This week my latest education article was published in IFA magazine. Basically it summarises the amount of additional downside risk a direct equities portfolio with a small number of stocks takes on compared to portfolio with a large number of stocks. There is myth that concentrated stock portfolios are more likely to outperform managed funds, an index, or a larger stock portfolio. This myth appears every bear market and must be exposed for what it is…rubbish.
If you can’t get the magazine, never mind as the article can be found by clicking on the following link… http://tinyurl.com/dmq7da
One of the most misunderstood asset classes is fixed interest. Most investors have a reasonable understanding of the risks associated with equity investing but fixed interest is very different. I have created a draft article for use by advisers and discusses the major risks of fixed interest investment in the context of the global financial crisis and its various effects on last year’s returns. Quite simply, interest rate risks positive credit risks were negative, duration risks largely positive, and liquidity risks frustrating!
For those interested my article can be found here … http://tinyurl.com/ceba9j
At the time of writing, sharemarkets around the world have experienced one of their strongest six week rallies in history. The push to get the ball rolling was the $1trillion Geitner package that was designed to remove toxic assets from balance sheets. The G20 meeting of world leadersproduced one of the more productive outcomes in recent times and all of this was followed by surprised quarterly profit announcements from some of the biggest American banks in Goldman Sachs, and Citigroup. Whilst the newspapers and various commentators are calling the bottom of the market, there appears to be little evidence suggesting that things are looking up for the economy. The grim reality is that the major economic statistics released in recent weeks have been terrible.
Globally, the International Monetary Fund is predicting the first global GDP contraction since the great depression and that advanced economies will experience deflation during 2009. Deflation is where prices decrease and is just as concerning as high inflation as Japan in the 1990s will attest. For example if prices are declining then consumers are less inclined to spend as prices will be lower tomorrow. This obviously leads to lower profits, less jobs, less spending and the vicious cycle continues. Industrial production around the world is at record lows, credit is still expensive, andthe banks are still writing off enormous assets. Many of the leading economists in the US believe the $1trillion Geitner package is insufficient and should be more in the order of $4trillion otherwise the only hope for the US banks is nationalisation…but in the land of the free nationalisation of a bank is sacriligious.
In Australia, recent months have seen unemployment rapidly increase from just around 4.5% towards the end of 2008 to 5.4% at the end of February 2009. The federal government was forecasting unemployment to peak around 7% by mid 2010 and there is little doubt this figure will be revised upwards in the current budget. Whilst Australia is not technically in a recession (i.e. two consecutive quarters of negative growth) it is just a matter of weeks before a recession in Australia is confirmed. In fact, even before the GDP figures are released Kevin Rudd has announced that “it is inevitable that Australia is dragged into recession”.
The Australian government starting responding to the threats of recession several months ago by announcing their $42billion Nation Building and Jobs Plan, with around $30billion of this to be spent on infrastructure over the next few years. Compared to the rest of the world, the federal government has been very active in attempts to re-accelerate economic growth.
The first Tuesday in March saw the Reserve Bank decrease their cash rates by 0.25% to 3%, which again, compared to the rest of the world is one of the largest and most rapid of interest rate reductions. Unfortunately, whilst bank cash accounts reduced interest rates the same cannot be said for home loans where only a small proportion of the rate cut was passed onto borrowers. In longer term interest rate markets we have seen government bond yields increase substantially in recent weeks. This increase is due to the government required capital raisings to fund their future debt and once again this is not helping those that wish to fix their home loan interest rates. Commonwealth bank announced that they are increasing their fixed rate for all mortgages with terms greater than 1 year.
The outlook for interest rates are further reductions. The Australian government bond maturing in September this year currently trades on a yield of 2.77% indicating at least one and most likely two reductions of 0.25% over the next few months.
Chart 1
The outlook for equity markets both here and overseas continues to be one of volatility. Whilst valuations (as defined by the PE Ratio) continues to be at low levels (Chart 1), the expected decline in earnings (Chart 2) and lack of earnings guidance from companies both in Australia and around the world provides significant uncertainty of potential. As chart 2 shows future earnings expectations are to be below 2005/06 and 2006/07 levels.
Chart 2
With low cash rates, volatile equity and bond markets, and continued economic uncertainty, diversification of investment portfolios is essential. Compared to the rest of the world the Australian economy is better positioned to withstand the slowdown. The government has one of the lowest debt levels in the world and the Reserve Bank still has significant room to move on interest rates. These factors provide opportunity to add further stimulus to our economy to provide jobs and economic growth. Whilst Australia is probably already in recession these factors suggest the slowdown won’t be as bad here as in the rest of the world.
The above chart is a couple of weeks old now but is showing the market PE ratio to be around 11 (so its probably 12 now). As the chart shows this is a PE ratio that was pretty much the average throughout the 70s and early 80s. Now a PE of 11 is an earnings yield of 9% and if we expect negative growth of say 1% then we’re left with an 8% earnings yield over the next 12 months. With the government bond yield at around 3% is 5% really a sufficient risk premium? With BBB rated corporate bonds with an average credit spread of at least 5% I’m not really sure the current PE ratio really stacks up as attractive given the incredible headwinds Australian companies are facing…many may say the market’s cheap and maybe a PE of 11 (or 12) is cheap…but not yet.
“Some of the people I know lost millions. I was luckier. All I lost was two hundred and forty thousand dollars… I would have lost more but that was all the money I had.”….Groucho Marx writing in “Groucho & Me”
Whilst the Reserve Bank drops their cash interest rates the credit spreads (as shown above) on investment grade corporate bonds are doing the opposite. It doesn’t matter whether you are a AA, A, or BBB rated corporate you are paying a record interest rate above the government interest rates. It amazing that these credit spreads are almost 2% higher than when Lehman Brothers collapsed. Anyway…I guess this chart explains to a degree why the banks have barely pass on any of yesterday’s interest rate cut…because credit is still very tight.