perhaps you’re a pension fund forced to buy gilts by dubious regulation.

Either way, a UK stock market that rises 72% even as gilt yields plunge to 2.8%, gold breaches $1,645, inflation tops 5% and prime London property surpasses its pre-crunch highs is a curious conundrum.

• A recovery? Then why are gilt yields so low?
• An inflationary spike to come? Ditto.
• Depression? Then why the equity boom and rising London house prices?
• Stagflation? Ditto.

Now, given the choice you’d rather make your money in pretty safe government bonds where you can be confident of getting your money back1 than in volatile equities. Ergo, if lots of asset classes are doing well at once, you’d rather do well in government bonds and limit your downside.

But does anybody seriously believe that government bond yields will fall further from here – and hence bond yield prices rise still higher? Sure it can happen – look at Japan – but it’s a fearsome prospect.

Earnings, earnings, everywhere

In contrast to government bonds, which haven’t so much climbed a wall of worry as dismissively vaulted it like a skilled practitioner of parkour, equities do not look expensive, even after their recent heady advance.

This graph of yield ratios from broker Brewin Dolphin is pretty revealing:

What this shows us is that the earnings from equities haven’t been more cheaply-rated in the past 23 years, compared to those from bonds. Either people really love bonds nowadays, or they really hate equities

Indeed, the ratio of less than one shows that investors would rather buy the fixed income from riskier high yield US corporate debt (blue line) than the earnings of similar companies, despite the latter’s potential to grow earnings forever into the future, and both asset classes being exposed to company failure.

Investors might prefer bonds because they fear corporate earnings are peaking. A second graph from the same source shows they might (superficially) have good reason to doubt the S&P can sustain its level of earnings:

I say ‘superficially’ because someday even these earnings (black line) will look like molehills against the mountains – total earnings should inevitably go up in the decade’s ahead, if only because of inflation. The mirroring of 2007’s peak is therefore pretty irrelevant – it’s just a dollar number, not a stretched ratio.

What’s more, 2007’s earnings were in retrospect puffed up by all kinds of credit boom frothiness. While doomsters may argue otherwise, I don’t think you can say the same about today’s earnings.

As far as I’m concerned, companies are leaner, meaner, and increasingly draw their earnings from overseas. They’ve worked hard for this income in a housing boom-less, de-leveraging Western world.

P/E ratios for the US and UK also indicate fair-to-undervalued equities to my eyes. True, the longer run Shiller PE 10 ratio (which computes P/E based on 10-year earnings) suggests at least the S&P 500 is over-valued, but unlike many I’m not very convinced by the predictive qualities of that methodology.

In part two: What you, me, and the government should do with our money!

1. So that is gilts and US Treasuries, as opposed to PIIG debt, then [↩]