May 2006 Investment Report
‘THE GODFATHER – PART 1’
European Stock Market
Benjamin Graham was the ‘godfather’ of investment analysis. His stock-picking criteria included a price/earnings ratio (based on the average of the past three year’s earnings) of less than 15, 33% earnings growth during the past ten years, and a good record of dividend payments and positive earnings per share during the past ten years. Currently just 2% of the market qualifies (in cap-weighted terms) and just 1.3% of stocks. The best of luck to anybody who wants to identify these stocks. Those people investing in the market generally will require more than luck; they will require a radical change in the performance of poorly valued stocks in order to avoid large financial losses.
US Stock Market
Those of you who received my May 2005 Investment Report may recall the following quotation from the Barclays Capital Equity Gilt Study 2005 – ‘Real equity prices may be considerably lower in 20 years time’. The rationale being that there is expected to be a smaller proportion of workers to savers, to invest in stock markets. The Barclays Capital Equity Gilt Study 2006 compares the actual and predicted rolling 15 year US Equity Returns, using trailing 15 year rolling returns and coincident PE ratios. There is a high level of correlation which suggests that from the year 2000, the US stock market may tend to produce a zero nominal return over the following fifteen years. As the return over the first five years has been precisely zero, the return over the next ten years can be expected to be zero.
I have written regularly of the problems that the developed economies of the world are facing – huge amounts of personal and corporate debt, low levels of savings and vast current account and trade deficits. Nevertheless, stock markets have recovered somewhat over the last three years on the back of an economic recovery and earnings growth. It is important to remember that the current good news is cyclical and the bad news is structural. In the longer term, the structural problems will have a greater impact on stock market returns.
Commodities
The recent strength of the US dollar and falling world money supply, suggest that the price of commodities and mining stocks will soon begin to fall.
Corporate Bonds
1/3rd of CCC rated bonds default within two years. Since 2003, the proportion of the market in CCC rated bonds has risen from 2% to 30% which suggests that default rates should soon begin to rise.
Gold
According to Paul Mylchreest of Chevraex, the ratio of the Dow Jones Index to gold has averaged 12.5 since the collapse of the Bretton Woods exchange rate system in 1971. If the Dow were to remain at the same level and the ratio were to fall to the post 1971 average, gold would rise to $900 an ounce. In 1980 the two numbers were virtually the same. I am not predicting the same will happen again, but economic fundamentals suggest that a gold price of 2000 and the Dow at 4000 are possibilities.
The long term ratio of gold to oil is around 16, according to Mylchreest, but the current ratio is about 9. If the oil price were to remain the same and the ratio were to return to the average; that would take gold past $1000. As I have said many times before, in order to have an average there has to be under average and over average and we have not seen over average for some time.
Gold mining shares are currently under valued relative to the gold price by 15%.
Property
Where house prices have risen faster than underlying incomes, only two possibilities exist. Either prices have moved to a higher equilibrium level, in which case future purchasers will have to save more and consume less. That would itself have significant economic implications. Or they have reached an unsustainable level, in which case they will fall in real terms. That would have far more significant economic implications.
The views reflected herein are those of Mitchell Neale Investment Services and should not be regarded as a recommendation to invest in any product or service; before investing you should always consider personal investment advice.
Mitchell Neale Investment Services does not accept any liability whatsoever for any direct or consequential loss arising from any use of this report or its contents. Investors should be aware that the value and income from investments can rise and fall and that past performance should not be considered as a guide to the future.
Mitchell Neale Investment Services
2nd May 2006