John Stepek: So far, 2012 seems to be unfolding like 2011 or 2010 an upbeat start, derailed by Europe and fears that money printing will end. Will it carry on like this?
Andrew Thompson: It feels ominously like 2011. We are in uncharted territory, certainly as far as the solutions that are being put in play go.
Jeremy Batstone-Carr: The global economy has never faced such serious challenges. Mountainous levels of debt in the West; an appalling demographic iceberg that we seem to be sailing towards blindly; deleveraging; plus the potential for hyperinflation due to rolling currency devaluation. Yet equity markets appear comparatively insouciant. That has to be down to liquidity infusions from central bankers whether it's Ben Bernanke or Mario Draghi or Mervyn King or Masaaki Shirakawa, they are all at it.
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The other problem is that the absence of alternatives has forced many investors into the market to look for income that they can't find elsewhere. A lot of our clients are looking for safe dividend-payers and companies that have a good track record of dividend payments.
John: Do you think that the defensive, income story is getting a bit old?
Jeremy: It depends on your timeframe. If you are a shorter-term investor, then you can buy riskier assets where and when you believe there is going to be an infusion of liquidity. But you have to be very nimble to get the timing right.
Tim Price: The other concern is that, certainly in the British stockmarket, it's effectively just R2D2 and C3PO trading against each other. Everybody else has gone. How many real investors are out there, rather than quants and algorithms?
Jeremy: Yes, volumes are incredibly low. The field has been left to high-frequency trading.
Derek Mitchell: That's true. We get daily complaints from brokers "please deal or we are out of business".
John: Why do you think that is?
Derek: It's de-risking there is less and less money in equities. Yet there is a positive case to be made for stocks. Companies are still talking pretty positively, and that's backed by the strength of their balance sheets. They feel very secure. Should things take a turn for the worse, they think they can trade their way through.
Tim: But they're not putting that money to work. In America, corporate profitability is at a record as a percentage of GDP, but it's not being reinvested. If I were running a non-financial business I'd hoard cash too, because this is a false market.
Jeremy: Yes. The market has lost its capacity for price discovery, due to the ultra-low levels of interest rates. The equity market isn't a discounting mechanism anymore all it does is trade the next headline. So if you are a company, there are good reasons not to invest. Plus, of course, you've got shareholders who are worrying about the return of their capital rather than the return on their capital.
Andrew: You can read too much into low volumes though. In 2009, the despair of the early months culminated in the sharp sell-off in March. Yet, by the end of the year, significant returns had been made. The same argument applied in 2010. We tend to say that the S&P 500 and the FTSE are range-bound, but look at some of the markets within them the Nasdaq is now back at levels last seen in 2001. So if you do get a change of sentiment, low volumes could force up prices very quickly.
Tim: But if you take the view from 30,000 feet, we haven't gone anywhere in ten years. It feels like the West is turning into Japan. There was a letter to the Financial Times from a Japanese gentleman last year. He found it "richly ironic" that everyone has been giving Japan unsolicited advice about how to get out of deflation and a banking crisis, yet now the Western world is in the same mess.
The sad reality, as he rather charmingly put it, is that once you've had a huge property bust, there is no alternative to "years of economic indignity". That feels exactly right to me. We are seeing monetary stimulus, but none of the underlying problems are being addressed. There is lots of sound and fury, but the market is not going anywhere.
John: What about capital controls? Spain just introduced limits on cash transactions. Does that worry you?
Tim: It's all part of the financial-repression rule book. We've got a meaningful amount of our client portfolios hoarded in the form of bullion. It would be nice to think that the government won't suddenly go after that. But anything is possible.
John: For all the gloom, is there anything that could change things?
Andrew: Central banks have created deliberate policies to try and force people into risk assets. Markets are ultimately driven by where the large institutions put their cash. Those institutions tend not to be too patient, and will be looking along the risk spectrum to find the least ugly asset to invest in. That will create the next opportunity.
But what will it be? It is hard to make a compelling case for conventional gilts, or even index-linked ones. With commodities, it's also difficult to see a value case. But if you focus on equities, notably income stocks, then, although it may not be the opportunity of a lifetime, at least you're being rewarded with steady income from cash-rich firms.
I agree that the West could face what Japan has gone through. But that may highlight one of the few opportunities right now that can be taken without undue risk. And that is to invest in assets within a region that is massively out of favour, undervalued and which has already gone through that cathartic process of more than 20 years of utter despair. Japan still seems hugely under-owned it's as if people have given up.
Tim: Everyone talks about it, but no one is actually buying.
Andrew: Yes, but if you are prepared to take the risk, then the downside is likely to be modest relative to some of the more richly valued markets, such as America.
Jeremy: Japan would be a massive buy if it embarked on a major devaluation. A 40% or 50% drop in the yen would be very bad news for everybody else, but really great for Japan.
John: They've been doing more quantitative easing (QE).
Tim: But they are also fighting the European Central Bank, the Bank of England and the Federal Reserve.
Jeremy: The Fed's problem is that it's got to get any further monetary easing past Congress, so it needs a bit of a crisis to get the go-ahead for more QE. We might see more operation twists' ahead of the election, but I can't see more all-out QE in 2012. Yet the market is fixated on the next bout of liquidity, which isn't helping.
John: What about China slowing? What impact might that have?
Derek: The mining sector has already underperformed substantially this year, which has been a drag on the UK market.
Jeremy: China does keep me awake at night. The banking system is very rickety. It will probably have some form of hard landing even though the authorities will do everything in their power to ensure as smooth a transition to lower growth rates as possible.
However, I'm not particularly concerned that Western-based firms operating in Asia will be hit disproportionately hard. China needed to grow at 10% before, but now that it's a bigger proportion of the global economy, it can probably grow at 5% or 6% and have the same impact.
John: What about government bonds? Could we see a 1994-style spike in yields?
Andrew: The big threat to the bond market will be interest rates starting to rise. Central banks have been very clear that this isn't going to happen any time soon. In technical terms, despite the recent jump in yields, the long-term bond trend remains intact.
At the same time, it's hard to make a compelling case for buying UK government bonds when they are returning 2%. There are also the longer-term risks of inflation coming out of all of this money printing. That may be the end game for the bond bubble, but it won't happen just yet.
Jeremy: We've done jolly well from corporate bonds over the past six to 12 months. But we are switching into equities because the aggregate yield of the corporate bond market is now below the aggregate yield on equities in Europe.
John: So is anything worth buying?
Derek: I believe the oil price is going to stay above $100 a barrel. So I am still keen on oil and oil services. America wants to be energy independent whether it's through shale gas or shale oil which is driving investment in that area.
Tim: I like the energy services story too. I still believe there has been insufficient energy infrastructure spending globally for decades and it doesn't really matter which type of energy ultimately wins out. So the energy services sector makes sense. Then there are certain niche players.
I've mentioned Aggreko (LSE: AGK) in the past if you are an emerging-market economy and you want to keep the lights on, you can either spend billions and wait decades to bring some new power stations online, or you can just call Aggreko and get the kit delivered the next morning.
Andrew: Private clients don't look much at currencies, but they may offer one of the great opportunities. Our base case is that China avoids a hard landing. But there are significant risks to that: the internal politicking, a very clear property bubble and yet also the great weight of hope that somehow China can help the West to grow out of its mountain of debt. History suggests that countries often fail to deal effectively with bubbles, especially property bubbles, so there has to be a risk that China does have a hard landing.
If so, who will that affect? Australia, for starters. Australia has also had a property bubble, on the back of a huge resources boom, but China has already indicated that its economy is shifting away from huge infrastructure and development projects, and that it is trying to focus more on growth within the domestic economy. Even companies like BHP Billiton seem to be accepting that the best years may be over for the commodity boom. So we think it's right to short the Aussie dollar against the US dollar.
John: Would you be happy to use an exchange-traded fund to trade that?
Andrew: As long as clients are aware of the risk and the costs involved.
John: What about America? Its housing market was one of the few to suffer a proper crash. Is it bottoming out?
Andrew: It is still very difficult to see a bottom. When crashes occur, prices don't rebound to the degree that people expect. They tend to flatline. The one positive I think you can find in the US is the performance of the Nasdaq. Twelve years on from the technology crash, many of those failed dotcom businesses are now part of the potential solutions for future growth. Some are real cash generators with a global imprint. So while I find it hard to be particularly positive on the wider US market the S&P to our mind is richly valued if you are looking at an area where there has actually already been a huge sell-off, the Nasdaq is one.
John: What's your take on Apple?
Andrew: When a share price has gone virtually vertical there is going to be scope for sharp pullbacks. With investors suddenly remembering that there are huge risks out there, the temptation is to bank profits where they can. Our sense is that the valuation is well ahead of itself for now, so we are continuing to hold, but watching carefully because these wonderful growth stories tend not to continue forever.
Jeremy: Apple is a short now, isn't it? Without any new revolutionary products on the block, it is simply going to cannibalise the sales it's already making. The days of exponential growth are gone.
Tim: This is the problem it is almost impossible to find a compelling reason to own any given market, but that doesn't preclude there being plenty of value, or special situations. It's genuinely a stock-picker's market. But I am concerned about the US, which I agree is not cheap. Interest rates can't go any lower. They can continue stimulus ad infinitum, but then they will destroy the currency. It feels like Last Chance Saloon territory.
Jeremy: I agree. The American debt ceiling will become an issue again in September. The Republicans have allowed Barack Obama to get away with it because they know that it's going to come back and haunt him two months before the election. Then we have 31 December, when all the Bush era tax cuts run out.
Tim: So even if you get a decent year for US stocks this year, it's going to be really nasty next year when all the bad news gets frontloaded once the election is over.
John: What about gold? Is the bull market over? Or just pausing for breath?
Andrew: We hold gold in portfolios as a diversifier. It's not perfect, but history has shown that, at the extremes, gold tends to do pretty well when most other markets are falling apart. Last August we saw a dire performance for equity markets and a glittering one for gold. Gold is also seen by many as an inflation hedge. I think many investors believe more money printing is coming, which in the longer run will result in more inflation. Distrust of fiat currencies, as central banks race to the bottom to devalue their currencies, adds to its appeal.
But you have to ensure you don't get too wedded to a bull market. Remember what happened in 1980 the gold slump was stunning. It fell 25% in a week and 40% in three months. Even more important was what followed a 70% fall to the bottom and almost 30 years of loathing of the asset class.
Jeremy: The end game in all this has to be widespread default or widespread, aggressive currency devaluation. That's why I hold gold.
Tim: Gold has been around for thousands of years. No paper currency ever has. You either hold paper or you hold gold or you hold a combination of the two probably a combination is the way to do it.
John: Let's get to your share tips. Derek?
Derek: Oil explorer Ophir Energy (LSE: OPHR) is successfully drilling off the east coast of Africa. It's the only small independent left in the region. The attraction for me is that it has an extensive drilling programme for this year and next. Given the success it's had and the people it is drilling with such as BG there is every chance of further success.
Then there's packaging group DS Smith (LSE: SMDS), which just doubled in size by buying Swedish rival SCA's packaging division. This opens up a whole lot of new markets in Europe. Whether that's a good thing or not only time will tell but in smaller deals that DS Smith has made in the past, it has always under-promised and over-delivered on synergies.
My next tip is ITV (LSE: ITV). The advertising market has been picking up and this is not being reflected in any of the statistics as yet, so I think there are some big upgrades to come through I can see the shares rising to £1.00 in reasonably short order. ITV has also got the benefit of the Diamond Jubilee and Euro 2012, plus the Olympics it's not covering the Olympics, but there are obviously a lot of big advertisers who want to get their products out there. It's not a great dividend-payer, but it's got £800m of net cash, so there is a bit of a refinancing opportunity to come through.
Tim: For my picks this week we've already made the case for gold, so I've a nice little double-edged bullion miner to buy: Fresnillo (LSE: FRES). It's the world's largest primary silver miner, but it also does gold. Then there's drug giant AstraZeneca (LSE: AZN). It could be a value trap, but a price/earnings ratio of six is about as low for a FTSE stock as I've seen recently. The dividend yield is around 7% and it's covered nearly three times.
My third pick is Bluecrest Blue Trend (LSE: BBTS), one of the largest London hedge-fund groups. It follows one of the longest-lived strategies systematic trend-following and is also one of the better-performing ones. The major Blue Trend fund since 2004 has delivered annualised returns of around 17%. It is a closed-end fund, so you trade it like a stock on the London Stock Exchange. If history is any guide, then, in shocking markets, it can deliver the goods.
Jeremy: I like AstraZeneca too. I will also suggest Imperial Tobacco (LSE: IMT). Like all tobacco stocks, it's generating cash like there's no tomorrow. Just look at the balance sheet and the reliability of the cash flow. It's got less emerging-market exposure than British American Tobacco (BATS), so if you buy the emerging-market story, then you probably own BAT, whereas if you are more agnostic, you own Imperial.
Another big cash generator is consumer products giant Reckitt Benckiser (LSE: RB). I also like GlaxoSmithKline (LSE: GSK). Chief executive Andrew Witty is pulling all the right strings in parliament and it's got a great Olympic angle every time I come in to London on the M4 I see their building, and it says, "We are the Official Testers for the Olympic Games 2012." Yet if I had to choose between Glaxo and Astra, it'd be Astra the free cash-flow yield is absolutely insane.
Andrew: As I mentioned, one of our top trades is to profit from the risk of a hard landing in China by shorting the Australian dollar against the US dollar. The Aussie is approximately 30%-35% overvalued on a purchasing power parity basis against the US dollar. Do beware of the headwind there is a cost of carry because Australia's interest rate is higher than America's. But at least it looks set to fall. [Editor's note: you can use the ETF Short AUD Long USD (LSE: SAUP) as an alternative to spread betting to play this, though do monitor its performance closely, and be aware that currency trading is risky.]
Next is Japan. On most metrics it is cheap compared to its long-term history, so you have a margin of safety. We like the fact that it's unloved. Jeremy mentioned what could happen in terms of the devaluation of its currency. If investors are concerned about this, they can use a sterling-hedged fund, such as GLG Japan Core Alpha (020-7016 7000). Or if you're prepared to take on currency risk, there are many investment trusts and passive vehicles.
John: By remaining un-hedged, to an extent you protect yourself against disappointment if it doesn't take off.
Andrew: Yes, a lot of investors remain willing to take on the currency risk, and we like the idea that if we're wrong on the market then at least we get protection with the yen. My third tip is gold. Gold offers diversification, particularly in times of crisis. We are also concerned about the longer-term effects of this huge money-printing exercise.
But there is one caveat when momentum does switch from an overbought asset class, it can change very fast, and we have no intention of running down the very significant profits we have in gold. Investors need to remember that, as the gold price falls, its yield does not get any better! That's why we're watching momentum indicators closely.
John: What about the gold miners?
Andrew: You hold gold as a portfolio diversifier and insurance. What investors shouldn't assume is that by buying gold mining stocks they are going to get the same protection that gold gives in times of crisis. The harsh reality is that gold mining equities will get killed in a stockmarket crash as they did in 2008. If you look at a couple of the finest gold mining funds during that period, they fell peak to trough by 60%.
John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.
He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.
His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.
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