Investment Review of 2009

This is an extract from the second newsletter from Cleary Wealth Management. My son, Neville, is an Associate with this company and assisted in the preparation of this review.

Market Summary – September Quarter

The upsurge in the markets that started in the second quarter continued into the third quarter. The S&P 500, the best measure of US markets, logged its best third quarter performance since 1939. Combined with the second quarter, the market registered its best performance in back to back quarters since 1975. Even September, historically a bad month for the Dow and S&P, saw the market eke out a small gain, ensuring the market had advanced in six of the last seven months.

Clearly everything is right with the world. Except the market is still down 32% from its highs in September 2007. The best analysis we saw about the market plunge in 2008 and subsequent vertiginous climb came from Richard Boon of Artefact Partners. He maintained that the first correction (down around 25% from Sept 2007 to Sep 2008) is pretty typical for a market expecting an upcoming recession. Valuations of companies drop in line with expected falls in their profits. What followed this relatively normal event was the market panic starting in October 2008 with the fall of Lehman‟s heralding the start of the GFC (it didn‟t take long for the industry to invent a three letter acronym for the event). GFC is, of course, the Global Financial Crisis.

From Oct 2008 to the lows in March 2009, the market dropped an astonishing 45% as various talking heads predicted a financial apocalypse and the onset of a second Great Depression. The world didn‟t end however and while the outlook is not rosy (as we will explore below), so stock prices had to rise as they no longer discounted the apparent certainty of a future Great Depression. Much of the gain is former market villains being priced as functioning economic entities again. Half the rise in the S&P 500 since March can be accounted for in five stocks : AIG, Fannie Mae, Freddie Mac, Citibank and Bank of America. This „dash for trash‟ is a perfect environment for stock pickers.

Overall, we see stocks priced today at levels similar to what we would expect in a „normal‟ recession. Around the world, more and more countries announced that they were emerging from the recession which is clearly a positive for markets. Australia in particular had a great quarter and the RBA became the first central bank in the world to start raising interest rates. China‟s stock market is now up over 100% from its lows and its property markets are almost becoming over-heated again. Europe with the exception of UK, Spain and Ireland, is starting to resemble economic normality. Quite clearly we are nearing the end of beginning; however this is much different from the beginning of the end.

While economies are recovering, the fundamentals are not strong. Much of the economic growth is the product of economic stimulus from unprecedented fiscal and monetary expansion. Much of the fiscal stimulus is also yet to be spent (the US$ has spent a mere quarter of the $787 billion it announced) and this will provide some support to economies for a long period to come. The issue is what happens when the stimulus is withdrawn. The US “Cash For Clunkers” is
instructive. In what can only be described as economic lunacy, the US Government essentially paid people to trash their cars and buy new ones. Surprise, surprise, people liked the idea of free money and exhausted the programme in three weeks. But now that the stimulus has finished, car sales in the US were down again in September. Watch for this story to be repeated over the coming months and years.

As stimulus is withdrawn, economic growth will retrench. Fiscal stimulus is certainly necessary in some measure to combat potential depressions but there is a difference between „smart‟ stimulus and „dumb‟ stimulus. If the money is used to build infrastructure such as roads, phone and broadband networks (as China is doing), it will improve future economic performance. This is smart. If it is simply given to people to spend (as Australia did), the effects will be temporary and actually even harmful if you consider the ramifications of the additional government debt required to fund such stimulus. This is dumb. And Government debt is a huge issue globally. The US deficit reached US$1.4 TRILLION in the year to September. This is larger than the GDP of all but the largest 11 economies in the world. There is only so much savings around the globe. Any dollar borrowed by a Government is one that cannot be borrowed by a corporation or individual. Gigantic deficits stretching into the future not only imperil a Government‟s fiscal position, but also begin to hamper the availability of capital to the private sector for investment into productive enterprises. Governments do not create wealth, they redistribute it.

Private sector creates wealth and if that is not possible due to lack of investment capital, living standards will fall. So where to from here? Companies are not grossly overvalued and earnings continue to be revised up. The year on year comparisons with 3rd and 4th quarters in 2008 will be extremely easy allowing lazy headline writers to show double digit percentage „gains‟ in sales, revenues and profits.

Furthermore, there is also still a lot of cash on the sidelines around the world. With that cash earning approximately 0%, there is a lot of demand for alternatives to cash. These potential positives combined with a fundamentally weak economy probably ensures that the market trade sideways for the balance of the year. It will be volatile based on the 24 hour news cycle but there seems no fundamental reason for it to be much stronger or weaker.

Economic uncertainty and continuing volatility are themselves not necessarily bad news for investors. Return on capital is likely to be higher when there is an appreciation for risk. In the midst of a the liquidity bubble of 2007, you were not being paid to take on risk. That has now reversed. One common theme we heard from fund managers this quarter was that while the market itself was „fairly‟ valued, there was a great dispersion between the valuations of great and not so great companies.

This is prime market conditions for active managers to deliver outperformance and we suspect their returns will outdistance passive funds over the next 6 months at least.

The 64 tonne elephant in the room is still commercial property. While the residential property market is showing signs of stabilisation, commercial property is charging towards its date with destiny. In the first four months of 2010, fully 70% of all US commercial real estate loans will roll over. Unfortunately, 75% of geared commercial real estate is in negative equity. This has not been priced in by analysts yet and is therefore not reflected in current market prices. In addition, while approximately 8% of commercial loans are in default, there is only provisioning of 2% by US banks in their balance sheets. This is simply unreal.

The prospects for the US banking system are dire if this situation is not addressed. The situation is even more alarming when you realise that around 100 US banks have already been seized by regulators so far this year compared with 25 last year and we still have 2 months to go.

Lastly, the local story of the last few weeks has been the „soaring‟ New Zealand dollar. Regrettably this misses the real story which is actually the plummeting US dollar, and to a lesser extent, British pound. The New Zealand dollar has risen against the US dollar but is at long term averages against the Euro (circa $0.49) and Australian dollar (circa $0.82). It‟s a simple example of demand and supply. The dollar and pound are proving that, with a fiat or paper based currency, if you issue more currency than the growth of nominal GDP, its value will fall.

The Central Banks are effectively printing dollars and pounds as fast as they can to purchase long term Government bonds so as to maintain low interest rates; the so-called quantitative easing. Too much supply, not enough demand. History suggests emphatically that you can‟t print your way to prosperity.

Not coincidentally, this also explains why gold has rallied to nominal all-time highs in the last few weeks. Gold has a -0.85 correlation with the US Dollar which means that when the US dollar falls, the gold price rises. If you take a commodity with an essentially fixed supply (gold) and price it in a currency which is being printed rapidly (US$), the price of that commodity in terms of that currency will rise. Forget all the talk of inflation expectations that the talking heads will use to justify the rise. Just remember – gold up, dollar down.

In the medium term, there is little chance of the US dollar losing its reserve currency status. Around 80% of all US notes in circulation are outside the US. Over the long term, the US Government must trim its spending - particularly in the entitlement areas of health care and social security - and increase its revenues to prevent ongoing depreciation in the US dollar. This is an extremely tricky task politically which no US Congress seems to have the stomach for. Failure to address it though will almost certainly ensure an Asian super currency being formed to supersede the US dollar over the next 20 years

Cleary View - our quarterly rant on topics which we find interesting

The Death of Buy & Hold One reasonably prominent investment house used to run adverts in the 90s saying it was “time in the markets, not timing the markets” that was important. What a load of bunk that turned out to be. The previous quarter saw an interesting statistical coincidence that some train-spotter noticed.

Dow Jones Sept 11,2001 9605.51
Dow Jones Sept 11,2009 9605.41

Eight years is pretty long term in our book and in that time, investors have received zero capital return. Zip. Nada. Zilch. Is this a one off or actually a lot more common than we realise?
Warren Buffett had a better example.

Dow Jones Dec. 31, 1964 874.12
Dow Jones Dec. 31, 1981 875.00

That‟s seventeen years without any return at all from the stock market index. Does that mean that capitalism failed over that time? Of course not. Some businesses made money, others went broke. Fortunes were made and lost.

But if you just bought „the market‟ and held it over that period, you would‟ve received dividends only and lost money versus having your money in the bank.

Share markets do rise over the VERY long term but that‟s generally longer than most people invest for. The point is that you will often hear various talking heads extolling the virtues of passive funds which mimic a sharemarket index. Please remember that in a raging bull market, this is probably your best bet as you capture any gain very cheaply.

But you need to know when that bull market ends because you can then experience long, long periods of nil return. We advocate a mix of active managers in a range of different asset classes. This, in theory, allows us to offer clients the ability to access returns in all market cycles and not be reliant on the overall market rising.

Regardless of where the market ends up in the next month or quarter, the legacy of the GFC is that we face years, if not decades of substantial headwinds to long-only asset class performance driven by a pervasive de-leveraging process, persistently high levels of Government debt and a looming demographic time bomb as the baby boomers start retiring.

Many commentators have suggested that the fallout from the GFC could lead to the US and the world experiencing Japan‟s infamous lost decade(s) after their bubble burst in 1989. Japanese investors who bought stocks in the 1980‟s are still showing losses twenty years later and that market is unlikely to boast new highs in our lifetimes. Buy and hold indeed.

Real Assets

One of our investment themes over the last 2-3 years has been the increasing importance of real assets in clients‟ portfolios. By real assets, we literally mean physical assets you can touch. Real assets include such things as infrastructure, forests, farms, property and commodities.

Property is a tricky one as it is a real asset but is subject to bouts of speculation which drive its price to dizzying multiples of the income stream generated from it (be that rent or owner-equivalent rent).

But real assets, in their purest form, are usually steady income producers, whose value does not fluctuate much but generally accretes over time. What is most important about real assets is that they are mostly UNCORRELATED with financial securities. A farm is a great example. Just because the Dow Jones crashed over night does not mean that the cows in the Waikato stopped producing milk this morning. Nor did that news stop you buying milk with your paper to tip over your cornies or into your coffee.

The value of real assets do fluctuate like financial assets, but usually for reasons far different than what causes global market rises and falls. Real assets have dominated the portfolios of the large endowment funds over the last couple of decades but they are generally harder to access for retail investors. It‟s just not possible for a retail investor to buy a forest.

However some limited opportunities are becoming available and we are aware of others that will be brought to the market in the future. We recently promoted the EPIC offering to our client base and hope to have other similar offers in the future. Macquarie recently produced an interesting presentation on „real assets‟ to accompany their EPIC offering.

Our Outlook / View

At Cleary Wealth Management, we hope we are smart enough to know what we don’t know. We will not offer market forecasts or attempt to make market predictions. What we prefer is to outline the major issues facing investors over the upcoming period, and our general strategy and thought processes with respect to these issues.

The most important decision with respect to investment portfolios is the allocation of assets amongst asset classes rather than the selection of assets themselves. There are three main themes which we expect to predominate over the coming one to three years and which are dominating our portfolio allocation strategies currently.

Increasing Correlation of Asset Classes
The general tenet of investment portfolio theory is no more complicated than the simple message of “don’t put all your eggs in one basket”. Diversification remains the primary tool in our investment kitbags for wealth protection. Simply put, you want to own a range of investment assets so that when one asset is going down, this is compensated by another one going up. Ultimately, a portfolio of uncorrelated assets is likely to provide investors with a higher return with lower portfolio volatility.

However the key word is UNCORRELATED. Portfolio diversification breaks down completely if all assets move in the same direction at the same time. Unfortunately this is exactly what we are now very close to experiencing. In 2007, one of the world’s foremost investors, Jeremy Grantham of GMO wrote that he was very wary because for the first time, the entire world was in an investment bubble. Every single asset class he looked at (with the possible exception of timber) was increasing in value driven by surplus liquidity, strong economic growth and benign economic outlooks.

From 2003 – 2007, it really didn’t matter where you invested, as almost every investment increased in value. Commodities, stocks, property, private equity, it was a heck of a party. As the former CEO of Citibank said in June 2007 (before his sacking) “when the music is playing, you’ve got to get up and dance. Right now, we’re still dancing.” Now, unfortunately, the music has stopped and we are in the downdraft of this great global bubble. Just like on the way up, there has been little difference between asset performance on the way down with the glaring exception of that most arcane of institutions, the global macro fund. As you will all know, virtually everything has fallen in value since the credit crisis started. Banks are down, property values are down, share markets around the world are all down. For the first time in history, it is estimated that every single country in the OECD is expected to have negative economic growth in 2009 (Australia may be the lone exception). Around $4.9 TRILLION (that’s 12 zeroes folks) of investment wealth has simply evaporated over the last two years of the economic crisis. Essentially all investors have paper losses during this period of market turmoil.

The losses are disconcerting enough, but what almost concerns us more is the indiscriminate nature of the losses. There have been few places to hide. We are very concerned that the benefits of portfolio diversification are becoming harder to access because there are no uncorrelated assets out there anymore. The US stock market rises, so the Asian ones rise, so Europe rises. US market falls, so does Asia, Europe and little ol NZ follows along dutifully. Watch what the talking head on ASB Business does when he talks about the NZ market. His first words are normally “following strong gains on Wall St, NZ market was higher today…..” or similar. It is for this reason that we categorically avoid any and all regional share market funds. There is no portfolio diversification benefit from owning say European shares. Therefore we are particularly focused on seeking out investments which are NOT correlated with the general markets. This is becoming harder.

Case in point are equity hedge fund strategies which were promoted heavily as firstly absolute return and then secondly uncorrelated with the market. The credit crisis of 2008 has seriously damaged these claims. Some individual managers such as Platinum International have demonstrated an ability to generate returns independent of the market movements, and these are the types of managers we continue to seek. Going forward suffice to say, a lot of our investment analysis is going to be devoted to asking how an investment performed not absolutely, but relative to other investment classes over the last ten years. The aforementioned Global Macro funds have demonstrated their value in these tumultuous times. These funds, which trade relative values of bonds, equities, derivatives and currencies around the world were promoted as offering zero correlation with standard equity / bond managers and would profit from market turmoil. And this is exactly what they delivered with many of the funds delivering double digit positive returns amidst the market panic in 2008. They have outperformed every asset class in New Zealand over 5, 10 and 15 year periods. We have maintained an allocation to such global macro managers as AHL, Winton, 36 South and Commodity Strategies and this was rewarded in 2008.

The Perils of Index Investing

Another issue which we see becoming more important is an increasing unease with index based investing. To quickly summarise, index investing involves taking a standard sharemarket index (say the NZX 50 or S&P 500) and investing your money in the shares that make up the index in the same proportion as the index. The theory is that over time markets will go higher and you can capture that gain very cheaply (index funds have lower fees). Index funds can work well in a secular bull market, but they are to be avoided at all costs in a down or sideways moving market and we believe we are in the latter. There are two main reasons to avoid index funds. Buying last year’s winners – indices around the world are comprised by measuring the market capitalisation of each company. So the bigger a company is, the bigger part of the index it will comprise. An investor in an index fund thus invests more in the bigger companies than they do in the smaller companies. Leaving aside the fact that this is a remarkably socialist way to invest in a capitalist economy, the problem is that market capitalisation is a function of the number of shares and THE PRICE OF THOSE SHARES.

When a company share price rises, so then does its market capitalisation, thus making it a bigger part of the index. As it becomes a larger part of the index, an index manager must buy more of the shares. An investor is thus purchasing more shares of a company as it gets more expensive. To take a thought experiment, if half of the S&P 500 is over-valued and half it under-valued, an index fund will, by definition, own more of the over-valued shares and less of the under-valued ones, the complete opposite of what an investor wants to do to maximise wealth. Thus what you always see is the speculative parts of the market represented in bigger proportions as the shares get progressively more expensive. At the height of the Tech bubble, technology shares represented 35% of the S&P 500 index. Similarly for banks at the height of the credit boom. Japan represented 51% of the MSCI World index in 1989. It currently is in single digits. At the moment, banks still represent far too great a percentage of the index in most countries and will be a major drag on their performance looking forward as banks ability to generate superior profits will be greatly constrained in a more regulated future.

Avoiding the dogs – during bouts of market turmoil, the most important goal is probably not to make money, but to avoid losing it. However, an index investor is guaranteed to own companies which experience problems and perhaps even go out of business. Investors in Dow Jones index funds have watched their investments in GM and Citibank drop by 100% and 90% in value respectively in the space of two months. Very few fund managers have owned these companies over the last two years for the simple reason that, on any rudimentary analysis, both were technically insolvent.

Our view over the next 2 – 3 years is that sharemarket indices are unlikely to provide any substantial return to investors as the world recovers from the credit crunch, profit margins are constrained and P/e multiples rise to reflect a more volatile outlook for corporate profits. We passionately believe that there will be pockets of value that smart and able fund managers will exploit. We will be seeking out such managers and allocating more capital to them over the coming year. Inflation or Deflation ? This is possibly the most important asset class call that we will have to make over the next ten years. Will the US enter into a deflationary spiral similar to what Japan experienced since its credit bubble collapsed in 1989 or will the unprecedented fiscal stimulus provided by Governments globally combined with soaring Government debt issuance cause inflation over the near term.

Deflation is a legitimate risk and a horrible environment for investors. However inflation is also tricky to deal with from an investment perspective as while your returns might be strong, the spending power of those savings is diminished.
If deflation becomes likely, then we would want to reduce exposure to the US dollar and all US denominated assets. Very few asset classes perform well in such an environment and those wishing to maintain the real value of their savings would have much higher cash weightings than normal. If inflation is more likely then we will want to be avoiding bonds at all costs, maintaining a larger allocation to equities, and investing strongly into commodities (particularly precious metals), infrastructure and property.

Currently it is our expectation that this is more likely but it is unlikely to become clear for at least a year due to the large amount of excess capacity globally. The jury is out. Our view, which is in accord with Kerr Neilson, is that we think hyper inflation is unlikely in the extreme simply because that is a function of too many dollars chasing too few goods. Currently we have too many goods chasing dollars being stashed under the bed which is inherently deflationary.

But we tend to think that inflation as measured by the spending power of your savings will be quite strong over the medium term as production capacity is slashed, yet monetary and fiscal stimulus remains strong. Note that the headline CPI numbers may indicate that inflation remains relatively benign but history suggests that Governments are notorious for fiddling CPI calculations during times of high inflation.

Deflation however represents the greatest risk to portfolios and thus, if we start to see evidence of it taking hold, will cause a rapid re-evaluation of our portfolios and some quite marked portfolio re-structuring.

 Grant Cleary                                  Neville Giles
 Principal                                        Associate
Cleary Wealth Management        Cleary Wealth Management