what-we-said-15-years-ago

INVESTMENT REPORT FEBRUARY 2011

I Have Been Wrong In the Past, I May Be Wrong Now

And I Will Be Wrong In The Future

We completed an annual review for a client in December who had been with us for thirteen years. For the first two of those years we provided negligible investment returns whilst the UK stock market gained 40.7%. Nevertheless we continued to pursue our investment philosophy of avoiding overvalued investment markets and buying undervalued assets. Thirteen years from the commencement of that portfolio, the UK stock market has gained 85.8% whilst our client’s portfolio has gained 400%. Sometimes the hardest decision to make in investment markets is to do nothing, but it is often the most rewarding.

CYCLICALLY ADJUSTED PRICE EARNINGS RATIO (CAPE)

The Cyclically Adjusted Price Earnings Ratio in the UK (currently slightly in excess of 15) is likely to travel in a similar range (5 to 15 and occasionally 20) as it did between 1974 and 1987. A fall to the bottom of this range would result in a fall in the UK stock market of approximately 66%. The US stock market is reckoned to be 73% overvalued.

Whilst bulls are targeting 1400 to 1450 on the US S&P 500 Index (currently 1343) for the end of this year and they may well be correct, Robert Shiller, Professor of Economics at Yale University and the master of CAPE and price to book ratios, has an expectation of 1430 by the year 2020!

FACTORS SIMILAR TO PREVIOUS STOCK-MARKET PEAKS

2000 to 2002 – the US stock market fell by 48% and the UK stock market fell by 51%.

2007 to 2008 – the US stock market fell 57% and the UK stock market fell by 48%.

Chinese interest rates are now close to the rate of inflation as they were in the middle of 2007;
Chinese gross commercial property started exceeds the amount sold by approximately 20% and both are falling as they were at the beginning of 2008;
Commodity prices are now higher than they were at the beginning of 2008;
Chinese Aluminium annualised production is now falling as it was in 2008;
The Baltic Dry (Shipping) Index is now falling at a similarly precipitous rate as it did in the middle of 2008;
The emerging market risk premium relative to developed markets is back at the low levels seen in 2000 and 2007/8;
Last year emerging markets outperformed developed markets as they did in 2001;
The Agriculture Index is exceeding stock market indices as it did in 2008;
Global industrial production levels have fallen back to 2008 levels;
The UK manufacturing purchasing managers index is peaking and consumer confidence is falling as they did in 2000 and 2007;
German consumer and business confidence is back at levels seen in 2007 and in excess of those seen in 2000;
Last year US smaller companies outperformed all other US indices as they did in 2000;
Last year the FTSE 250 Index outperformed all other UK indices as it did in 2001 and 2006;
The UK Equity yield is currently falling and is lower than inflation which is rising as they were in 2000;
The percentage of stock market bulls now matches the high levels seen in 2007 and 2008;
OPEC spare capacity is back at the high levels experienced between 1999 and 2002;
World equity price to book ratios are back to levels seen in 2001 and 2008.

AVERAGE HOLDING PERIOD IN US SHARES

The average holding period for US shares fell to 1 year before the 1929 stock market crash and then increased to ten years by 1940. The holding period has subsequently and gradually fallen to one again, demonstrating that investors are continuing to take short term bets rather than invest on a long term basis. It is again likely that a severe correction will have to occur in order to educate investors the hard way.

KONDRATIEV

The twenty six year inflationary cycle that has been in place since the eighteenth century is not due to peak until 2026. As the emerging markets are the current source of strength and inflation in the global economy, we need to pay slightly more attention to their behaviour than those of the developed world. Inflation can fall temporarily during periods of rising inflation (this is likely in the UK with broad money now falling at a rate of over 3%) and we may see such an event this year as the emerging world attempt to curb inflation by raising interest rates. The interest rate policies of the developed world are unlikely to have much impact on inflation. Developed economy inflation may also be influenced by the further depreciation of their currencies over several years.

DELEVERAGING

Researchers at the Bank of England have concluded that the new Basel III rules requiring banks to hold more capital are too weak and should be doubled to provide optimal protection against future economic shocks. The discussion paper calculates that forcing banks to hold twice as much equity against potential losses would cut economic growth by 6%.

UK banks began the financial crisis with debts exceeding deposits by $640bn. That has now reduced by $240bn by transferring debt to the government. This deleveraging is likely to continue for another three to four years. A bank capital ratio of 53% of risk-weighted assets sounds ridiculously high. The current standard is about 7%. But David Miles and two colleagues at the Bank of England argue that depositors would only have been absolutely safe at all times since 1821 if equity made up half of the banks’ risk-adjusted balance sheets. The required ratio drops if the future is expected to be somewhat calmer than in the past, but is still 15% to 20%.

Current minimum international bank capital requirements are 8% and are due to rise to 10.5% by 2019. In 2008 average bank capital ratios were as follows and are now only marginally better:-

Russia 13.6%

United States 9.3%

Italy 6.6%

Spain 6.4%

China 6.1%

Ireland 4.7%

Germany 4.5%

UK 4.4%

Amagerbanken, a small Danish bank announced this month that it would transfer assets to Denmark’s Finansiel Stabilitet, the state-owned company charged with winding down the country’s insolvent banks, after failing to meet solvency requirements. Finansiel Stabilitet was created in 2008 as part of a wide-ranging bank rescue package and has already taken over a number of bankrupt Danish financials. Bond holders and depositors of more than 100,000 Euro’s in the bank are anticipating losses of 41%. The deterioration in Amagerbanken’s financial health might come as a shock to investors and depositors. The bank had a tier one capital ratio, a measure of balance sheet strength, of 13.9% and a core tier one ratio of 8.8% at the end of September.

So far Ireland has created the largest challenge to Euro officials with banking sector assets (loans)representing 20% of Euro area GDP. Spain’s banking sector will be more of a challenge with assets representing almost 40% of Euro area GDP and the economy contributing little more than 10% of Euro area GDP.

The Washington based Institute of International Finance reckons that in the US about $1.4 trillion of Commercial Real Estate loans must be refinanced before 2014. Alarmingly, half of these have mortgages in excess of the current value of the property. It seems hard to believe that all that refinancing will occur smoothly. Barring a miracle, defaults will rise. An estimated 30% of US residential mortgages exceed the value of the underlying homes, giving rise to a $700bn shortfall.

UK ECONOMY

The contraction experienced by the UK at the end of last year was exacerbated by the wintry weather. But even without such distortions the economy would not have grown in the last quarter of 2011. That increases the risks of Britain succumbing to a double dip if the government’s austerity programme has more of an impact on consumer confidence than forecasters currently assume. If the Bank of England raises interest rates prematurely and the pound overshoots, the UK economy may struggle in 2011. Conversely if the Bank leaves interest rates on hold and elects to keep looking through the near-term rise in inflation, gilt investors may start to believe monetary policy is falling behind the curve. Sterling bulls should be aware that the Bank’s dilemma will only become worse during 2011.

CHINA

Excessive investment has soared to 44% of GDP. Economies that witness high investment are prone to booms and busts. The minimum wage in Shanghai has increased by almost 200% in the last ten years. There are 91 cities in China with populations in excess of 1m compared to 39 cities in the US. China also has the highest overall score of school achievement in the OECD.

JAPAN

Deposits at banks exceed outstanding loans by a record $1.8 trillion, equivalent to about a third of GDP. Japanese equities are also priced at a discount to book value.

Gross cash does not equal net cash – non-financial sector leverage is at an all-time high, according to the Federal Reserve’s flow of funds data.

PROPERTY

In 1990 Japanese residential property values represented nearly 5% of GDP and over the last twenty years have fallen in value by approximately 60%. The UK residential property market now represents 6% of GDP and will either fall dramatically in the short term with rising inflation and interest rates, or slowly over the next decade or so with deflation and depression.

WINE

The price of wine has been closely correlated with the price of oil for the last twelve years – wine investors should watch the price of oil closely and if they feel it is becoming too expensive they should consider selling.

The views reflected herein are those of Mitchell Neale Investment Services and should not be regarded as a recommendation to invest in any one 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

February 2011