Toppy Market - Stocks As An Inflation Hedge?

30th Dec '10 by tacheman

29 comments 25581 reads

I’m still going through the process of catching up on my Christmas reading - one web site that I like to keep an eye on is that of John Hussman, who writes an excellent weekly update of the market. I found the entry from the 20th December very interesting, and would recommend having a read.

The Market has been hitting yearly highs, and the all time high is within sight. This has been making me feel uneasy as it appears that all the current problems are being ignored and that the financial crisis has been forgotten about. The one thing that I’ve been wrestling with is, how much will the QE effect the markets in 2011?

Under normal circumstances, and given the recent run, I’d cash in my gains and (hopefully) wait for the markets to pull back to what I consider a more reasonable level before re-entering. However, these aren’t normal circumstances and I’m worried about sitting in cash in these (potentially) inflationary times.

The Hussman article has reassured me that moving into cash might not be such a bad idea, and has an interesting comment regarding holding stocks in inflationary times (which would be one of my main reasons for staying invested):

“Investors sometimes make the mistake of believing that since nominal earnings can be expected to grow during periods of inflation, stocks should be a good inflation hedge. Straightforward reasoning, but unfortunately, it’s not true. Sustained periods of inflation are disruptive, so even during the period between 1960 and 1980, S&P 500 nominal earnings still did not accelerate from their normal 6% peak-to-peak long-term growth rate. Moreover, stocks only behave as a good inflation hedge after high inflation is already fully anticipated. During the transition from low inflation to high inflation, stock prices have historically provided awful returns. “

At the moment I don’t see much value around and am inclined to take my profits. It’s also interesting to see all the resource stocks that are all the rage with the yearly competitions on Fool/Stockopedia, the contrarian in me thinks this is a clear sell signal. I must confess however that I still have large holdings in both SOCO International (LON:SIA) and Kalahari Minerals (LON:KAH) , but consider these…

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repobear

31st Dec '10

E.g. they are affordable after all but due to low interest rates but what's wrong with that! Is that not the point of low interest rates to stimulate an economy.

Anyway I do agree house prices might fall but the OP was postulating a high inflation environment and in this case they are likely to tread water or rise slightly. If this happens the B&B sub-debt will do very very well.

Actually if you look at the affordability right now it is not very stretched it has been way more stretched in the past and is at about an average level.

Affordability might not be at all stretched for those who had the nous to secure a good long term mortgage deal when there was plenty of money about but you can guarantee for every one of them there'll be at least three of four who took on a 2/3 year 'sweet' mortgage deal on a high LTV who have, or,are, coming off them and are really struggling. These people are, and will be be, paying the income on our RBS prefs. Add in some food and fuel inflation and a global reality check on wage inflation and affordability is an increasingly Important issue.

In the last bust more of these people might have been repoed but the lenders, aided and abetted by their new owner HMG, are going easy on them for now because crashing the market won't do anyone any good.

Low interest rates won't last forever, and the banks still have balance sheets to repair, which will mean good margins and fees on their mortgage lending. Even a1% rise in interest rates, which is nothing by historical standards, could tip many mortgagors over the edge.

I think your assumption that rising inflation is good the housing market, because wages will rise in line with prices, is just plain wrong in today's global economy, as I have pointed out above. That doesn't necessarily make the B&B sub debt a bad investment but, in my opinion, there is some clutching at straws going on, if you think that inflating away debts, as has happened in previous decades, will ease any worries that you may have over that investment. It'll be a long, long haul I reckon and if you stick it out there is a decent chance of success, imv.

repo

dodge1664

they are affordable after all but due to low interest rates but what's wrong with that!

Because a mortgage has to be paid off over many years, not just 2 or 3. Current interest rates are at emergency levels, and that cannot last without causing trouble elsewhere.

loglorry

All good points but this isn't really what the numbers are telling us if you look at them closely. UK house owners have been on the whole paying down debts at record levels. Sure there will be a lot of people who get unstuck if rates rise and they start paying 7-8% on their floating loans coupled with public sector job cuts and increased taxes. The stats are showing that actually mortgage debt is not a huge problem and in general there is a huge amount of wealth stored as equity in our housing stock still.

However what you seem to be saying is that we'll get massive increases in non-housing inflation but a fall in house prices and a fall in salaries and a rise in taxes all at once and the Bank of England will raise rates to steady inflation. This will cause massive defaults in mortgages with B&B and so it is a bad inflation hedge. I just think this is unlikely and that in fact if inflation takes off then it won't be focussed on everything non-housing. I personally don't think it will take off but if it does then I suspect house prices will rise too.

As an instance of my argument look at house prices in Aberdeenshire and Deeside since the price of oil and rose above $90. All the oil money in and around Aberdeen has been filtering down through the economy in the region and has caused inflation all the way across the board including Aberdeen house prices and the Aberdeen rental market too. You can bet Alan Booth and the directors of XCite with their new bonuses are buying houses in the region.

All boats will rise on the same inflation tide however some might not rise as much.

Log

Isaac

I'm interested in this comment since it is firmly in opposition to what I'm seeing amongst colleagues/friends etc.. who are all in the first time buyer category and have modest incomes and lifestyles.

nigel

What do you regard as a modest income? £25K ? & Which areas are you talking about? London?

marben100

1st Jan '11

Hi tacheman,

I've seen RCP mentioned several times in the past, and understand that it's an Rothschild IT which is held in high regard. I'm keen to understand what the attraction with this?

Given your view that the market is "toppy" generally (which I disagree with - but do feel that some stocks may be, whilst others are fairly- or under-valued), then this wouldn't be the time to invest.

What do I like about RCP?

Their investment philosphy is closely aligned with mine (see below)
Their long term performance (and 3 year performance) has been excellent, outperforming the FTSE by some margin.
They can access investments that I cannot and which I like (see below)

My investment in RCP provides a benchmark against which I measure my overall performance (as well as a against indices). It also offers me a "lazy way" of investing for the long term.

RCP Investment Philosophy

From their annual report:

Our approach remains clear: in markets like these our aim of preserving shareholders’ capital takes precedence over short-term capital growth. If that means we miss some periods of market strength we will bear the disappointment. This is why RIT fared relatively well as markets fell both in the winter of 2008-09 and the past two or so months

If, in falling markets, our aim is to preserve capital, in better times I ask shareholders to note that our growth objective is long-term, not short. We watch and indeed compare our performance with relevant indices like the MSCI World Index, and we reward our investment team in part by reference to it. But we do not feel tied to a formal benchmark. The success of this approach is evident from our record over several years rather than a single one. It lies in caution, in combining a wide range of asset classes that correspond to no specific benchmarks, and in our extreme flexibility and pragmatism of investment approach so that we are positioned to take advantage of opportunities. We include, for instance, opportunistic investments in unquoted entities from which shareholders have benefited significantly over time.

RCP Unquoted Investments

RCP is able to access a broader range of investments than I can directly.

These include hedge funds operating both absolute return and long only equity strategies specifically for RCP. In addition, RCP has significant direct investments in private companies, Agora and Agrifirma (as well as several other private companies). I would like to invest directly in both of these, if I could. Agora is a partner to Encore Oil, with a similar 15% share to Encore in the Catcher field. Agrifirma is the follow on to the highly successful publicly quoted Galahad Gold, managed by Ian Watson and Jim Slater (yes, that Jim Slater ;0)), with a focus on Brazilian agriculture.

UK Housing

Concerning interest rates, my point is that the current period of exceptionally low interest rates cannot last forever - and, as others have mentioned, homes that may currently be affordable, only due to such low rates, will no longer be. FWIW, my view appears to be supported by the consensus of property experts for 2011: http://www.ft.com/cms/s/0/dbbed8c6-1457-11e0-a21b-00144feabdc0.html

The housing market is expected to suffer modest falls in both prices and the number of transactions next year as government austerity measures weigh on demand for homes and mortgage availability remains constrained.

The consensus of forecasts for house prices suggests that the average home will lose about 4 per cent of its value by 2012, although predictions from the more established bodies range between a fall of 10 per cent and a rise of a little more than 2 per cent...

...The leading estate agencies are also broadly downbeat in their outlook for 2011. Knight Frank forecasts a 6 per cent fall in the main UK market, hampered by weak growth in real incomes, declining consumer confidence and the difficulty in accessing the mortgage market.

Savills calculates that prices will fall by about 3 per cent by the end of next year in the mainstream market, while Carter Jonas predicts prices will decline 5 per cent and Hamptons expects values to fall by 4 per cent for the UK market.

Catherine Penman, head of research at Carter Jonas, said: “The stalling economic situation reinforced by the comprehensive spending review, weak outlook for mortgage demand and the imminent public sector cutbacks collectively imply a further weakening of demand in residential property over the year to come.”

Almost all agents believe that there will be greater stability in London, however, in particular in prime areas, which are expected to continue to benefit from an influx of overseas wealthy buyers looking for safe haven investments. Both Hamptons and Carter Jonas predict that London homes will rise by 5 per cent in value during 2011...

Regards & Happy New Year,

Mark

oilretire

2nd Jan '11

Surely a large number of people with mortgages set up some level of over payment on the way down so on the way back up the first two or three interest rate rises can be absorbed without increasing your monthly outgoings?

I would like to think I'm not in a minority group here and therefore the initial stages of interest rate increases will not be as painful as feared?

Then again, maybe I'm blinkered & too close to the 'what recession?' zone where I sometimes wish the likes of Xcite directors etc were not on the house hunt ;-)

nigelpm

nigel

What do you regard as a modest income? £25K ? & Which areas are you talking about? London?

Take average salaries and house prices :

Salaries - £26k (http://www.statistics.gov.uk/cci/nugget.asp?id=285)
House prices - £163k (http://www.nationwide.co.uk/hpi/historical/Dec_2010.pdf)

The average house would have at least two bedrooms thus taking joint average income of £52k and comparing against £163k (3.1x earnings) seems reasonable.

A deposit of at least 10% (£16k) is required and should take two people a good few years to save up.

Nothing unreasonable so far.

Sure, there are overheated areas where the above calcs will be completely wrong but that's always going to be the way.

I wouldn't consider house prices overvalued on an affordability basis. Historically yes - they look slightly toppy but that is NOT a reflection on future prices as we all know.

tacheman

Thanks Marben for expanding on your reasoning for selecting RCP. Putting capital preservation before growth does appeal, this seems to be backed up by comparing it's performance during the downturn to other indices.

I've downloaded the annual/half yearly reports, and had a quick initial look. With investments in Agriculture, Water, Oil and Health, the IT seems to be playing on the same global themes that I am keen to have exposure to. As you say, I probably won't invest right now, but do think it 'll be one for my watchlist.

I've also noted that there's a reasonably active board on iii here.

Fangorn

I'm not sure about the joint average income being so high Imv. Wouldn't it be safer to expect that most households would have one main earner(26k aver) and then the spouse, more often than not, perhaps only working part time, or not at all. Or is this an old fashioned view? Much has been made of the gender pay gap so I'd expect the joint average to be less on that basis alone.

Housing does seem to be prettty over priced imv down south and I have to admit that I've been one of those expecting far larger falls in property in prices than we have seen to date.

emptyend

Hi Mark,

IMO, over the next few years UK house prices are more likely to fall than rise. Current house prices are at ludicrous levels and completely unaffordable for the average home buyer. The only reason that they have held up is because interest rates are at historic lows, allowing over-borrowed households to stay put.

Only once interest rates start rising will the true extent of overborrowing be exposed, which could result in a severe correction of current UK house prices.

I agree completely with that. However, whilst I can see wholesale market rates gradually moving up to 4-5% I doubt that mortgage rates will do the same, mainly for fear of a crash and thus (literally) collateral damage for the mortgage banks. Housing prices I see as being under gentle downward pressure for the next 10 years...minus 2-3% a year perhaps.....nothing so great as to spook the populace or change their lifestyle plans but enough to gently deflate the wasteful over-investment bubble that has led people to regard property investment as "as safe as houses" and treat them as "their pension".

the events of 2008 have taught us that it is dangerous to ignore the economic backdrop. However, I also feel that focussing on the UK gives a very blinkered view and that the economic situation looks very different in other parts of trhe world. There are distinct signs of a pickup in the US, with lower than expected unemployment claims numbers being reported today.

You are quite right re 2008 but I think you are much too relaxed on the USA. Yes there is certainly some evidence of a pick-up, but the economy remains heavily over-borrowed and the recovery being stoked by QE is largely a jobless one. In addition, IMO, the weak fiscal position in the US leaves them exposed to being hit extremely hard in the event of unexpected major forces.......and here I'm thinking of, for example, another 1983-style oil price shock caused by a supply side problem (be that Iran, Saudi, Venezuela, Angola or whatever) .....or the long-expected "big one" earthquake in California (a state which is also already fiscally on its knees). I think that the US is "riding its luck" to a very large degree - and the risks to the economy are much higher than generally perceived.

I note your exposure to Brazil - and I think the Brazil situation is, quite probably, the most interesting and the least-discounted of all the BRIC opportunities. But I'm still mulling it over. In particular, the political backdrop of recent years has been unprecedentedly favourable - and it isn't clear to me (given the change at the top of government at the weekend) whether that will actually continue. Indeed I wouldn't rule out some destabilising events in South America given the permanent belligerance of Chavez and the incipient Falklands/Malvinas issue provoked by oil exploration...let alone the questions of Cuban politics when Castro finally dies.....all being overlain on fresh governments in Brazil and others.

In the fixed income class, I am trying to hedge the risk of either an inflationary or a deflationary scenrio by exposure to both index linked gilts (that will gain from inflation) and to prefs and bonds (that will gain from deflation).

This is essentially what I did within my cashed-up pension funds when I went to cash (at FTSE 6700) in 2007. I hold a chunk in both index-linked and conventionals.....and both have performed. Despite the likelihood of rising rates I don't see any need to change those holdings - although interest rates will tend to rise, I think there will continue to be a good bid for "safe" government bonds of all varieties that may well offset the potential for rate-induced price falls.

The bottom line is that I don't think equities are yet cheap enough for the risk profile I perceive them to have. I'm happy with my remaining holdings in E&Ps, but mainly because I think they have particular attractions from an M&A perspective in an environment where "resource-grabbing" is going to continue to be an important theme. The locus of this activity is gradually moving east, I think, and I consider that 2011 could be a very active year.

Time will tell...... ;-)

rgds & NHY

hello nigel:

Whilst its good to see some hard numbers, I would question the basis of your calculations.

You assume that each household has 2 full-time reliable breadwinners. I think that's a pretty questionable assumption, especially at a time when public sector cuts are about to hit. That makes house prices more highly geared to the level of unemployment. It used to be considered sensible that a couple should be able to pay the mortgage even if one partner lost their job, and I expect people will think that again in the future once they have suffered the consequences of what happens if you don't take this precaution.

I also think more care needs to be taken with the averages used. Whilst the average income is £26k, I have read that the median income is more like £20k, because of the skewing effect of high earners. Presumably the median house price would also be lower than £163k, but how much lower?

I managed to find some figure on the ratio of median house prices to median incomes here:

http://www.communities.gov.uk/housing/housingresearch/housingstatistics/housingstatisticsby/housingmarket/livetables/

In 2009 it was 6.27, down from the peak of 7.23 in 2007, but much higher than the 3.5 recorded in 1997.

I would also comment that having 2 breadwinners per household doesn't seem to have supported US house prices very much. Perhaps that's because unemployment is higher....

Hi ee,

There is much that I agree with in your post... but I'll start at the end, with the main point I'm trying to get across in response to tacheman's original article:

The bottom line is that I don't think equities are yet cheap enough for the risk profile I perceive them to have.

I disagree with the premise that "equities" should be lumped together as one asset class. If one were considering investing in an index tracker vs the fixed interest asset class you have chosen, I would largely be in agreement and favour the latter. However, the term "equities" spans such a broad range of assets, especially these days (including, for example, commodity ETFs) that I think the equity class needs to be subdivided and that superior returns can be achieved by diligent selections within that class and timing (based on value fundamentals for each specific equity).

Turning to the US:

I think that the US is "riding its luck" to a very large degree - and the risks to the economy are much higher than generally perceived.

Broadly, I tend to agree - but I'm sticking my neck out and saying "not yet". There are emerging signs that the nascent recovery in the US is no longer "jobless" (typical of recovery cycles, when job creation follows early recovery stages) - but it's too early to know for sure. I am sure that there is trouble ahead for the US$, but it is in no one's interest for there to be a sudden collapse - especially from the Chinese POV - so world powers will do everything they can to arrive at a soft landing. Whether they will succeed remains to be seen but I suspect we have a few years before we find out.

IMO, US politics and decisions take by the electorate will play a huge part in determining the outcome. For the meanwhile, however, we're likely to have a gridlocked congress for the next couple of years, so I don't think we're likely to see anything dramatically negative in 2011. I acknowledge, however, the risks that are there.

In that regard, my decision to invest in your bete noir, gold miners, over the last couple of years has worked out well. Looking at any overall lesson there (and from your experience in the 1980s), I think it is that gold does not work as a hedge against equity market crashes but does work as a hedge against debt and currency crises (especilaly whilst real interest rates remain negative). Given that I think we agree that neither of those crises is over yet, I remain comfortable with a certain degree of exposure to selected gold mining investments.

Now to Brazil. I must point out again that Rousseff is regarded as (and tries to give the impression of being) the continuity candidate, not a dramatic change in government direction: http://www.google.com/hostednews/afp/article/ALeqM5hyjmM7PkIuwyRDZRJtPqzyoho28w?docId=CNG.d0742101cf6091a508d93992474e7181.701

BRASILIA — Brazil's new president, Dilma Rousseff, started her first full day in office Sunday with a series of short meetings with world leaders, according to her aides.

Rousseff, who on Saturday took over from her mentor Luiz Inacio Lula da Silva, was meeting the leaders of Uruguay, South Korea, Portugal, the Palestinian Authority, Cuba and Japan.

She started the bilateral meetings with a face-to-face with Spanish Prince Felipe de Asturias after Venezuelan President Hugo Chavez reportedly canceled the meeting and flew back to Caracas.

The leaders were among dignitaries who attended Rousseff's inauguration Saturday, which took place in Brazil's futuristic capital under rainy skies.

The event was a carefully staged endorsement of continuity, with Rousseff, 63, vowing to maintain Lula's policies that have turned Brazil into an economic and diplomatic power to be reckoned with.

She wiped away tears as she gave her first national address as president in which she described the "emotion" at seeing her predecessor go.

"But Lula will be with us. I know that the distance of this position won't mean anything to a man of such greatness and generosity," she said.

[My bold ;0)]

The difference in our investing approaches illustrates the truism that each person's investing strategy must be tailored to their own circumstances and proclivities. I have little doubt that your decision to disinvest from equities in 2007 worked well for you, as it has returned perfectly respectable and above average results. My own policies led to more of a roller-coaster ride, (for my main SIPP portfolio) with my biggest ever mark-to-market loss of -27% in 2008 - but my biggest ever gains of 50% in 2009 and 42% in 2010, rather more than making up or that.

2011 and beyond will show whether I have simply been lucky over the last couple of years or whether I have learnt as I have gained experience over my 6 year full-time investing career. Looking back, I certainly feel that I have learnt a lot more over those 6 years that the preceding 20 investing as a hobby. I must acknowledge a debt to several "online" mentors (most of whom I have also become aquainted with in the "real world"), including yourself ee, for your insight into the investment banking world and warning of the perils of gearing. Carmensfella deserves a special mention, for his boundless energy in advocating shareholder activsm and arranging numerous events, without personal reward, for investors to engage in dialogue with company managements and with other investors.

Best,

PS, just so people don't get an incorrect impression, I should point out that my relative weighting in natural resource linked investments, is 1.5 : 3.5 : 1 gold : oil & gas : uranium. I also have smaller weightings linked to coking coal and nickel. I have to admit, though, that this is more an historic accident as my portfolio has developed rather than a deliberate decision - but I certainly do wish to have significantly larger exposure to oil & gas than to gold at present.

Just a couple of points:

....mmmm. Whilst there is ALWAYS going to be some truth in that argument, I am reminded that it was one that I have deployed myself in recent years and I have since become vastly more cautious of that view. Back in 2007/8 I reasoned that E&P equities should be relatively "safe" because they never discounted oil prices above $90 or so (despite actual prices north of $140) and the structural reasons for holding them were not going to disappear with the banking crisis. That didn't stop the market trashing the whole sector along with everything else......and indeed in some cases perhaps the falls were substantially larger than were justified by the fundamentals simply because they were more liquid (and thus easier to sell) than other assets.

On the US:

Broadly, I tend to agree - but I'm sticking my neck out and saying "not yet".

....I would argue that your view relies on "situation normal" for 2011. Yes if "nothing bad happens" then certainly equities and the economy will be engineered higher in tandem for political reasons.....but IMO the downside risk if that happy scenario fails is vastly larger than the upside profits if it succeeds (and in any event may merely be a deferral of problems to be faced).

It is wrong to refer to gold miners as my bete noire. I've invested a number of times in gold miners in the 1980s and 1990s - and whilst I have proven to my own satisfaction that they don't hedge against equity crashes and indeterminate feelings of uncertainty, they are certainly an attractive hedge against worries over the fundamental monetary system (and boy have we had those in spades recently!). However, it is my opinion that the same can be said of most real asset that have long-lasting value.....and I personally have preferred long-lived reserves of oil and gas. In the short run they have certainly underperformed gold - but I'm now thinking that gold is near to topping out (unless we get a whole new leg of systemic problems).

OTOH with gold, there IS a real demand for jewellery etc - and rising wealth in, for example, India seems to be stimulating MORE consumption, rather than being deterred by high prices. In the short term this fundamental demand story has strongly helped gold's performance....but I don't think one can necessarily assume that will continue.

On Brazil, I fully agree that the new PM is positioned as the "continuity candidate".....but on the other I find it very interesting to note that various points about her past seem (according to TV news in recent days) to have emerged only after the election has been done and dusted......such as aspects of her time as a Marxist rebel and political prisoner. Some, for example, seem to worry about change in the relationship with the US, given her comments about Iran....and it will be a case of carefully watching her actions I think before one can draw solid conclusions about continuity.

rgds

Whilst its good to see some hard numbers, I would question the basis of your calculations.

You assume that each household has 2 full-time reliable breadwinners. I think that's a pretty questionable assumption, especially at a time when public sector cuts are about to hit. That makes house prices more highly geared to the level of unemployment. It used to be considered sensible that a couple should be able to pay the mortgage even if one partner lost their job, and I expect people will think that again in the future once they have suffered the consequences of what happens if you don't take this precaution.

I also think more care needs to be taken with the averages used. Whilst the average income is £26k, I have read that the median income is more like £20k, because of the skewing effect of high earners. Presumably the median house price would also be lower than £163k, but how much lower?

I wouldn't dispute any of that. My point still remains though house prices are not ludicrously overvalued per earlier posts with very basic maths before we start confusing things.

Sometimes it's best to Keep It Simple.

RE: median incomes as a historic indicator - this is hopeless for the very simple fact that disposable incomes are dramatically higher and people spend much more money on leisure time.

8th Jan '11

Checking the FT's weekly market ratios published today, there are some interesting figures, which I've selected:

Market	P/E	Yield

Brazil	14.6	2.7%
China	13.5	2.5%
India	23.6	0.9%
UK	15.7	2.7%
US	17.5	1.8%

More significantly, these figures suggest that Chinese and Brazilian markets are not toppy at all, as might be expected after they've been relatively static over the past year. This illustrates, once again, that the view we have of our local markets here is not necessarily an appropriate view for other parts of the world. In this globalised era, when it is relatively easy to get exposure to global markets, IMO investors need to take a broader view than just one of their own local market.

I have recently added some Aberdeen Asian Smaller (LON:AAS) to my portfolio, to add exposure to the most dynamic parts of the Far Eastern economies.

Regards,

deucetoace

Mark,
There have been some discussion on TMF about warrants & subscription shares. I wonder if you have considered SDPS (which I hold) or perhaps AAIW to give some gearing to your exposure.
deucetoace

In terms of "toppy markets", the UK and US do look somewhat pricey, on a simplistic basis. In the UK's case, however, I wonder to what extent the apparently high rating is due to the market being dominated by global oil and mining companies?

You are suggesting a P/E of 15.7 and Yield of 2.7% is "toppy"?

Given base rate at 0.5% and very low inflation I'd argue it's probably fair value/ even edging toward slightly cheap.

Toppy Market - Stocks as an Inflation Hedge?

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Tacheman

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