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The bull market hits a speed bump

The market is riding a rollercoaster again

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:

"Earnings, earnings, who'll buy my equity earnings?"

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:

Let's party like it's 2007.

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 []

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{ 8 comments… add one }
  • 1 ermine August 3, 2011, 10:06 am

    It’s going to be a lovely, long, hot angsty summer, hopefully the stench of fear should be stalking the land and pushing the stock markets lower 🙂

    The fear is making IT NAVs swing back to discounts, it’s bringing yields back up to decent levels, and the last crash was so recent there’s probably some validity in looking how potential purchases weathered the last storm.

    Exciting times ahoy. You were missing the credit crunch a while back. Looks like the second shoe of outrageous sovereign debt is going to drop.

    Exciting times, it’s not often you get a second bite of the cherry so soon after the lessons from the last crash are fresh in the mind. I’m getting greedy, I love the smell of other people’s fear in the morning.

    Of course, it’s possible that this is the last call for the spirit of capitalism and we’re all going to go down and never come up as the free gift of plentiful energy is withdrawn. I’m not with you at all on the prospect of 20% returns for the next decade, there’s a lot of evil macroeconomic storms ahead. I sure hope you’re right though!

    But I’m with you on earnings and yields, these look like they are about to get a damn sight cheaper. I’ve had an eye on that Caledonia IT since you mentioned it and there’s some things to like and it would give me diversification into some new areas. But the price and yield were wrong for me. They’re getting better 😉 Likewise those increasing discounts, yes, more please. I didn’t get finished with buying income ITs before the discount started to get awfully close to premiums, I missed the boat on EDIN.

    Game on….

  • 2 Mr Jones August 3, 2011, 12:30 pm

    Emerging Markets – surely it always makes more sense to invest in countries where inflation is higher than our own. Eg. India with 8-9% inflation and 7% interest rates. Local investors but believe the stock market will return more than the interest rate at the banks and if you are investing in companies with a strong local presence then you will see some advantage of the inflation in the level that your company that you are investing in can sell their goods for and therefore their ROI… A good bet in comparison to investing in the UK… To not have %60+ of a portfolio exposed to emerging markets or at least companies who are largely tapping in to emerging markets is madness to me. Our wealth in the west will stagnate whilst by 2050 GDP per head could be as high in India/China as many Western countries. Follow the money… It may be volatile but hold for 20 years or more and there’ll be some huge gains…

  • 3 Lemondy August 3, 2011, 12:32 pm

    “Then why are gilt yields so low?”

    I’ve just done a post on this: http://stocktickle.com/2011/08/03/who-ate-all-the-gilts/

    With the EU blowing up, and UK banks as forced buyers due to capital requirements… what’s not to like? You should have bought the 10 year at 3.8% in February, just like I said! 😉

  • 4 The Investor August 3, 2011, 1:44 pm

    @Lemondy — I’ve been enjoying your StockTickle posts recently! With you back in the frame I’m tempted to abandon some sleep to find time to get posting again, too. As for gilts, you’ve certainly had a two year string of great calls! Do you think the yields will stay low if the BoE stops buying, though? Do you have a target yield?

    @ermine — You’ve correctly anticipated part two, which even begins with a link to your recent post on gloom! Yep, I’m still happy in shares from here. That said, if I were you and I feared an earnings collapse, I’d certainly hold fire. For my part, I don’t.

    @MrJones — Happily something like 75% of UK listed companies are generated overseas. Unilever for instance now gets 56% from emerging markets. I therefore don’t see it as either / or at all, and am happy to get plenty of my EM exposure (not all!) without so much EM market risk. I agree with your main thesis, and am frankly astonished by bears who don’t or won’t see the EM potential.

    My fears are that the global stage is buckling under the environmental impact, not that most of the world won’t want to play on it.

  • 5 Lemondy August 3, 2011, 4:08 pm

    The Bank are not buying at the moment… they are holding. I would sell at least half my gilts and buy equities if they start more QE. Never forget March ’09 🙂 I’ve no yield target, I just indulge in some cheeky market timing when rebalancing to keep my gilt allocation at 20%.

    I share your general confusion about the mixed messages from Mr Market. BLND and LAND have done amazingly well this year. And even in today’s rout, it is not a complete panic; I see green from VOD and good old SSE.

  • 6 The Investor August 3, 2011, 4:59 pm

    Yes, sorry Lemondy, loose wording on my part. Thanks for the fuller thoughts, and agree re: QE3. I think it’s very much a possibility in the US!

  • 7 Claire August 3, 2011, 11:02 pm

    How do I go about buying shares for dividend producing income in the UK? How safe is it once you hand over your money, is there a risk you could lose all your money with no protection. Sorry for the basic questions!

  • 8 Monevator August 4, 2011, 9:19 pm

    Claire, that’s a huge question. The first thing to say is that there is absolutely the possibility that you’ll lose at least some of your money. The idea is you buy a basket of shares to spread this risk. But if all the companies you bought into went bust, you’d lose all your money. Not likely, but feasible.

    Much more likely is that a portfolio of even well-chosen shares goes down for a while in a bad market, some go up, maybe one or two goes bust, while another soars, and the income from them fluctuates a bit depending on company fortunes.

    You have no protection if shares go down in value or go bust. You are buying a stake in a business here, not investing in financial product, and as such you are exposed to all the risks and rewards of business ownership.

    I have covered investing in such shares here on the site. Note that this is just for information as part of your research, it is NOT personal advice and I can’t take any responsibility for anything you choose to do:

    (Scroll down to ‘further reading’ to see the other three parts in the series)

    A much more sensible approach for a novice investor who wants to buy shares specifically for income is to invest via investment trusts. Note again that you can still lose some/all your money (and your investment portfolio’s value will definitely fluctuate) but the income *should* be pretty stable, and over the long-term (multiple years) you’d expect your trusts to rise in value:


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