It is reported that the long standing Japanese leader Shinzo Abe will resign, as a corruption scandal threatens to damage him and his party
Education
Ebb and Flow
I have the pleasure of looking over the River Neris from the terrace along one edge of my house. The restful and usually peaceful view often assists my thinking. As anyone familiar with the great works of literature or even the main religions of the world will know, there are not many tales that don’t at some stage involve a river. Two of the great rivers of the world get a mention in the very first chapters of the Bible, the very pen name of Mark Twain is derived from the language of the river and there are more examples of books th
at feature rivers heavily than I could possibly list. See how many you can think of!
I mention this because a large powerful ever flowing river is a good analogy for global stock markets. Most of the time it flows along with the level varying not much from day to day topped up by occasional rain and supporting the activities of all sort of dependent beings from fishermen and ducks to factories and hydroelectric schemes. But at times the level changes more than usual and I have noted this happens in two main ways, which is the same for stock markets.
A less common but very noticeable event is a sudden increase or drop of several meters in the water level. This is prompted by a single event or series of closely linked events – exceptional rainstorms or a call to release water rapidly through the dam of the downstream hydro electrical system, for example. Generally such a rise or drop is reversed very quickly. The 1987 stock market crash, or the correction in Summer 2015 would be analogous events.
More commonly there is a seasonal change in the long term weather pattern and the river rises gradually to eventually reach a flood level or declines until near drought conditions prevail. In both the flood and drought outcomes the consequences are serious, but are only appreciated right at the end of the long process. On a day to day basis, the changes are not very noticeable and not even consistently in the same direction.
This is how it is with markets most of the time. A very sharp correction can often be reversed almost immediately. Long slow declines or periods of steady appreciation can seem almost endless and indeed the ‘inflection’ point when an underlying change in the long term background conditions is rarely detectable until after the event. However, large amounts of money are made and lost by investors who are in reality not even paying much attention.
In my view we have passed the inflection point for the long rising market that started in 2008. The conditions have changed – liquidity (a very appropriate word) is now flowing less freely and will be further constrained and the overall volume of wealth in the system is already shrinking. Investors need to understand that and expect not to make money from rising river levels, as suggested by the famous saying “a rising tide floats all boats”, but from seeking out protected pools and rivulets fed from long nourished underground springs. That requires rather more effort in exploring and researching. Doing nothing will likely see wealth declining over a period of several years.
What you should have bought on January 1st 2018
Hindsight is the only perfect vision, it is said. The publishers of the FT Trustnet web site have recently put together some charts showing how various regions and asset classes have performed in terms of value changes so far this year. It is not a pretty picture.
The only way you could have made good value from high level asset allocation decisions would have been
Unpredictable consequences – trade restrictions
Stock markets have fallen today as the US/China trade war escalates. I already wrote a short piece about that subject ahead of the latest round of stone throwing, here.
We can’t say what the results will be for any given class of investments, but we do have a recent real example to analyse. The EU banned all sorts of exports to Russia (an extreme sort of infinite tariff) to protest about Russian interference in Ukraine. We can see some of the effects of that now after 3 years. I will just look at an example.
In the UK, you might pay a couple of quid for a kilo of apples sourced from around the world (I checked with Sainsburys Online). Here I pay about 40p for Grade 1 Polish apples of the same sorts of variety. Now food prices in Lithuania are not typically 20% of what they are in the UK. The reason apples are almost being given away is that Russia was a huge market for fruit from Central and Easter Europe. That fruit is now coming into local markets and there is excess supply.
Lucky me – I like apples. But what about Russia – the target of the sanctions? I guess, with some media coverage supporting me, that prices for some foods went up in Russia because of the sanctions. But that means Russian growers can increase sales at higher margins and possibly even plant more orchards. Russia is a gigantic country with an enterprise culture (where it is not dissolved in vodka). So the simple analysis of the consequences of interfering with the trade process is this:
- Some products get redirected to different markets, creating surpluses and so prices fall.
- Some suppliers have no profit margin and go bust, so capacity in the supplier market eventually reduces
- Prices rise in the tariffed market, so that encourages increased local supply (witness the wine industry in South Africa during the anti Apartheid sanctions period). The sanctioned/tariffed economy slowly becomes more independent (if it is a a well resourced large country), or the population fall into poverty (if it a weak undeveloped country)
- Global trades shrinks.
This is an economic analysis and no political impacts are under consideration. Elected politicians create risks for investors because their time horizons are short in economic terms (to the next election) and they are not even interested in the long term consequences of what they do (in the main – there are honourable exceptions).
In the case of the USA and China playing tit for tat tariffs, we are looking at two huge economies with plenty of internal resources. So, they can probably tolerate the consequences and reshape. Maybe the US will modernise its manufacturing base, but Americans will pay more for their goods. Those of us who are neither in China nor the US can expect cheaper goods coming our way – the EU (+Britain) is a great place to go selling the stuff the US does not want from China and vice -versa. I predict, tongue in cheek, more soya and pork from McDonalds and Huawei phones at half the price of Apple!
Diversification is like gardening
Here is a rather technical looking graph (courtesy of CF Miton). To simplify the orange line is meant to be predictor for economic growth in the US. The blue line measures the relative value of cyclical stocks (those that do well when the economy is booming) with defensive stocks (which do better when people think a recession is possible).
It is no surprise with the luxury of hindsight that the curves are roughly the same shape – you would expect people to be buying shares that benefit from economic growth if they are reading surveys and analysis that says there will be economic growth and so momentum (more buyers than sellers) will push the price of cyclical stocks up. Thus the relative value of cyclical stocks is higher in a growing economy.
The skill required of your chosen fund managers is to decide when to change the mix of shares ahead of a change in sentiment. This mix of defensive and cyclical shares is very important and one that is often not picked up in the asset allocation models of advisers. For example in an income portfolio, it is possible that the search for dividends will have resulted in a heavy bias to defensive stocks, like tobacco and pharmaceutical companies (people still buy fags and pills, possibly even more, in a recession).
If you think of diversification in the context of gardening (NotHarry is a keen gardener), you will realise that you need to have plants and trees that cope with different weather, grow at different rates, flower in different colours, have different shaped and coloured leaves, will survive on poor and rich soil, acidic and alkali soils, are eatable and are not and so on. An experienced gardener also knows how to combine things to get an overall pleasing effect, with some insurance policies! Even after diversifying at the high level, say planting apple trees and blackcurrant bushes, the gardener will invest in more than one species to further reduce the chance of failure. Gardeners would make great asset managers!
When to sell and hold cash
This topic is one the exercises the minds of financial advisers and investors on a regular basis and is certainly worth discussing at the moment, with volatility returning to markets. So it justifies a longish post and I am not restricting this to members, as everyone ought to appreciate these points.
Advisers don’t as a rule like clients to sell assets and hold cash because adviser fees are either a percentage of the assets they control, or based on trades. This is one reason why NotHarry thinks that the best advisers charge fixed fees: it takes away this inevitable bias against using cash as an asset class. Some wealth managers and platforms do charge percentage fees on cash holdings as well (which is a rip off, designed really to protect their earnings when clients have money out of the market).
A famous quote from the legendary Fidelity Special Situations fund manager of some years back is: ‘it is not timing the markets, but time in the markets’. What he was stressing was that trying to sell at the top and buy at the bottom (timing) is never really going to work and it is better to stay invested and be patient. It is pretty easy to prove that he is correct by trying to time markets yourself – trust me! There is other evidence, used in a slightly misleading way at times, showing that not being in a given market for just a few days would mean much reduced returns over time, as recoveries are often extremely rapid after dramatic sell offs and people miss the best ‘up’ days.
Why the latter observation is misleading is that it is based on the idea that someone is buying and selling tactically, so sells close to the top of the market (clever) but is not quick enough to buy back in at the bottom (psychology makes it hard for most people to buy a falling market). When the market suddenly turns after everyone has lost faith in it, and the cash gets put back in far too late, the timing advantage is lost. This is an entirely valid observation of reality, but it is misleading to use it as a generalisation, because there can be other good reasons for selling out and holding cash that are not driven by a motivation to be a tactical speculator.
Take another scenario. It is 1999 and you don’t believe in dotcom companies. You have made money on the general boom in Western market stocks (a ‘bull’market) but decide valuations are just mad so you sell out and go to cash. If you held your cash for 3 full years, you could buy a whole bunch of assets much cheaper in 2002. So this ‘intelligent’ timing worked well. It would have worked even better if some of your money was left in Asia Pacific markets that had bombed in 1996 (a currency crisis) and which did very well indeed as Western markets struggled. My advice at the time was exactly that.
So the issue is not so simple. How can you make decisions? There are some reliable rules or processes.
- The first is what is called valuation. There are a number of ways of deciding if stocks are expensive or not (in the Useful Links you can connect to Robert Schiller’s work if you really want to understand this subject). This varies across global markets, naturally. If stocks everywhere are expensive compared to the long term average, it might be sensible to sell.
- The second is time horizon. All major market corrections are part of a cycle and valuations of the market as a whole will recover. So if you are saving for a pension many years in the future you can pretty much ignore the cycle and let your fund managers take what advantage they can of it (at times when cycles turn, inflection points, good managers earn their fees, doing better than passive trackers). If you own just a few stocks of your own selection, you may need to reflect on what is changing and how to reposition – good luck, as I have never thought I was clever enough to do that. If you need your money soon, say to build a house, pay your pension income or similar, then the time horizon is very short and you need to take money off the table and have it available in cash, or you will maybe end up selling at exactly the wrong time.
- The third is diversity. You can in fact leave money in the markets (of various types) and also hold cash at all times. A “Boris” solution of having your cake and eating it. There is a cost to holding cash when markets go up – you miss out on the high returns. I consider that opportunity cost to be an insurance premium – the cash is there to spend when markets fall, so you don’t have to sell assets at the wrong price and can wait for the cycle to move on. The loss of upside return is the premium.
At the moment, on valuation grounds, most markets are expensive and some (bonds or fixed income stocks) very expensive. So if you have a need for cash and not much already on hand, selling some of your investments might be prudent. Bear in mid that you can often buy other assets that diversify stock market risk, but that is not at all easy at the moment. NotHarry knows of a few options and will write a members’ blog on the subject. I will also write longer piece on diversification in the near future!