Sunday, 7 March 2010

MARCH 2010 Investment Outlook

In this month's On the Money, I presented an eye-opening glimpse into our investment future using a very simple type of technical analysis.  Considering how significant - and imminent - are the potential dangers and opportunities it reveals, let's see what the probable scenarios mean for various types of asset, including an extended section this month on that least-loved investment class, CASH & SAVINGS. 


  • If stocks survive the next one-to-two years then begin to advance, foreshadowing a sustained recovery in the economy, house prices will likely move higher.  That is not, however, the most probable historical scenario - see charts and analysis in this month's On the Money blog.

  • Right now, the UK market is topping out.  Both the Nationwide and Halifax indexes registered falls in February.

  • Our situation is mirrored in the US, where prices and sales are beginning to fall once again

  • US commercial property is on the edge of a cliff - and hundreds of banks are lined up like sitting ducks on the rocks below.  Elizabeth Warren of the Congressional Oversight Panel gives this simple, jargon-free introduction to her recent alarming report:



    • Whether this bubble is set to burst or just pause a while before bubbling up further, now is a perilous time to buy

    • UK gilts remain unattractive: while worries about our government debt increase, bond traders are proving quick to sell as the pound tumbles  

    • I am looking for any large spike in yields in a crisis as a potential opportunity to buy UK gilts for the long term


    • As mentioned here before, it remains all about the US Dollar; amidst the incessant talk of inflation it is creeping deflation that is now taking hold (see Cash below), and a continuation of that trend will see the dollar rise further and commodities in big trouble

    • The dollar now seems vulnerable to a pullback to its 200-day moving average currently around $78.68.  If so, we're likely to get a quick spike higher in GOLD...

    • While OIL could shoot up to $90, not good news for petrol prices or overall energy prices in a cash-strapped economy


    • It's time to take a long hard look at the charts I detailed in my March On the Money post.  I'm posting them here again for your convenience and also include the years from 1947 - 1982 for further comparison:

     Dow Jones 1982 - 2010
    & the Rate of Change

    1947 - 1982
     1920 - 1948

    • Unless a strong burst higher materializes similar to the 1936 example or we find ourselves in a sudden crash scenario a la 1987 (both of which at this point seem unlikely) we will essentially trade sideways for some months; one or two more breaks to a new high are probable before a serious sell-off begins

    • The first of these new highs is close to being hit in the US and has already occured in the UK FTSE100.  We will probably take a few weeks to form a top, then drop back towards the lows we saw in February

    • I've now taken profits in the trade I described last month, which proved remarkably successful and pain-free, and will look to set up an aggressive short trade to take advantage of any coming downswing as and when signs of technical weakness appear. 



    Boy, could an investment class get any uglier?

    If there's one whinge you hear more than any other these days when people talk money it's "my savings rate is crap."

    I know it is, Mrs Pugh.  Banks are laughing in the faces of their customers, offering pitiful rates to those savers who require instant access to their cash (which is of course 99% of us).  With inflation currently ticking up, money sitting in these accounts is actually eroding in value at a steady pace.

    But a few moments spent searching the monesphere - through comparison sites like moneysupermarket and moneysavingexpert in the UK, bankrate in the US - will open up lots of alternatives if you don't mind being a little more crafty and strategic in your search for a decent return. 

    For example, Santander (who now own what were once Abbey and Alliance & Leicester) have just set up an instant access ISA offering a market-busting, virtually-guaranteed-not-to-fall one-year rate of 3.5%.  If there isn't a stampede into this account I'll eat my bonus.

    There are also ways to game the various 'regular savings' accounts which pay a much higher interest rate but on fairly small amounts and with onerous conditions. 

    But this isn't the place to pore over the minutiae of all the various products as you can do that perfectly well yourself and, in any case, rates are constantly changing.    

    However what I can usefully do is suggest a framework for how one might view and use cash and savings as part of an overall financial strategy


    I was unfortunate enough to catch LBC radio presenter and former 'The Apprentice' contestant James Maxx a little while back, cheer-leading the property market on his Sunday finance show.  He chided one nervous listener for daring to consider selling her buy-to-let property. "The question is, where else would you put that money? That's what people need to ask themselves!" he finger-wagged. "You've got to consider the alternatives!" (as if there were none). "If you're just going to put that money in cash", he spat, "aren't you better off leaving it where it is?"

    Oh James, no wonder you didn't win.

    This typifies the complacent and frankly cock-eyed attitude to risk displayed by those who got us into the mess we're now in.  Duh!  Property is not a risk-free investment compared to cash!

    If you buy a house to live in for half-a-lifetime, that's one thing.  But viewed purely as an investment, property is vastly more risky unless you hold for the very long term. It carries the substantial risk of capital depreciation if you time your purchase poorly, and can bankrupt you if you can't keep up your repayments. It is often illiquid (ie. you can't get at the money in your investment if and when you need it, since it's difficult to realize the value immediately even if you're able to sell. And as we saw in late 2008, when the market mood turns it can become very difficult to sell, overnight).

    Cash invested wisely generates a safe, predictable yield which can easily match or exceed that of a rental property, though of course there's no asset appreciation; but when you've seen an historic bubble in property values, which has popped worldwide yet still only barely begun to deflate in the UK, it's only a 24-carat fool who believes the rewards to be had now are sure to be greater than the risks.

    I obviously doesn't mean to suggest that property is always a worse investment than cash - long-term it is of course far superior.  But I'm giving this example of sloppy thinking to illustrate that one always has to compare the risks of investing in an asset with its potential rewards at a particular point in time - and compare it to the alternative of cash.

    So let's do just that.

    Here, courtesy of the Financial Times, are the returns from some popular asset types over the last decade compared to a boring fixed-interest savings account.

    Please click to enlarge

    Smart cookies who got out of stocks and shares in 2000 at the peak of the dot-com bubble and stuffed their wad into fixed-interest savings bonds comfortably outperformed stocks and other liquid asset classes over the past decade, with virtually no risk or analysis and barely a sleepless night. 

    Much of the speculative money which came out of stocks after the dot-com bust in 2000 went into property, helping create a bubble with returns which as we know outstripped everything else.  But unless you believe that, having popped, the property bubble can now be re-inflated (something never before seen in history), could it be that boring old cash will once again triumph over riskier assets in the next decade?  


    After the enormous run up in stocks we've seen in 2009, I believe there is an extremely high probability that

    • cash, invested smartly in fixed-rate savings over the next few months, will trounce stock returns over a one-to-two year period whatever the economic outlook

    That's right: whether my overall opinion about the direction we're heading in is on the money or not, I am very confident you'll be better off in cash.  How can I be so sure?

    Returns of US Dow Jones index at current Rate of Change
    1977 - 2010

    Returns of US Dow Jones index at current Rate of Change
    1920 - 1946

    Here again are the two charts I examined in depth in March's main post, but this time their returns up to two years out are highlighted.  In each and every case where stocks had become as over-extended as they are now, their return over a one or two-year period was at best flat to minimally positive, at worst extremely negative

    Sometimes stocks ran up in the first year but, as we discussed in the blog, they could not sustain the momentum and always fell back or crashed in the second.  In one or two cases stocks troughed after a year then began rising strongly in a sustained bull market.  Were that to happen, any cash savings could very easily be transferred back into the market.  It is in my view an extremely rare, virtually no-lose situation.

    US and UK markets move in near lock-step, with occasional and minimal variations, so don't count on our situation over here being any better.  In fact, even if you discount this particular technical indicator, the evidence is unambiguous.  I looked at the aftermath of every single major sell-off (20% or more) over the last century.  Once stocks had staged a rebound which lasted 12 months as ours has, returns going forward one to two years further out were,  overwhelmingly, either flat or down.  For a picture of the period from 1947 - 1982, take a look in the section above on stocks.  


    • Love cash when risks to your other assets are elevated

    There is, as we've seen, a big risk in holding shares over the next one to two years; there has also been a stampede of buying into bonds, creating a potential bubble with similar dangers.  Property is walking a narrow path between two chasms: rising mortgage rates on one side and a double-dip recession the other.  Either of these would in my view lead to house prices declines and, over the course of the next couple of years, one of these is highly likely to occur. 

    While the potential rewards in these assets are so questionable, you are simply better off in solid, boring, risk-free cash.  No, it's not going to make you rich, but look:

    There are periods in history when the economic environment rewards - and other times when it punishes - risk-taking behaviour.  We have experienced a 25-year high summer when it truly was time to get rich.  We are now in the early stages of an economic winter in which crippling debt has to be excised, bad businesses and business models flushed out and banking and household finances restored to health before we can make any further long term advance. 

    In this environment, asset prices are extremely vulnerable.  Japan has gone through this process for the last twenty years - their stock market is STILL 72% lower than it was at its height in 1990 and Tokyo property prices are STILL 70% below their peak.  Many intelligent investors are being sucked into this current market advance in the belief that our troubles are behind us.  Having seen nothing but asset price gains for their entire adult lifetime, they have become insensible to risk, literally unable to comprehend the possibility that the tide has turned against them.  Increasingly they are back buying property, back partying  like it's 1999 and ordering Cristal like it's 2007.  But very few of them will still be standing in ten or fifteen years by the time this whole thing is through. 

    So the trick will be to take great short-term opportunities when they arise, to party by all means, but be ready to evacuate the building at a moment's notice.  The priority for really smart investors is now not to get rich but to stay solvent - not 'return-on-capital', but the return of capital. 

    • Loathe cash when inflation and asset prices look set to rise long term

    A short term drift higher in inflation is one thing - in the UK, that looks to be our current situation.  But if I'm wrong about the economy and a solid recovery takes hold - something we should find out within the next year - you should flee cash and invest in some hard assets.  Low inflation is fine for most assets but the theoretical risk we face, if demand rises too fast and the monetary genie bursts out of its bottle, is of runaway inflation.  In a worst case scenario, the ghosts of Zimbabwe could yet rise in England's green and pleasant land.

    Serious inflation is least bad for property and best for precious metals such as gold.  Inflation-linked bonds are a somewhat less titilating alternative, of which more in a moment.  Stocks, despite olde investor lore, factually do not do well in highly inflationary periods.

    • Love cash the most when asset prices and everyday prices are falling - long or short term!


    For the first time in decades, developed nations are facing a major threat of deflation.  And it's not theoretical, it's right here, right now.  Both the UK and US dropped into deflation for a while in 2008, the Eurozone is hovering just above the zero line and last month, the US core rate officially dipped into deflation for the first time in living memory.  Whatever one's opinion of the outlook, the current trend is not up for debate: we're going down.

    The US Consumer Price Index excludes housing costs, otherwise it would show a nation firmly in the grip of deflation

    In deflation, where prices fall generally and asset prices are hard hit, your cash gains in value.  As house prices deflate, that money you're saving for a deposit will buy you more.  The price of consumer goods also falls, giving your pound greater purchasing power.  And since your debts stay the same even as your assets deflate in value, the only guard against those debts overwhelming your ability to pay is to sell those assets and hold plenty of cash.

    In deflation, typically, institutions are prone to fail, so it's important to keep your cash in the safest spots.  Generally speaking the government guarantees cash deposits up to £50,000 but there are pitfalls.  We'll examine what's truly safe in a later post, should the economic picture become markedly more dangerous.

    The UK is currently getting a mini-burst of inflation, but almost all analysts believe it's only temporary and, for once, I agree.  Technical factors (to do with the way the figures are measured) plus the return of VAT to 17.5% from 15% and rising energy costs have plumped up the headline rate, but later this year the primary trend towards falling prices is likely to re-establish itself.  Why?

    For the last sixty years it has been employment costs which have determined the likelihood of inflation.  So-called unit labour costs have continued to be a consistent leading indicator - and now they point firmly towards deflation.

    But for now, UK interest rates on deposits are either holding steady or rising.  The pound has been selling off as fears about our government debt grow in the bond markets, which is pushing rates higher.  This is lining up to provide us with an excellent opportunity.


    • Be sure to use your tax-free ISA allowance this year if you haven't already.  Taxes have only one way to go from here for all of us - up.  A cash ISA will shelter £3600 from the Chancellor's clutches before April 6th (£5,100 if you're 50+). 

    • From April 6th, everyone can stash away another £5,100 in cash tax-free. 

    • I'll be looking for signs over the next few months that stocks are topping, or that savings rates have stopped rising, to start switching money into fixed-rate ISAs and savings.  I will of course be sharing my discoveries with you, dear reader, in these columns. 

    • If we get a major UK bond sell-off with an accompanying rise in savings rates, that should be seen as a tremendous opportunity to lock in a high return.  I'll specifically be looking at two-year (and longer) fixed-interest savings rates which allow me to withdraw funds from my account before the end of the fixed term.  This flexibility will be extremely important and could be crucial to the success of the strategy.

    • To guard against the small risk of runaway inflation, I'll be looking to make an (initially modest) investment in gold and / or inflation-linked bonds.

    Enough already!  I'm off to soak up a damn good dose of spring sunshine.

    The febrile state of our currency markets, sovereign debt anxieties around Europe and our impending General Election all increase the potential for some kind of crisis - and opportunity - during March.  So, be sure to tune in next time - all the essential news will, of course, be here, posted Sunday April 4th.

    Meantime, have a great month!