Investment Postcards from Cape Town

This post provides links to a number of interesting articles I have read over the past few days (while touring through Europe) that you may also enjoy.

• Gary Stix (Scientific American): The science of economic bubbles and busts, July 2009.
The worst economic crisis since the Great Depression has prompted a reassessment of how financial markets work and how people make decisions about money.

• Matt Taibbi (Rolling Stone Magazine): The great American bubble machine, July 9-23, 2009.
From tech stocks to high gas prices, Goldman Sachs has engineered every major market manipulation since the Great Depression - and they’re about to do it again.

• Bill Gross (Pimco - Investment Outlook): “Bon” or “non” appétit?, July 2009.
Investors who stuffed themselves on a constant diet of asset appreciation for the past quarter-century will now be enclosed in a cage featuring government-mandated, consumer-oriented fasting. “Non Appétit,” not Bon Appétit, will become the apt description for the American consumer, and significant parts of the global economy, including the US. Because this is so, short-term policy rates will be kept low for longer than cyclical norms, and the outlook for risk assets - stocks, high yield bonds, and commercial and residential real estate will involve just that - risk. Investors should stress secure income offered by bonds and stable dividend-paying equities.

• John Hussman (Hussman Funds): Green shoots and a grain of salt, June 29, 2009.
Let’s take a breath. Economic reports - especially growth rates - can be very misleading when they are not placed into context. In short, beware of analysts bearing indicators that all is suddenly well, and check their facts.

• Martin Feldstein (Financial Times): The Fed must reassure markets on inflation, June 29, 2009.
The immediate challenge is to reassure investors about both the risks of inflation and the projected growth of fiscal deficits.

• Robert Samuelson (Washington Post): “Reforms” won’t prevent future crises, June 29, 2009.
Since its earliest days, the United States has suffered periodic financial crises. Now we’re in the midst of another crisis. It would be reassuring to think that the Obama administration’s financial “reforms” — or, indeed, any conceivable alternative — would prevent these collapses for all time. Dream on.

• Martin Wolf (Financial Times): The cautious approach to fixing banks will not work, July 1, 2009.
The financial system had to be rescued from its own mismanagement of risk. This is not going to be changed by external supervision, which would be like moving the regulatory deckchairs on the deck of the Titanic. It is going to be changed only by fixing incentives.

• Brad Setser (Council on Foreign Relations): The savings glut. Controversy guaranteed, 30 June 2009.
It is quite possible to believe that the buildup of vulnerabilities that led to the current crisis was a product both of a rise in savings in key emerging markets, a rise that - with more than a bit of help from emerging market governments - produced an unnatural uphill flow of capital from the emerging world to the advanced economies, and policy failures in the US and Europe.

• Anatole Kaletsky (Times Online): How the ECB’s fig leaf has completely withered away, June 29, 2009.
Leaving aside the question of whether it is a good or a bad idea to print money, which of the world’s leading central banks is printing money faster: the Fed or the European Central Bank?

• Wolfgang Münchau (Financial Times): Germany and France need to sing in tune, June 29, 2009.
Debates over fiscal approaches aside, it is probably not a good idea for the two largest members of the eurozone to move in opposite directions.

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The performance of a number of global stock markets is given in the table below in local currency terms for different measurement terms ended June 30. Other than to say that the second quarter delivered exceptional gains and that the first half of 2009 is not looking too shabby either (bar a few exceptions such as the Dow Jones Industrial Index), the numbers speak for themselves.

Click here or on the table below for a larger image.

The gains/declines mentioned above are all in local currency terms. However, converting the movements to US dollar shows a better picture for the non-dollar countries (see table below).

Click here or on the table below for a larger image.

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This post is a guest contribution by Niels Jensen*, chief executive partner of London-based Absolute Return Partners.

As investors we are faced with the consequences of our decisions every single day; however, as my old mentor at Goldman Sachs frequently reminded me, in your life time, you won’t have to get more than a handful of key decisions correct - everything else is just noise. One of those defining moments came about in August 1979 when inflation was out of control and global stock markets were being punished. Paul Volcker was handed the keys to the executive office at the Fed. The rest is history.

Now, fast forward to July 2009 and we (and that includes you, dear reader!) are faced with another one of those “make or break” decisions which will effectively determine returns over the next many years. The question is a very simple one:

Are we facing a deflationary spiral or will the monetary and fiscal stimulus ultimately create (hyper) inflation?

Unfortunately, the answer is less straightforward. There is no question that, in a cash based economy, printing money (or “quantitative easing” as it is named these days) is inflationary. But what actually happens when credit is destroyed at a faster rate than our central banks can print money?

Let’s begin by setting the macro-economic frame for the discussion. I have been quite bearish for a while, suspecting that the growing optimism which has characterised the last few months would eventually fade again as reality began to sink in that this is no ordinary recession and that “less bad” doesn’t necessarily translate into a quick recovery. I still believe there is a good chance of enjoying one, maybe two, positive quarters later this year or early next; however, a crisis of this magnitude doesn’t suddenly fade into obscurity, just because the economy no longer shrinks at an annual rate of 6-8%.

Click here for the full report.

* Niels Jensen has 24 years of investment banking, private banking and asset management experience. He founded Absolute Return Partners LLP and is its chief executive partner.

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With the printing presses working overtime, government debt sky-rocketing and the US dollar getting debased, are we heading for an era of hyperinflation? Ron Paul, Peter Schiff, Jim Rogers, Tom Woods and Gerald Celente have strong ideas about this, as reported in the three-part “Hyperinflation Nation” video.

Part 1:

Part 2:

Part 3:

Source: YouTube, June 28, 2009.

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Bill Bonner (The Daily Reckoning) said: “While Bernie is behind bars, the SEC and FED officials are still at large. Both are clearly guilty of dereliction and negligence.

“But, what is the point of keeping Madoff in prison? He represents no threat. Rather than pay $30,000 per year to keep him locked up, we suggest that he be forced to do community service work. He should be pressed into service as the next head of the Federal Reserve after Ben Bernanke’s term expires in December.

“With Madoff in the big office, there would be no longer any illusions about what sort of bank the Fed is running.”

Source: The Daily Reckoning, June 30, 2009.

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The  seasonally  adjusted  Kagiso  PMI  for  June  increased  slightly  for  the  second  consecutive  month  to  37.9  points  from  37.3  during  May, confirming a bottoming out of the index in May.

The slowing in the contraction of output volumes continued with both the seasonally adjusted business activity and seasonally adjusted new sales orders indices increasing from 35.1 and 35.7 to 37.9 and 38.2 points respectively.

May’s  inventory  turnaround  was  not  sustained  œ  the  seasonally  adjusted  inventories index dropped from 35.4 to 29.1. In contrast, purchasing commitments posted a slight increase from 29.6 to 31.1 index points. The erratic behaviour of these indicators may reflect high levels of uncertainty amongst purchasing managers regarding future demand prospects, while the low index levels remain consistent with a contracting manufacturing sector.

In contrast to the weak near-term indicators, a majority of managers still expect  business  conditions  to  improve  in  6  months’  time  œ  the expected   business   conditions index remained above 50 at 52.8 points. The PMI component results are a mixed bag with some disappointment on inventories being countered by moderating output volume declines and a more positive outlook.

Although the May and June PMI data indicate that the worst of the factory recession may be over, the low index levels (significantly below 50) hint that positive growth is not on the cards anytime soon. Indeed, the average PMI for 2009Q2 was 36.9, down from 38.6 index points during 2009Q1.

Source: Kagiso Securities, June 30, 2009.

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An interesting analysis on the performance of the S&P 500 Index during various phases of the economic cycle was highlighted in a recent report by Citigroup Investment Research & Analysis, courtesy of US Global Investors.

The table below shows the performance of the Index in 15 complete economic cycles since 1921 and part of the current economic cycle. The performance has been broken down into five phases of each economic cycle: early expansion, middle expansion, late expansion, early contraction, and late contraction.

Interestingly, the average and median figures show that most of the stock market performance occurs in the early and middle expansion phases, and in the late contraction phase.

In order for this study to be of use one obviously needs to know where in the economic cycle we are. In this regard, Merrill Lynch (again via US Global Investors) has just published The Global Wave indicator, which quantifies trends in global economic activity. This measure signaled a downturn in September 2007 and troughed in June, suggesting that the global economy could be on the road to recovery. Following troughs in The Global Wave, global emerging markets tend to be the best-performing category with a median return of 39.6% over the subsequent 12 months, whereas the US usually lags with a more pedestrian 10.0%.

Based on past economic cycles, the above studies indicate a favourable environment for stocks over the next six to 18 months, short-term corrections aside.

Source: US Global Investors - Weekly Investor Alert, June 19, 2009.

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An excellent interview by Kate Welling with Barry Ritholtz, author of the must-read “Bailout Nation, How Greed and Easy Money Corrupted Wall Street and Shook the World Economy” and editor of The Big Picture blog, has just been published in the welling@weeden series.

Here is the introduction:

“Barry Ritholtz is not a man to mince words. For one thing, he doesn’t have time. Writing is a sideline to his day job as CEO and research director of FusionIQ, an online quantitative research firm and money manager, running about $100 million, long and short, mainly for high net worth individuals. Besides, as the proprietor of a popular financial blog, The Big Picture, he has been chronicling the foibles and follies of financial man for a number of years now and well, just doesn’t suffer fools. His readers know him for clear explorations of even the densest of topics and for honest vitriol when he comes across self-dealing and worse.

“There is plenty of both clear prose and pungent language in ‘Bailout Nation’, as it explores, in gory detail, where we’ve gone wrong in finance and in society. Not to mention who done it.

“My time between its pages left little doubt that Barry, whose legal training at New York’s Benjamin N. Cardozo School of Law focused on economics, anti-trust and corporate law, has more than a few ideas about what should be done.

“So when the unveiling of the Obama Administration’s regulatory reform proposals left me asking, ‘Is that all there is?’ I immediately put in a call to Barry.

“I wasn’t disappointed. Listen in.”

Click here or on the image below for the full interview.

Source: Barry Ritholtz, The Big Picture, June 28, 2009.

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Source: Tom Toles, The Washington Post, June 30, 2009.

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The raison d’être of investment or wealth management is to maintain, or hopefully improve, one’s standard of living, i.e. to earn a real return on the investment amount. This sounds easy enough if one considers that the S&P 500 Index (and its predecessors prior to 1957) delivered a nominal return of 8.7% per annum from January 1871 to June 2008. With an average inflation rate of 2.2% per annum over the period, this meant a real return of 6.5% per annum.

Yes, I can hear many readers arguing that much better returns can be generated by “playing” the market cycles, especially given the fact that the S&P 500 has made no headway since 1998. Ah, the art of market timing! Perhaps, but keep in mind that very few people have succeeded in consistently outperforming the market over any extended period of time, especially once costs and taxes are factored in.

Let’s go back to the total nominal return of 8.7% per annum and analyze its components. We already know that 2.2% per annum came from inflation. Real capital growth (i.e. price movements net of inflation) added another 1.8% per annum. Where did the rest of the return come from? Wait for it, dividends - yes, boring dividends, slavishly reinvested year after year, contributed 4.7% per annum. This represents more than half the total return over time!

Have a look at the following chart:

The numbers are summarized below in table format.

Source: Plexus Asset Management (based on data from Prof Robert Shiller and I-Net Bridge)

In an environment characterized by increasingly shorter investment horizons, the concept of compounding sounds so passé, but it remains one of the most important principles governing investment. The time has perhaps come to look beyond the short-term noise and focus on good old stock picking, and specifically those companies with strong balance sheets that will be growing their dividends over time with a reasonable degree of certainty. After all, compound growth has not without reason been referred to as the eighth wonder of the world.

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