Investing for Gloom

11th Jul '10 by siestainvestor

11 comments 7486 reads

Given the prevailing macro-economic environment, it is difficult to be optimistic at present and it's even harder to work out where to invest.

Debt and Recession

The recession is not over. There has been a massive growth in household and sovereign debt. Sovereign debt is still growing. Rabobank and others have estimated that gross public debt increases by an average 78% after a financial crisis (their figures analyse 33 such crises). There has been a reduction in US household debt over the last three years but this is almost entirely due to defaults on mortgages. Governments have two solutions: (i) default, which leads to a depression or (ii) more politically palatable, inflation. We will see inflation.

Inflation

Inflation in Anglo Saxon countries has been around 2% for some time: roughly 3% wage inflation mitigated by price deflation imported from China. This is about to reverse. There will be downward pressure on wages but China now has 2.7% inflation and the RMB is crawling up. We will therefore import inflation: some commentators say inflation will drift further upwards beyond 4%. I wouldn’t be surprised to see some printing of money and inflation allowed to go to 6-7%.

China the engine for World growth?

The IMF gives a world economic growth forecast of 4.25-4.5%. But “downside risks have risen sharply”. This could be an understatement. The forecast depends on Emerging Asia growth rates, in particular China at 10.5%. China has its own looming problems caused by boom. Property price inflation is one aspect. But infrastructure capital is also in boom: there is competition within regions to establish regional airports - some regions have up to 30 regional airports under construction. Someone at a recent meeting said this reminded him of the 19th century railway boom when, for example, three separate lines from London to Peterborough were funded. A stumble in China would be bad news. It is the last economic stimulus standing.

Greece and the Euro

Greece(and the other PIIGS) are overborrowed and uncompetitive. Greece is certain to default as its cost of borrowing exceeds its rate of economic growth (compound interest works against it). However default will not make them competitive which can only be achieved by a break away from the Euro and a subsequent devaluation. As so many economies are in this trap, a Euro break up is now being talked about…

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emptyend

12th Jul '10

Hi Siesta :-)

So where to invest?

We are about to enter a period where maintaining the real value of one’s wealth is the objective. This suggests index linked gilts or perhaps US Treasury Inflation-Protected Securities (TIPS) as the dollar may fare better in a second global crisis. Another home for investment might be German Bunds as they will appreciate in capital value following a break up of the Euro. Other than that, real physical assets might have a role: oil in the ground, gold etc. Mining companies with physical assets and real estate companies will become cheaper in the crisis and may make sense later. For now liquid, inflation proof investments look comfortable if not exciting.

I would welcome contrary arguments as I would like to restore my belief in the long run value of owning shares in well managed, well funded Western companies.

You could always try "investing" in a bigger boat ;-))

Unfortunately, I'm not going to be able to offer much of a contrary argument, as my macro view is very similar to your own! There is plenty for us all to be concerned about....and I have previously reached similar conclusions to those that you outline above.

As you know, I've stayed in cash, linkers and bonds in my pension fund since late 2007 - and I remain content to keep it that way, whilst being concerned about the near-zero returns on cash and the market risk of non-indexed bonds. I am more sanguine than the market about the latter, due to the lack of attractive alternatives to which you allude!

But the question you pose is now looming on my own investment horizon, being faced with the possibility that my main holdings of oil E&P companies will be assets that will be called away from me fairly soon (with DNX being bid for and, IMO, SIA unlikely to be very far behind). I have a feeling that when that time comes, I may be staying rather nearer zero duration cash and simply waiting for opportunities to emerge as the debt shoes continue to fall.....

rgds

marben100

Hi siesta,

I would like to write a detailed & properly referenced response to your post but unfortunately, I dont have time. Nevertheless here are a few quick thoughts, FWIW:

I strongly agree with your inflation hypothesis and have a significant investment in index linked gilts to guard against that eventuality.
I feel that CAPE & Tobin's Q are deeply flawed .

Firstly, does CAPE take account of inflation & growth? If not, then it offers a distorted picture. Moreover it assumes that a cycle lasts 10 years. Looking at CAPE today, surely we are looking at one of the worst 10 year periods that could be chosen? - starting at an economic peak in 2000 and only just emerging from a second trough now (maybe!).

Secondly, AFAIK Q takes little account of businesses built largely on intellectual capital, as opposed to real, hard tangible capital investment. Whilst I'm not a great fan of Google or the investment case for it, using Q on it or the part of the economy it represents (more signfiicantly) will not yield meaningful results. it certainly isn't a worthless business, which Q might suggest.

I do not trust those measures as judges of market valuations... but then I don't buy or sell the market, rather shares in individual businesses.

Concerning China, yes it is true that there are inefficiencies such as overinvestment/bubbles in property & possibly in certain assets you mention. However, there is little doubt in my mind that both China and India DO need massive infrastructure investment and are working hard to ensure it goes in. An example of this is nuclear power plant construction which both governments see as essential to fulfilling their countries' future energy needs. Massive construction of such plants is already underway in China, not merely plans. Unlike the west (and for better or worse), NIMBYs don't get a say. Another example is that China needs and is trying to build an aerospace industry to serve its undoubted needs (watch out Boeing & Airbus!). It has decided that the city of Chengdu (pop > 10m) will be a centre of excellence in that industry and has established educational institutions there to fill the need for a large number of engineers to serve that industry.

As anyone that has observed my investment focus will have seen, I like investments that I believe will benefit from those trends.

I believe that this is a very exciting time to invest (the market is throwing up some extraordinary anomalies, as it did during the 1930s and I did not see during the preceding 20-25 years of my experience) - but you need to choose your investments carefully and certainly don't count on a rapid recovery in the west. I would not be at all keen on investing in an index tracking (or closet index tracking) fund.

Another area that I have not yet explored but may offer great promise is genomics. Just as the Internet has revolutionised our lives, great strides appear to be being made in "genetic engineering" (and related disciplines) and these seem likely, in the fulness of time, to have a profound effect on economies globally. I note that Jim Mellon has announced that he is moving to San Francisco, specifically to study this area of investment (though he may have been a bit seduced by Craig Venter ;0)).

D'oh - once I get started I find it a bit hard to stop. :0)

Best regards,

Mark

siestainvestor

You could always try "investing" in a bigger boat ;-))

As it happens, I am. Might as well spend whilst the cash is still worth something.

S

13th Jul '10

As it happens, I am. Might as well spend whilst the cash is still worth something

No surprise, of course ;-)

I've recently been making some investigations re relatively expensive cars - and the dealers tell me that business is brisk as people are concluding that cash is vulnerable, investment returns are low and uncertain - and they may soon be dead or struck down....

....as my father used to say ....."You can't take it with you".

Re Mark's comments, I'd note that the current investment climate seems to be leading people to search for gurus in areas like the internet or genomics etc, as well as established gurus like Buffett. This seems to me to be profoundly unhealthy and reflects the difficulty of the present investment climate.

cheers

dodge1664

Mark:

I suggest you read the book "Valuing Wall street" by Andrew Smithers. He describes the case for and against Q in great detail, and I find his arguments compelling. Your point regarding intangibles such as patents and trademarks adding value may be true for one company in particular, but it cannot be true in aggregate for the the whole population of companies competing against one another. Intangibles have real value only if they allow a company to achieve an above average rate of return on capital. But the aggregate population of companies cannot all achieve an above average rate of return! In other words, for each Google, which achieves a higher rate of return due to its "goodwill", there are competing companies which achieve a lower rate of return due to their lack of goodwill. Therefore Q is still a sound measure of overall stockmarket valuation, even if it doesn't work so well for individual companies.

a thumbs down for that, and no response, wow. there really are some complete muppets reading stockopedia!

Betasurfer

Well, this isn't Advfn. I think people here generally operate on a "say something if there's something to say" basis - i.e. trying to keep a high signal to noise ratio. I, for one, couldn't think of anything smart enough to reply to your post. Not sure that's the same thing as being a muppet. You certainly did deserve more thumbs, though (come on, lurkers!). There's one more from me (FWIW).

14th Jul '10

Hi Dodge,

Been away, so hadn't so far seen or responded to your post.

But what has Q got to do with rates of return (directly)? It simply expresses the relationship between market caps & book value. [I have simplified slightly - for the full definition of Q & some interesting commentary see this ]. Book value may be useful as a measure for "metal bashing" style companies without clear "moats", but even Ben Graham acknowledged that it doesn't work for companies that are built mainly on intellectual capital.

The key to the theory behind Q is that if you are paying more than the book value for a company, why can't a competitor make the same capital investment and achieve the same return for a smaller investment than you are making when you pay an inflated price in the market?

An increasing part of the US market in particular is comprised of companies where capital investment (and hence book value) bears little relationship to returns (think Apple, IBM, Cisco, Google, Microsoft etc), so is Q valid as an aggregate measure?

Oh... and would oil or mining company investors think that book value (which does not reflect the size of commodity reserves) is a good basis for valuing their investments?

ee,

Nope, I certainly don't advocate blindly following "gurus" but I am merely suggesting an area that might be worthy of further study. ;0)

The one constant for investors is change. That makes investing interesting, exciting and extremely challenging for me.

Best,

Mark

So you couldn't think of anything smart to say, apparently have no counter argument, but you have still managed to reach the conclusion that it "certainly deserved more thumbs". Well, that's very intelligent.

I really think the thumbs down facility is a huge mistake. It just provides troll fodder - witness the group of idiots that took great delight in giving every single Fangorn post the thumbs down in the BP crisis play thread.

Hi Mark,

As I said before its best to read the Smithers book, as he can explain his reasoning far better than I can. Your criticism of Q is one that is often made, and his (scathing) response can be found in the book.

To summarize as best I can:
1. It is not the case that Q is irrelevant to a service economy. Firstly many service industries like hotels and supermarkets actually have very large capital requirements, and secondly the relevance of Q is independent of the amount of capital employed.
2. Intangible assets that have been bought have been paid out of profits, which affects the net worth of a company. Net worth is used as an input to Q.
3. Intangible assets that haven't been paid for must necessarily have zero aggregate value across the economy as a whole if you assume that corporations are competing with one another for profit. If AMD has a clever patent that allows it to make better microchips, it increases the value AMD, but it decreases the value of Intel, and the aggregate value can still be calculated using net worth.

I find it surprising that so many people persist in using market valuation measures other than Q, which are generally so unsound. I assume this is because it gives an answer which doesn't fit with their over-optimistic expectations, or perhaps their desire to talk up the market.

Dodge

Hi dodge,

"It is not the case that Q is irrelevant to a service economy." I didn't say it was. ;0) The thrust of my argument concerning the application of Q to the US market in particular is that a large part of that market now comprises companies that are not capital intensive (not necessarily service companies), making Q a considerably less meaningful metric.

"Intangible assets that have been bought have been paid out of profits" Yes, Q does take account of acquisitions & capitalised R&D & oil/minerals explo costs. However, the book value of such intangibles is a very poor relfection of their worth. Sometimes they are worth more, sometimes less - but, most importantly, it is NOT a zero sum game where the degree of overvaluation (at book value) of some assets balances the undervaluation of others. Oil explo is a classic illustration, where capitalised explo costs (an intangible) have almost no bearing on the value of oil reserves discovered.

Delving into that example in more depth, one could argue that if book values in general over- or under- stated the value of explo, more or less explo would ensue, bringing the figure back into balance. However, that doesn't take into account the changing cost of explo - which impacts the current "intrinsic" value of past discoveries that is not refeclted in book values.

- hey, isn't this great, Googled to find some data to back up my point and where did I find it? Right here on Stockopedia! http://www.stockopedia.com/content/bp-plc-royal-dutch-shell-conocophillips-chevron-total-exxonmobil-are-rising-fd-costs-inevitable-in-the-oil-industry-43713/

"If AMD has a clever patent that allows it to make better microchips, it increases the value AMD, but it decreases the value of Intel, and the aggregate value can still be calculated using net worth."

Sorry, that doesn't stack up. What about the era before EITHER Intel or AMD existed? Jointly they (and others) DID perform the trick of making something out of nothing (in terms of capital) - that is what Q fails to recognise, why it is fundamentally flawed and why few investors pay it too much attention.

Capital investment is important - but it is far from being the ONLY important thing which is what Q boils down to saying. Q is a dismal, perma-bearish view that does not take account of human ingenuity - and is not a good predictor of market behaviour as the references in the Wikipedia article I referred to in my last post show.

Good debate. ;0)

Cheers,

Investing for Gloom

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Siestainvestor

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