Sunday 13 December 2009

DECEMBER 09 Investment Outlook



Whether you've been tucking your hard-earned away in a pension, property, stocks, bonds or more esoteric investments, 2010 is likely to be a much trickier ride for us than the jolly we enjoyed in 2009. 

The low pressure weather system swirling around the debt crisis, temporarily staved off by an effluvium of monetary wind from the world's central banks, will gather strength and start heading inland at some point next year. 

Following another sag in house prices, banks will start to suffer renewed losses and reign-in their lending yet further; consumers, cresting in their age-related spending and with one eye on rising unemployment and the other on their mortgage, will prove unable to stimulate recovery as in previous recessions; and as interest rates begin to edge higher businesses, anchored by an overhanging belly of debt, will find it increasingly difficult to re-finance their loans or generate enough income to service their payments.

Add in one or two potential extraneous shocks (military conflicts, Eastern Europe going bust etc.) and I expect the cumulative effect of these problems to weigh increasingly heavily on the economy and markets as we progress through the year.


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Each month in this space I'll gaze into my crystal ball to try and divine the most profitable (or most risky) places to stash your money.  I'll give a brief overview of the outlook for each type of investment: savings, commodities (eg. gold, oil), property, bonds and stocks. 

Plus, each month I'll subject one of them to a more detailed analysis.  This month I'll concentrate on the outlook for stocks, which have had a rollicking ride up over the last nine months.  If you're in already in should you stay in? And if you're not, should you get in?  But first, let's look at...

SAVINGS
  • The top fixed-rate savings accounts are being snapped up and closed faster than ever
  • Interest rates are being clipped as banks can now get funding cheaper elsewhere - it's therefore a good time to lock in fixed rates on cash you won't need for a year or more
  • Top ranked cash ISAs, especially those with fixed rates, offer excellent value

COMMODITIES
  • GOLD has had a parabolic run up and is in bubble territory; it may well go higher if the dollar's rise relents, but determined investors should only buy on a pullback to $1100 or below 
  • OIL is struggling as the dollar surges, but sentiment readings suggest another push to new highs is probable if the dollar turns lower.  A breakout above $80 or a pullback to $65 would be low risk entry points.

PROPERTY

BONDS

                    --------------------------------



STOCKS - GASPING FOR BREATH


It's been a blast...almost literally.  We've seen the strongest surge in stocks since 1932.  I'm glad to say I spotted the bottom last March to within a day (and wrote so in an email update); yet although I've taken several bites out of the rally on the ascent, I can't say I've been fully invested all the way up due to my worries over the long term picture.

For some time my view has been that we're in a lingering sweet spot which, for all the reasons given in my December 5th post, cannot be sustained. Our mission therefore, if we want to protect ourselves yet not lose out, is to carefully milk the upturn for all it's worth, whilst simultaneously executing a market escape worthy of Houdini.


In October's Investment Outlook I re-posted the scenario for the Dow Jones Index I originally sent out way back in April and, as it still chimes with my overall view and has been spot on so far, let's take another look.




I'm featuring the Dow here, but the same basic story could be told for virtually any other major international index including the FTSE 100, since world markets remain highly correlated to the American stock indices and dependent on the US economy (markets in some emerging economies like Brazil and China show greater strength, but will still be capped by US / European weakness since they need fat-walleted and willing consumers to export to).


The chart above envisages a substantial reprieve for stock investors lasting some way through 2010, during which serious cracks begin to reappear in the bullish firmament, optimism gradually breaks down and the bear market resumes with a vengeance in 2011.


I didn't know it, but at the same time I was cogitating over this forecast some tight-suited nerds at Morgan Stanley were fondling their own crystal balls and coming up with a not dissimilar conclusion.  They researched a whole slew of major downturns over the past century - 19 in fact - in an attempt to figure out if there were any common themes and patterns in the subsequent market behaviour.

Turns out there are many. They looked at 'secular bear markets' aross several countries - that is, bear markets not caused by the cyclical factors which create your common-or-garden recession, but those mainly associated with credit busts and banking crises. They composited the results and published this generalized illustration of stock markets' typical performance over the next several years.




It's a sobering picture.  After a long downturn, the market rebounds strongly in a 'sweetspot' phase, with average prices rising 70% off the lows. We are currently close to fulfilling that requirement, having risen around 60% since markets hit bottom in March '09.  There then tends to be a substantial retracement of part of that rebound (an average drop of 25%) as investors fear, then get, higher interest rates...followed by a long, wide trading range: over this period of several years, prices do very little but zig-zag up and down between two points, the highest of which is still well below the peak set in the previous boom.

Overall, depending on where you bought, the story is for markets to return either next-to-nothing (excluding dividends) or else fall, over a period of more than ten years.

For a long-term 'buy and hold' or pension investor, this scenario is truly depressing. Keeping your money in stocks in such a market is like flashing your cash at a pickpockets' convention.  A whole world of risk for virtually no gain. If your stocks pay dividends you'll do better, but dividends are of course neither guaranteed nor fixed and capital appreciation over many years is likely to be non-existant to negative.

Morgan Stanley's research very much reflects my own view that we will reach a peak in stock markets at some point in the next year or so which is unlikely to be surpassed for a decade. This, I suggest, will be the moment for you and me to sidle to the wings, pack our bags and say thank you very much and goodnight. After the rollercoaster decade from hell, long-term investors are being gifted an opportunity to exit at somewhere near 'break-even' - and they're beginning to take it.



Lately, investors have been cashing out of American stocks and piling in to bonds.


You might imagine that most ordinary investors, having watched markets rocket since March, would be scrambling to get in.  But the data tells us that money is instead exiting the market at a steady pace.  This is a fascinating development, and has started alarm bells ringing with a number of savvy analysts.  This is because quite simply, markets need more and more ordinary investors to pile in as prices rise in order to sustain their advance. Usually this happens gradually as stocks come off a low point. Not this time. As David Rosenberg, widely respected former Chief Economist at Merrill Lynch recently noted:



And remarkably, he goes on to say:



To my knowledge this is the first time a senior working economist, whose opinions are highly influential, has publicly recognized the critical importance of demographics to our economic future.  Of course, dear reader, you've been suffering my rants on this subject for a year now but it's becoming increasingly clear to those who are prepared to look: ageing baby-boomers are not going to risk their retirement savings in stock markets which have, twice in a decade, left them badly burned.  

Not only that, money-managers investing on behalf of pension funds and unit trusts are starting to run out of cash.

Having been left flat-footed as markets turned and soared, they quickly jumped back in to try and grab some gains. But now their cash reserves, a major part of what fuels market rallies, are actually starting to run dry.




When this rare signal has been triggered in the past, looking back 60 years, it has always been a death sentence for a rally.  The turning point is not necessarily immediate.  The market can stagger higher for several months, but it's a clear warning that the fuel indicator for stocks is flickering red.

There are also some disturbing signs from other technical indicators that a correction of some kind is in the offing.  It's probable that this will be a modest pull-back in the rally rather than the beginning of a big move down, but given the bigger picture we can't be certain.  So here's the summary:



ONE TO TWO MONTHS


If you're thinking of investing new money into stocks, you should wait for a pull-back.  Technical signs are clear that indexes are ready for a pause, and there is a growing risk of a more substantial decline.  The FTSE 100 will begin to become interesting around 5100 but could go as low as 4950; the Dow is worth a nibble below 10,100 although a drop to 9800 is possible.  Even if stocks push a little higher in the next few weeks, don't be tempted to jump in - a fall is coming. 
 
 
THREE TO TWELVE MONTHS
 
 

Once the correction has run its course, I'd be reasonably confident of another attempt to push higher.  Despite the increasing headwinds, this may succeed and force the indexes to new highs.  The next technical targets for the FTSE range from 5500 - 6000; for the Dow, 11,000 - 11,250.  Beyond that, we find ourselves in rarified air.
 
 
ONE TO THREE YEARS


Investing any money now on this kind of timeframe is fraught with danger, for all the reasons I've previously given.  Over twenty years or more there's little doubt you'll come out ahead, but in any case it would be far, far better to wait for the next major downdraft to hit before committing any funds long term.  A plunge back towards the lows back in March is a real possibility considering all the risks and the above market precedents. 
 
In the meantime, I continue to suggest a strategy of gradually taking your money off the table as we rise through the target levels mentioned, combined perhaps with taking out other forms of protection like warrants or options.  Check this link for comprehensive advice.  It's also possible to buy unit trusts and Exchange-traded Funds (ETFs) which profit as the market falls.  Adding these to your portfolio when the market is about to pull back can protect your profits whilst you decide whether or not to sell your investments longer term.
 
Pension holders, consider switching a portion of the funds your pension currently has in stocks, into cash.  Most pension funds will allow you to do this.  If yours does not, consider as a matter of some urgency transferring it to one which does, or into a SIPP - a self-invested personal pension - which enables you to take more control of your investment decisions.  How will you feel if, having been aware of the risks, stocks fall substantially and you cannot protect your pension?


                   ----------------------------------


Right, that's quite enough about keeping it, I'm off to spend it.  Time to spread a little Christmas cheer to the good shopkeepers of Oxford St.  That's your lot for 2009; next month's fun-packed blog and Investment Outlook will appear, hangover permitting, on January 3rd 2010.  Until then, goodnight, good luck, have a wonderful holiday and as the blessed Dave Allen used to say, may your God go with you!
 
 

Sunday 6 December 2009

WHY THIS TIME REALLY IS DIFFERENT




"The four most dangerous words in investing are
'this time it's different'."
Sir John Templeton,
founder, Templeton Asset Management



"This time it's different!"


Those four little words have rung out like bells at the peak of some of the greatest booms in world economic history. Investors, in delirium as their stocks and property prices skyrocket, persuade themselves that a new day in economic history has dawned.


This time (they rationalize), something has fundamentally changed to keep prices from falling. "Those tulip bulbs aren't just flowers you fool, they're priceless!" (tulip mania 1600s); "the South Sea Company has a monopoly on New World trade - don't you understand? This time is different!" (South Sea Bubble 1700s); "Rails / oil / gold are the path to certain riches!" (1800s); "automobiles will change the world!"  (1900s); "stocks can never go down!" (1920s); "Japan, Land of the Rising Sun, will rise forever!" (1980s); "internet stocks are taking us to a new paradigm!" (1990s); "house prices will always go up!" (2000s); "unstoppable China will overtake America!" (to be concluded)...


You get the picture. Each time, markets go pop, bankers jump from windows and ordinary folk get shafted as the economy plays out yet another saga of boom and bust. But now, with 2009 drawing to a close and our economic near-death experience a fading memory, we seem to be on the way back. The story of the great banking panic is today's chip-wrapper and the recession is technically all but over.  Governments and greybeards step forth to proclaim that the worst is behind us.


In the aftermath of every recession in living memory, capitalist economies have always come roaring back. So if history is any guide, aren't we entitled to start breathing a sigh of relief? Aren't I being way too gloomy? Can't we say this thing is over?


I say, it's only just begun.


I realize that from where we now sit this is both an outlandish and a thoroughly unpopular view. So what evidence do I, a scruffy know-nothing actor, have to suggest that this time is different from anything seen in the annals of modern economic history?



----------------------------



THE THREE 'D'GREES - 
DEBT, DEFLATION AND DEMOGRAPHICS

You may raise an eyebrow at the sub-heading of my blog.  A 'depression'?  To western minds, cuccooned in the comforts of modern life, the idea is inconceivable.  But the truth is that the last 30 years, which is for most of us our only economic reference point, is an anomaly. In historical terms its near-vertical ascent is almost a freak occurence.  Right up until the middle of the 20th century, major slumps and savage stock declines were a regular feature of economic life.


Without central banks or government intervention on any scale, market economies were left to their own devices and often over-heated during boom periods; these purple patches were then followed by downturns and depressions which could last decades.


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So, unless one believes that for some reason a depression is impossible (if so, please re-read 'this time is different', above), the fact that we came perilously close in 2008 should lead one to consider whether the circumstances which led to previous slumps are actually in place, in our own time.  Let's take a look.

DEBT - 
PORK BELLY, PULP FICTION

Tried the new Kit-Kat Chunky Caramel?  I can promise you this: if you're ever feeling low, if you're sagging badly or in low-carb hell, one of those choc-slathered beauties will get you through. I can also promise you that, packing a total of up to 543 calories per sitting, an addiction to these is your fastest way to a pork belly future.


Developing one certainly won't take you twenty five years, which is how long it took the world's most advanced economies to develop a creeping, blooming then ultimately raging addiction to debt. 






Now I'm not a debt fascist. As long as you're sensible, the strategic use of other people's money can turbo-charge your investment returns. 


Like that mid-morning injection of sugar, credit gives your cash an instant boost, levering up its investment power. From the largest corporation negotiating a 'leveraged buyout' to the littlest guy on the street buying a couch on his credit card, its impact was essentially the same: spending and investment soared, each boosting the other, creating a self-reinforcing upward spiral.




Over time, financial institutions used debt more and more extravagantly in their investments (and called it leverage, a way to describe borrowing which makes debt sound intrinsically good).


Leverage of 10 to 1, 20 to 1 or even 50 to 1 (ie. borrowing 50 times your own capital to invest) became de rigeur, allowing banks to trade more and higher-value assets while risking, they thought, less of their own money. Private-equity firms used the same trick to gobble up businesses, property companies used it to scoop up large areas of land and commercial property and most importantly of all, of course, ordinary Joes and Josephines used it to buy the biggest investments of their lives - their own homes.



Without higher leverage in the mortgage business - allowing Joe to borrow five or six times his income instead of the boring old standard of two-and-a-half to three times, or allowing 'teaser' rates and 'NINJA' mortgages which were certain to self-destruct - lenders would have made fewer loans and risked falling behind their competitors. And banks would have had fewer loans to securitize and sell on, castrating their own profits.



[Jargon-watch: securitization was the process of packaging up loans and selling them on to other institutions. By doing this the seller got an instant cash return, while the buyer received a steady income from the mortgage repayments. Banks also believed that by tarting up and selling on any dodgy loans they made, they could shuffle off the risks].



Thus, the indiscriminate use of legitimate investment techniques, coupled with low interest rates, useless regulators, an increasingly reckless attitude to risk and all-out hubris and greed at virtually every level, allowed debt to build up in our economy like countless layers of fat on the proverbial middle-aged waistline.







Now, carrying a little spare tyre is, some might say, reassuring evidence we're getting richer. And certainly, as long as you are otherwise healthy and active enough to work off the excess, a slight softness in the tummy is not necessarily anything to be concerned about.


The problem comes when you can't see your own feet - or feel the solid ground beneath them. When the fat starts to become a drag on your lifestyle. When you start ditching the aerobics for sofaerobics, it's time to quit the pies.   When you're a junkie taking more and more of your chosen jolly to produce the same effect, it's time for cold turkey.  Continue to ignore doctor's advice and bingeing will turn to pigging, snorting to intravenous injection. 



Then you'll have a coronary.




US BANKING INDEX 1999 - 2009



By 2007, the advanced world's economy was the equivalent of a drug- addled two-ton tessie. Large banks had become behemoths which, through the seductive and mutually-delusional practice of securitization, encouraged their leaner cousins all over the world to shoot up from the same filthy syringe they were using themselves.  Between summer 2007 and mid-2008 our economy suffered periodic blackouts as doctors argued over the prescription and diagnosis. Finally, in September '08, hit by palpitations, high blood pressure and blocked arteries, it OD'd.






If you've ever watched Tarantino's Pulp Fiction you'll know what happened next.  If not, brace yourself and click on the link underlined.  For Travolta and Stoltz, substitute Bush, Bernanke or whichever headless chicken in power you prefer.



Confronted with the prospect of an apocalyptic depression - and yes, that really is what we were facing - governments across the world essentially stabbed their economies in the heart with a syringe full of monetary adrenaline.  Having taken the shot, the patient sat bolt upright, became lucid and started crawling back on its feet.  



Fast forward a few months and, to the uninitiated, it might seem that the patient has been cured.  But what if only the symptoms, not the causes, have been treated?  If the mounds of constricting fat, the deterioration of internal organs and the crazed addictions remain, the eventual outcome is not in doubt.  As any doctor will tell you, it's not a question of if but when the patient suffers another poleaxing failure.



We will then have a straightforward choice of alternatives: cold turkey, calorie constriction & fat extraction - or death.



The problem ( with projections after 2009)




DEFLATION - THE BLACK HOLE THAT SUCKS


To appreciate the scale of our problem, then, we need to acknowledge the extreme debt at its source.  And if debt was the source, it's plain that more debt cannot be the solution.  Government spending and bailouts certainly help contain the damage, but they also transfer vast losses and massive risks from them (profligate banks) to us (the cash-strapped taxpayer) and serve to put off the true day of reckoning.  Unfortunately there is only one solution to the central problem itself. 


Destroy the debt.


In the real world this is already well underway, though it's currently most evident in sectors of the economy such as property and finance where defaults, write-offs and loan restructurings are happening every day.  For a breathtaking picture of the scale and breadth of the problem, check this article in last weekend's Sunday Times. 


Debt destruction can hit the mainstream economy too, as a symptom of deflation.  As the name suggests, deflation is the hideous twin sibling of a phenomenon we know all about. 


With inflation, too much money chases too few goods and prices tick upwards.  Deflation shows precisely the opposite dynamics: too little money, too many goods, prices drop.  House prices drop. Stock prices drop. Wages drop.  The price of everyday goods and services drops. 


But hang on - deflation?  Isn't there supposed to be a gathering fear of inflation?  Aren't we being told that money is being spewed from central Bank printing presses like sewage from a pipe?  Ah, but there's the rub.



US Monetary base doubles in a year...


With interest rates already floored and the economy still in the tank, our central banks needed a way to get yet more money into the system.  But instead of channelling it into the hands of consumers directly, they decided the most efficient way to get things moving again was to stuff cash into the hands of the commercial banks and encourage them to lend it to worthy borrowers.


So the Bank of England, the Fed and others have been buying up billions in assets, bonds and securities directly from commercial banks.  These now sit on central banks' books.


A good day's shopping for Ben Bernanke


Then, instead of printing actual notes to pay them with, central banks create that money electronically and place it in reserves for the commercial banks to draw upon.  The theory being that RBS, HSBC, Bank of America et al would then go out and lend, putting all that central bank largesse to good use.


But they didn't. 
They haven't. 
And they won't.


Excess US bank reserves - the cash ain't shifting



No matter what they say publicly or how they try to spin it, the fact is that banks aren't lending.



In fact they're lending less...




Why?  Well perhaps the banks are smarter than we give them credit for.  Perhaps they know that, with all those toxic loans still sitting on their books (yes, they're still there), this thing might not be over.  Perhaps they know they will have hundreds of billions in losses to take over the next decade and they're hoarding like squirrels.  


Whatever the reason, they're becoming stingier in every department.  In commercial and industrial loans, certainly, but also consumer loans and credit cards...



What's clear from this is not only the scale of the bust
but the stupendous boom which preceded it


The result is less money in consumer's pockets.  Eventually that feeds through into the Consumer Price Index, which shows the first deflation in US consumer prices for more than fifty years.  The UK Retail Price Index has also shown Britain to be in deflation since April.






What happens next is the kicker.  Like its better known sibling, deflation soon stops being a purely monetary phenomenon and human psychology takes over.  Instead of 'inflation expectations' setting in, when people rush to the shops to buy things today fearing that the price will go up tomorrow (as with house prices before 2008, gas and petrol prices in early 2008, and of course, Zimbabwe), deflation expectations set in.


People sit on their hands and wait for prices to fall. They don't spend until the sales begin. They scour the internet for an even cheaper deal. They buy less of a particular item than they did last week, because next week it will probably have dropped in price... and so on. The result is that money circulation slows, prices fall, businesses can't pay their debts and go under, unemployment rises, spending drops, prices fall... and lo, we drop into a vortex.


This isn't dry theory.  Deflation - not inflation - was the regular threat in western economies right up until the mid-20th century.  It devastated businesses in the Great Depression and is currently doing so in Japan, as it has done, on and off, for the past twenty years. 


Without a pick up in bank lending, this will be our fate too.



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So far we've seen how a massive rise in and dependence upon debt by both businesses and consumers over decades led us inexorably towards a brush with economic catastrophe.  Debt - or rather the sudden inability to repay it - triggered the Great Depression and the Japanese 'Lost Decade' of the 1990s, as well as sparking numerous smaller banking panics over the past eighty years.

In both those two most serious cases, deflation was the distinctive common characteristic.  In our situation, conditions once again appear ripe for deflation.

But there is one more major player in this drama, rarely discussed, barely acknowledged, yet set to play a pivotal role in what may become an epic generational saga.





DEMOGRAPHICS -
THE EIGHTY YEAR FLOOD






Much coverage was recently given to some terrible floods in Cumbria, in the north of England.  They had a devastating effect not only on hundreds of lives but on many of its venerable old bridges. A number were swept away and even the sturdiest structures were discovered to be at risk. Yet it was reported that engineers found it difficult to calculate which were in greatest danger due to one hidden factor. 


What often causes a collapse is not the effect of fast-flowing water on the brickwork, but the erosion of the base soil on which it stands. Whilst the masonry above can stay strong, the rushing water works away invisibly below, eating away at the river bed and destabilizing the bridge from beneath until it falls under its own weight.


Demographic ageing in our economy is, in effect, the erosion of the soil on which we stand. 


We know that consumer spending is essential to our prospects of recovery.  It contributes 66% - 70% of our national income.  But what the study of demographics reveals is that how much people spend depends very much on their age and stage of life.





Incomes have risen in real terms over the past forty years, yet the relative level of incomes between the different age groups has remained largely the same.  Those under 34 earn least in our society, while the clear cut winners are those between 45 and 54, who earn almost 50% more.


Not only do they take home a whole lot more, they then spend it on goods and services which, in the great economic scheme of things, really matter.  Houses, cars, appliances, financial products, not to mention feeding and clothing their burgeoning families.  Those big-ticket items have the greatest 'multiplier' effect on other industries, creating jobs and incomes for millions in back offices and feeder factories across the world.  These items are also, unfortunately, the ones most reliant on the supply of credit.






The huge bulge in the above chart represents the largest generation in history - the baby-boomers born in America between 1945 and 1961.  This boom in births was a true worldwide phenomenon, repeating in almost every western country to some degree or other, and those lucky guys and gals now form an unusually large proportion of the population.   



Source: Prof. E. Philip Davis, Brunel University, 2003

Note how middle aged Japanese baby boomers peaked in number around 1990.  That is when their bubble burst, as ours is doing now around 2010.



But the boomer generation is rapidly heading into advanced middle age; most are now at or beyond their natural peak-spending period which occurs, on average, between the ages of 46 - 50.  According to statistics from the Consumer Survey, from here on in the amount we spend is due to begin a long natural decline. 


This drop in spending is not a result of having less income (income holds up well into one's fifties), it's almost entirely a result of a change in needs, attitudes and circumstances as we age.  After all, this is the time when older kids are beginning to leave home and are becoming less of a daily drain on the bank of mum and dad. We up-size from two to three to four bedrooms as babies pop out, but once that's done, average home buying peaks. Result: a plateau in home-related expenditures around age 45. 


Also, once you hit your late forties, retirement no longer seems a lifetime away - so a hard look into meagre pension pots focuses many people's minds, encouraging thrift and greater saving.  Spending less begins to seem like a smart move.




Couple all these motivators with a shocking downturn in the economy, a vertical drop in home prices and well-warranted uncertainty about the job situation and you have all the ingredients of a full-scale consumer spending retrenchment.

In fact, if the theory is correct, an economy dependent on consumer spending should boom when these middle-aged spenders grow in number, and contract when their numbers fall or when they suddenly zip up their wallets.  Checking the stock market should give us a clue...






Shift the birth index forward 48 years to represent an approximate peak in consumer spending and its remarkable correlation with the stock market becomes clear. 



                             -------------------------------



BOFFINS IN SHOCK AS 
ACADEMIC RESEARCH BACKS UP COMMON SENSE



It therefore appears possible that, by identifying peaks and troughs in the population of consumer-led societies, major economic turns and market movements can be foreseen years, if not decades ahead.  In this regard the record of demographic forecasting in predicting stock market turning points has an unblemished record of success.  Yet many economists have remained airily dismissive since it was first seriously formulated by HS Dent back in the late 1980s. 


Perhaps the fact that the theory is instantly graspable by ordinary people doesn't help.  Economics is a profession which respects complexity, not simplicity.  In fact, the mystique of economic complexity is what keeps most economists in business (despite their abject failure to come up with accurate forecasts) and keeps the rest of us in the dark.  This leads us in turn to distrust our own common sense:  "It's blindingly obvious...so it can't be true."


Some academics however, unfazed, have zeroed in on the potential correlation between population ageing and the stock market and after analyzing it in various ways, have come to a most remarkable conclusion.


In a 2002 Yale discussion paper entitled 'Demography and the long run predictability of the stock market', researchers looked at whether the fact that people sell their financial assets later in life to boost their income has historically had a predictive effect on the stock market.  They concluded:



For the sake of your own eyesight, please click on the link!



The following year, E. Philip Davis, economics and finance professor at Brunel University, conducted an exhaustive study entitled 'Demographics and financial asset prices in the industrialized economies'. The paper was the most comprehensive look to date at the evidence on the impact of population structure on investment returns and no paper since has disputed its findings.


After a thorough review of all the prior available research and rigorous statistical tests on data from advanced economies across the world, this was how, in the somewhat arid language of statistical academia, he summarized his view:





When Prof. Davis ran his model in 2003 to get its prediction of the market's future direction, this is what came out:





What is alarming about this is not only that the Davis model predictions after 2003 were broadly accurate, but that his forecast for the market over the next fifteen years is frankly apocalyptic.



                         -------------------------------


YES, THIS TIME REALLY IS DIFFERENT



That we're in for a difficult journey, even most optimists would admit.


But if we have money at risk I think we owe it to ourselves to be neither optimistic nor pessimistic, but realistic.  In normal times it almost always pays to look on the bright side.  But the rare and raw headwinds we face now are so strong and the potential risks to our investments so great, that blithe self-assurances of better times ahead just don't cut it.


The monumental debts we've built up can only be sustained whilst we can keep up the repayments.  We've now reached a point where increasingly, individuals, businesses and whole nations are simply unable to pay their debts




Rising loan defaults, delinquencies, bankruptcies and home reposessions are the inevitable consequence.  Governments everywhere, up to their eyes in it, are already plotting tax rises for the likes of you and me in order to service their debt.  Thus, in extracting money from our pockets, they reduce our ability to spend as consumers and add to downward pressure on the economy.


Deflation is therefore baked in to our future.  But that bullet could be dodged in the short term, so let's instead assume modest inflation and a rise in interest rates.  The result?  Even a small rise would mean that many individuals and businesses already struggling with their debts would be hit with substantially higher payments and once more begin to default.  Banks would have to take the hit and would cut lending further, sending us ultimately back towards...deflation.  This was the Japanese experience of the 1990s.


And even if we were to dodge both inflationary and deflationary bullets, a demographically-induced downturn in consumer spending will take hold over the next several years leading economies to weaken to a point where, again, it will be impossible for those debt payments to be serviced.  Banks, governments and ordinary people are all at risk in the potential fallout.



BREAKING NEWS:
END OF WORLD NOT NIGH



In making the case for an extended downturn it may seem that I am predicting some kind of apocalypse.  But a drop into the chasm of doom is unlikely.  What's more plausible is that this process will be extremely drawn out, featuring numerous bouts of optimism and recovery (as now) punctuated by violent setbacks.  I believe that the overall effect will be for stock markets to slide and/or zig-zag sideways, for many years. 

So we should avoid Armageddon...which'll be nice. But avoiding the devastating effect of big market swings on a pension and other investments will require a bit more work.  By taking some simple steps however you, dear reader, having become fully aware of the risks, should be able to remove your finances from the path of the oncoming storm.


It's possible of course that the analysis presented here is wrong.  But if you have money in markets I'd suggest that, since the likely cost of it being wrong is small compared to the potentially devastating cost to you if it's right, you should take steps to protect yourself.


That's why, next weekend, Sunday 13th December, I'll post an Investment Outlook with some practical ideas on how to keep your savings and investments growing yet secure over the next several months, as we begin to navigate the murkier and far choppier waters of 2010.


Your next On the Money will be posted on Sunday 3rd January.  Thanks for reading and have a great month!








PS.  Due to poor signposting on my part, some friends missed my October Investment Outlook.  No excuse now!




Tuesday 20 October 2009

WELCOME TO ON THE MONEY









In fall 2008, as I watched the stock market move steadily towards its date with destiny, I had what could be described as a moment of clarity - or perhaps more accurately, a rush of blood to the head. Witnessing Lehman Brothers' bowel-emptying demise, I decided to write a long financial missive to colleagues, friends and family. Let me tell you why.


In 2002 I had become strangely confident of two things. First, that the economy, house prices and stock markets would boom for several more years; second, that the bubble would burst spectacularly towards the end of the decade and lead to an historic, even epochal, long-term bust.


I soon told family, friends and anyone I thought might be interested. I pronounced to all and sundry that the coming downturn would be no ordinary recession but a huge downdraft in which the value of many people's pensions, investments and property would be devastated. I distinctly remember in 2003 instructing one friend to sell his house in 2008.


You can imagine his response. Most of my victims tended to nod politely, stare at the floor or look at me askance, the unspoken question being: 'but you're just an actor, what makes you think you could you possibly know all this?'


Sadly I have no special powers. I had simply stumbled upon an economic theory - based on academic research, economic logic and plain common sense - which claimed to be able to forecast booms and busts in our economy decades in advance. The very idea that this might be possible is met with almost universal disbelief. But rigorous statistical analysis and successful real-time forecasts over 20 years suggest that it might not be such a crackpot notion, as future posts here will show.


The theory's forecast since its inception in the late '80s had been that we were entering the greatest economic boom in history.  It would be founded on technological and financial innovation, powered by the spending of the baby boom generation, and would end - not unlike the 1920s - with a bubble, which would burst around 2008.


This was one of only three long-term forecasts made since it was first published in 1989. Each has proved stunningly accurate.


It suggests that what we've dubbed the 'credit crunch' is merely the opening chapter in a full-length saga of recession, crisis and decline - a saga which will last another ten to fifteen years. Considering the potentially crippling financial fallout how could I, in all conscience, shore up my own finances yet make no effort to inform or warn my colleagues, friends and family?


So I wrote a report.


If you've not yet read it, feel free to download it from the above link (right-click and select 'save target as').


The tone was unapologetically alarmist. I suggested that we were flying into an economic Bermuda triangle, a once-in-a-lifetime financial storm which would not abate until the next decade is out.


I described in detail the reasons for my sombre view and how unprepared investors, pension-holders and home-owners who failed to protect themselves could see their wealth sucked into a financial black hole. I tried to show the risks of inaction, but also the numerous ways it should be possible to survive unscathed and even prosper, in this treacherous financial climate.













If I were proved correct we could expect to see some wild swings in share prices so, naturally, over the years I looked for ways in which I could profit. Having carefully studied investment and trading techniques, learned from my numerous mistakes and eventually made money, I had become just smart enough by the time the downturn struck to feel I could offer a little constructive advice to anyone who asked.


One or two friends did.  Then, when it came time to send out my January report, I needed to show that my thoughts were based on something more than hot air. After all, I'm not a qualified financial advisor, I have no experience in the City and am not and never will be a 'banker'.


So I attached a year's worth of investment advice I had emailed to a friend, overlaid on a chart of the FTSE 100 index. This made it possible to see whether, between late 2007 when the storm was gathering and late 2008 when we were still hiding in bunkers (and my correspondence ended), I had had anything worthwhile to say.


It turned out that I did.




After my report went out in January 2009 there was an initial (no doubt embarrassed) silence, followed by a period in which my forecasts began to play out. In the spring, I sent a couple of updates to those who had expressed an interest. In the first on 4th March - two days before free-falling stock markets finally bottomed - I described a bullish scenario which I saw as increasingly likely:


...'the major indicies could rally in excess of 30%. The Dow would hit its target of 10,000 in the second half of this year...technical conditions here are definitely ripe for a substantial rally'.




Markets turned up violently two days later and never looked back. On 2nd April I sent out a postscript:


'Making definitive predictions in the short and medium term is fraught with danger. But there is one I can make with a high degree of confidence today. A SIGNIFICANT STOCK MARKET RECOVERY IS UNDERWAY. The US markets have gained over 20%...the chances of a further advance of at least 20% from our current levels are high'.




Between that email and the date of today's writing, the Dow Jones has broken 10,000 and risen a further 25%.
















Over the last few months, then, I've increasingly found myself being asked for an opinion on the state of the economy, the markets and on what twists and turns might lie ahead. These twists can be sometimes be predicted, and the market turns can be tempting to take. But without a reliable map of the whole terrain it's all too easy to get lost.


In fact offering ad hoc advice in an environment which is constantly shifting and uniquely dangerous is a job for a full-time financial advisor which, of course, I have no interest in becoming.


Eventually it dawned on me that I could set up a blog.





Here, in this little black & white corner, I could update friends if need be, ring occasional alarm bells on the market's prospects, unabashedly ride a couple of hobby-horses and share some general investment ideas which have in the past proven to be either lucrative or life-saving. I can also provide links to a few sources I've found genuinely illuminating in this darkened financial landscape.


From now on I'll add new posts the first weekend of each month, with the first post proper being in six weeks time, December 6th.*


If I feel an urgent update coming on I'll post a little more often or, as and when chaos descends, update immediately if I feel I can add any insight. But usually the day-to-day swirls and eddys of financial news are dull and frankly irrelevant in the greater scheme of things.



I shan't waste your time with the kind of guff you could read in the daily business pages; I will try to provide a broader, shrewder, longer-term perspective which could help in the making of your most important financial decisions. 










Today, my view is that we are entering a strange economic netherworld, a kind of halfway house in which we've passed over to the other side, yet everything seems pretty much the same as it did before. Like Bruce Willis wandering through his old neighbourhood in The Sixth Sense, most of us get on with our everyday lives unaware that, from an economic perspective, the world we knew has gone.





Unless you've lost a job or been turned down for a loan, this changed world may have barely impinged, except perhaps as something distantly gleaned from the news.  The reality of our situation may only slowly become apparent, as a hoped-for return to normality stubbornly refuses to materialize, the markets gradually and inexorably roll over and our long economic winter begins to take its icy grip.




Meanwhile, economists and pundits continue to chirp their predictions for a 'V'-shaped recovery in the deluded belief that 2008 was little more than an inconvenient blip.  Among the general public there remains a natural and heroic assumption that, yes, we had a nasty shock last year and we're having a nasty recession but we've had them before, we've beaten them before and they always end the same way - in a bloody good recovery.





'WHY THIS TIME REALLY IS DIFFERENT' will be the subject of my next post in early December.




Meanwhile, thanks for checking in and have a great month!




James Goode, October 2009








*Ed. note: this missive was originally posted in 2009.  Now, new updates are posted as events warrant and on an ad hoc basis.  To avoid missing any urgent updates, please subscribe via email or follow me on Twitter, using the links top right.