OCTOBER 09 Investment Outlook

Welcome to Investment Outlook, which will appear as a monthly feature on this blog.  


In this space I hope to serve up regular brain-food on the practicalities of making and keeping your money, along with a run down of the markets and what I'm expecting to see play out over the next several months.


It will reflect my current thinking about my own personal finances and is not intended (yes, I'm getting my disclaimer in early) to represent personal investment advice nor is it an exhortation to buy or sell any particular financial instrument or product.  The value of any investments you may make can go down as well as up.  Thankyou. 


In this bumper issue, I think I should first fill you in on my basic approach.

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RISK, REWARD AND THE SECRET OF GREAT COMEDY

Your money is always at risk.  As we've discovered, even when your hard-earned is sitting safely in the bank, it's not safe.  Greedy people can do stupid things when they're allowed to and sometimes with your money, as investors and depositors at RBS, Northern Rock and those wretched Icelandic banks discovered.


Outliers notwithstanding, there's usually a direct correlation between the amount of risk you take with any investment and your potential return, eg. bank deposits = safe but boringly low rates of return, stocks = vast potential gains but vastly heightened risks of loss.


So here's the simple question which needs to be asked wherever, whenever and with whomsoever you decide to park your money: 


Is the potential reward I'm being offered greater than the risk I'm taking? 


It seems an obvious question, and sometimes the answer is obvious.  But very often it's not.  Sometimes it seems obvious when it absolutely and categorically is not.  After fifty years of consistently rising residential home values, many US banks - and this is actually true - calculated their mortgage lending strategies on the assumption that house prices could never go down. 


They miscalculated.


So, unless you're a millionaire and can afford to lose more than one shirt, you'll want to do your research and understand exactly what you're getting yourself into.  You'll need to find a way to quantify the risk you're taking.  You'll need to identify an exit strategy if you're wrong.  Then, by investing only when you believe the risks are substantially less than your potential rewards, you'll stack the odds firmly in your favour. 


This is something all successful investors habitually do.  It's built in to Warren Buffett's* investing world-view and methodology.  And it's something we're actually hard-wired to be good at, because we do it constantly in almost every other aspect of our lives.



*Warren Buffett is generally acknowledged to be the most successful investor of all time and is regularly listed among the world's two or three richest men.

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Every day, from the moment we step out of our front door, we are subconsciously checking the risks of every little decision we make. Crossing the road, switching lanes on the M40, making or not making that awkward phone call. We constantly reference our past actions and their consequences before deciding whether a decision is more likely to lead to a positive or a negative outcome.


This is wise. When attempting to cross Shepherd's Bush Green, you know there is a small but not insignificant chance of getting creamed by a truck. Would you casually step out into the traffic without looking?  If you have small children would you knowingly leave them within reach of a carving knife or a pot of boiling water? Of course not - you know the risks.


Taking care of your money is no different. Yet many of us blithely sign away control of our pension contributions to unknown beauracrats and computer programs, buy shares on a tip from a friend or plough into the property market on assumptions of inevitable gains. If we don't properly assess and limit our risks, rewards can still come to us through good fortune but, indulged in over time, such a strategy will eventually backfire.


The fact is, we have lived through a unique 25-year period in which market conditions showered rewards on risky behaviour to an unprecedented degree. This orgy of speculative success finally blinded not just bankers but millions of ordinary people to the risks they were taking.


In my view this period has now ended. Some bankers, investors and property-addicts however, never having lived through this type of once-in-a-century tectonic shift and having become conditioned to their high-risk behaviour, are convinced the good times will soon be back.  They're reverting to their old ways and for now stock and property prices are rewarding them. 


BUT IT'S A TRAP. 

If it didn't pay before, it will now pay big-time to know and limit your risks. Check this chart of the UK FTSE 100 since 1996.

(click to enlarge)

Look at those beautiful great hillocks.  Alas, not so beautiful if you're an 'average long-term investor'.  Over the last decade there are pitifully few long-term investors in stocks who can honestly say they made a brass farthing on their money.  We all bemoan the low rates on offer in our bank accounts, but if 'average long-term investor' had left his cash in a bog-standard savings account earning 5% per year over that period he'd not be doing any bemoaning now. 


And consider this: if he'd been in stocks until the peak in 2000, in cash savings until the low in 2002, back in stocks until 2007 then out until the recent trough in spring '09, he might now be floating on a yacht in the Bahamas...

THE SECRET OF GREAT... RISK MANAGEMENT

"But", you protest, "don't be ridiculous.  The market is a lottery.  How could anyone possibly have timed those peaks and troughs so perfectly?"  The answer is that, by knowing precisely what signs to look for, you most certainly could have.

(click to enlarge)

This is one of the tools I use to keep myself out of trouble.  It is a rough and ready but extremely effective measure of investors' appetite for risk. 


The red line represents the value of the US Semiconductor Index divided by the Japanese Yen.  One is a leading indicator of risk appetite (semiconductor chips being at the leading edge of technology innovation), the latter a reliable leading indicator of risk-aversion (call it fear) over the last several decades. 


In other words, when the line is rising, it indicates that the world's investors are feeling confident enough to seek a decent return on their cash and are willing to bet on stocks; when it's falling investors are getting nervous, bailing out and scuttling back to their safe-rooms to count their money (which many prefer to do in the perceived security of the Yen).  This relationship has held over two decades and, until, better measures of risk appetite appear, it will continue to be instructive.


The grey line in the background is the US S&P500 index over the same timeframe for comparison.  The yellow and green lines in the chart are moving averages of the indicator, which give a smoother picture of its overall trend.  As you can see, selling when the line drops below its moving averages might have saved you not only several sleepless nights, but a whole shed-load of cash.


There are many more (and more sophisticated) indicators I use to stop myself doing stupid things, but this is just to give you an idea of what's possible.  (FWIW, my risk-aversion indicator has now issued a sell signal, but is attempting a comeback.  Will update shortly if needed... Ed. 6th Nov)

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THE SECRET OF GREAT... ECONOMIC POLICY

My message then is that unless you're a very young buck, can hold your stock investments for a lifetime and ride out the storms, you'll need to be sure you're not piling in at the top of big bull markets or bailing out at the bottom of horrid bear markets.   For example...

...you'll need to be sure you're not doing a Gordon.  Yes I'm talking about our great, wise and smiling Leader, who as Chancellor of the Exchequer committed one of the most heinous crimes in British investment history and sold our gold deposits at the absolute trough of the bullion market in 1999.  The metal has subsequently quadrupled in value.  Hmm... 

And you'll need to be even more sure you're not doing a Herbert.  Yes, I'm talking about the sadly un-lamented President H. Hoover who, as stocks surged 50% after the initial Wall St crash in '29, met a delegation pleading for more government spending programs.  "Gentlemen", he pronounced, "you have come sixty days too late.  The depression is over."  Here, illustrated by a chart of the Dow, is what happened next.

(click to enlarge)

Proof once again that the secret of great comedy is...

TIMING

Now, I don't yet believe we're in for a trip as bad as they took in the early 30s, but we very well could be approaching a peak over the next few months which will cap the market (and therefore your investment and pension returns) for many years.  If this is correct, savvy investors need to find a way to protect themselves from what could be another savage blow to their long-term financial health.


The problem now for Cassandras like me is that our message is thoroughly unpopular.  I mean, who wants to hear that things are going to get worse?  Statistically, we are (almost) out of recession.  We appear to be turning the corner, we're seemingly on the road to recovery.  Sure, we can expect to encounter the odd pothole but, say pundits, from a valley this deep the only way is up. 


For those who can't see over, it's tempting to simply extrapolate this upward trend into the future and breathe a sigh of relief.  But the example of poor President Hoover shows how an intelligent person can, by following consensus opinion, extrapolating present trends and falling prey to their own hopes and fears, unwittingly put their entire financial future in jeopardy.  

LEMMINGS LOVE COMPANY

It turns out then that successful investing can be a lonely business, because the ones who are most successful very often find themselves in head-on conflict with the consensus view.  But the fact is that it's impossible to beat the market by following the crowd.  Why?  Because most people will, by definition, be buying near the peak of a boom and selling near the bottom of a bust.   


When almost everyone who is going to buy has bought, prices must fall; and when every poor sod desperate to sell has sold, prices must rise.  That's the beautiful yet terrifying logic of supply and demand.  Here, as an illustration of the inevitability of this phenomenon, is the cycle of greed and fear on which it feeds:

(click to enlarge)

I suggest we reached the 'delusional' phase by 2007 and that we are now writing the chapter entitled 'Return to Normal'.


So when the trend, whichever way it's going, is approaching a climax, savvy investors want to be opposing the crowd, not trying to gatecrash the fag end of the party / join in the fire-sale.  Emotionally this is often extremely difficult because one is prey to either greed or denial, delusion or despair depending on the stage of the cycle (see illustration) and it's why I've learned to rely on objective indicators to tell me if and when the herd is getting too pessimistic, too optimistic or stampeding right over the edge of a cliff.

THE HILL OF DOOM

Back in January I originally envisioned that this entire bear market in stocks - which was shaping up to be a three-phased sequence of major crash - huge rally - major crash, would be complete either by now or shortly hereafter.  But the waves of price movement, both downward and upward, have been far more violent and protracted than in any of the comparison periods I studied. 


This suggests either that we have a monumental down-leg in stocks yet to come, or that there'll be a 'bouncing ball' effect, in which we bump along the bottom for many years, unable to regain the highs of 2007 yet still not breaking down through the lows set back in March. 


Either scenario, from a pension-holder or long-term investor's standpoint, is strikingly bad news.  The good news however is that, with a little care, it will be possible to follow a profitable investment strategy which trumps the market whether it zig-zags sideways or swirls back down the plughole. 


Here is the generalized outlook for the Dow I still think most likely to play out and which I first presented in my April '09 update:

(click to enlarge)

 And here is a recent snapshot:

(click to enlarge)

As you can see we have witnessed a huge rally since March, lifting the Dow into the range I identified as likely to mark a peak.  The three horizontal purple lines are important technical levels traders watch, indicating how much of the previous decline this rally has retraced. 

Since taking this snapshot, the Dow has breached 10,000 and is closing in on the centre line, a 50% retracement of its losses since 2007.  More and more investors are being suckered back into the market by incessantly rising prices, blind to the fundamental weaknesses which threaten to drag this economy back down in the longer term. 

In December's update I'll attempt to justify my less-than-joyful prognostication while offering up a festive smorgasbord of sanctuaries for your investments in 2010. 

Whilst you wait breathlessly for that, a further gain of between 5% - 15% over the next several months is quite possible as our phantom recovery - or what I prefer to call the Night of the Living Dead - summons battered investors and clapped-out consumers from their graves for one last hurrah.

If you have money in shares, directly or through a pension, this monster rally is truly a gift from the investment gods.  Enjoy - in 2010 I fully expect the monster to bite back.   Contrary to consensus views of gradually accelerating growth or a 'V'-shaped rebound, I believe that our economic ship is holed below the waterline and that risks are therefore not decreasing as the market soars, they are increasing. 

That's why cautious investors and pension-holders would be wise to consider steadily reducing their exposure to the stock market at these levels and above.  This may involve gradually shifting any ISAs, IRAs, 401k's, unit trusts or pension holdings out of stocks and into cash reserves and fixed-interest savings (I am currently wary of bonds, which are vulnerable to a sell-off.  Other so-called safe-haven instruments, like gold, are more risky than they appear for reasons I'll go into in next month's blog.)

Holding cash is currently poo-poohed, but when inflation is this low and threatening to turn negative (it's already negative in the US), locking in a risk-free return of 4% - 5% over a couple of years is eminently sensible, even though rates still have room to edge higher over the next few months.  Ideal exit points to start transferring funds would be 1120 to 1230 on the S&P500, 10320 to 11,200 on the Dow, or FTSE 5500 to 6100 - though be warned, we may not make it that far.

STOCK MARKET OUTLOOK

ONE TO TWO MONTHS

Frustrated buying interest and unusually benign conditions for the current US company reporting season mean that stocks have continued to attract new investment.  Technically, though, the market is extremely stretched and liable to give back any short term gains it makes.  This tends to lead to a generally sideways or zig-zagging market in which we could well see sudden plunges followed by lurches higher, and it will be difficult to make money other than with an opportunistic short-term style of trading. 

We may have already hit the final highs for 2009, just below the technically critical level of 1120 on the main US S&P500 index.  I am inclined to think that mark will eventually be hit, though it may not be before the New Year.  Until it does, the chances of an irrecoverable decline leading to long term loss of capital is low.  
  

THREE TO TWELVE MONTHS

The 1120 level - which roughly coincides with Dow 10300 and FTSE 5500 - will likely be a roadblock to the progress of the rally in the short to medium term.  Whether that level will get hit within a couple of weeks or a couple of months is hard to tell.  A deeper sell-off is then probable. Subsequently the market will, if historical precedents hold, make an attempt to regain its highs, offering the nimble a chance to make an opportunistic profit on the way back up. What can't now be known is whether the market will then have the strength to push higher.

Whatever happens, I am confident that consumer spending, the only 'stimulus' able to fuel a sustainable recovery, will become a source of increasing concern as 2010 wears on.  The spectre of a 'double-dip' recession will then loom and, amid growing signs that the recovery is stalling out, investor-vertigo will set in.  This will make stocks, pensions, stocks-and-shares ISAs, IRAs, 401k's  and property investments extremely vulnerable if a stampede for the exits ensues.  Fixed-interest cash (now offering over 5% long-term and edging higher) could, despite the seemingly modest return, be not only the safest but the most profitable place for investors to be from that point on.

ONE TO THREE YEARS

A return to US and European consumer spending growth is essential to our prospects for genuine economic recovery and for stock markets worldwide.  While consumption could show signs of life in the short term, the ageing profile of western consumers, already beginning to tighten their belts and increase their savings, will ensure a steady downward trend in spending over the next decade.  This, combined with continued lending restrictions by banks (which are far from being out of the woods), the steady withdrawal of credit across the economy, periodic deflation and/or interest rate spikes driven by speculation in oil & gas prices, a renewed downturn in housing, public spending cuts by governments, tax rises and  innumerable risks of financial and geopolitical turmoil, means that stock markets will come more and more under pressure over time.

Whether the result is a long steady decline, a hideous crash or a combination of the two is, as yet, impossible to say. 

Given the unprecedented conditions and associated risks, I believe there's only one sensible course: to ride the tiger but be oiled and ready to jump when it starts getting hungry.  By the time this rally is in its terminal stage and panic breaks out, I aim to be sipping cocktails somewhere and watching it unfold on the news.

So, my friends, that's my strategy, and I'll be sharing its progress with you in this column.  Armageddon may have been averted, but we can still look forward to an almighty rollercoaster ride betwixt heaven and hell.

I'll return with a (mercifully shorter) post the weekend of December 6th.

Thanks for reading and have a great month!