Preserving Gains

May 2021 Investment Report

 

Rising inflation within plain sight

We have been warning for several years about the dangers of excessive levels of debt and the severe overvaluation of stock, property and bond markets. It was not always clear in which way or when this was going to be resolved, other than the knowledge that ‘fiat’ money (https://www.investopedia.com/terms/f/fiatmoney.asp) has a history of ending with very high levels of inflation. The path to those very high levels of inflation has just become more obvious.

 

I shared the following chart with you in a recent weekly update. It demonstrates a high correlation between the US twin deficits (current account and budget) as a percentage of GDP (dark blue line) and the US Dollar Index (light blue line). As the chart illustrates, there is a strong implication that the US Dollar is likely to suffer a devaluation of around 50%, its largest since the American Civil War in the 1860’s. Currency depreciations are associated with rising levels of inflation as foreign capital is withdrawn and the cost of imports escalates. Historically, stock, property and bond markets fall heavily during periods of strongly rising inflation, for which the beneficiaries have historically been Index Linked Gilts, Commodities, Energy and Precious Metals. Our portfolios are highly geared towards these outcomes.

 

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Preserving gains

Investment markets have been a little volatile over the last few years and investors have become attuned to and generally tolerate that environment. The higher rates of inflation that we are anticipating generally bring with it higher levels of volatility. Many investors will not be able to tolerate this higher volatility, particularly if they are not prepared for it. Our portfolios are already designed to benefit from an inflationary environment, but we can also prepare for this increased volatility.

 

The investment performance of most of the asset classes and funds that we recommend has been excellent over the last few years. Based upon our analysis of where economies and investments are likely to travel, this should continue in the future, but with more volatility. For example, some of these funds could grow by as much as 800% over several years, but within those gains, there could be setbacks of as much as 60%. Whilst these numbers may appear speculative and excessive, they will not be that great when adjusted for much higher levels of inflation.

 

So how should we manage the volatile markets that we anticipate?

 

Firstly, the majority of investors are making the mistake of considering relative value. For example, the Price to Book ratio of the US S&P 500 index is currently 3.98 and for the UK FTSE All Share Index it is 1.55. This suggests that the UK FTSE All Share Index is around 60% cheaper than the US S&P 500 index and theoretically has the potential to grow to bridge that gap. However, we also know that in extremely bad market conditions (the 1930’s and the 1970’s) markets traded at a price to book ratio of below 0.5. Consequently, the risk is that the US S&P 500 index falls by at least 87% and the UK FTSE All Share Index falls by at least 68%. In reality, it would be good to avoid both of these losses rather than adopt a relative view.

 

There are a number of ways in which we can apply some discipline to preserving gains.

 

Our investment philosophy includes the following factors:

• Avoiding overvalued markets

• Buying low price to book (offering security)

• Buying low price to cash flow & sales (growth)

• Selling high price to book, cash flow and sales

• Recognising long term trends

• Tweaking short term trends

• Not attempting to act on every move in markets (accepting some volatility)

 

Selling high price to book, cash flow and sales

The US S&P 500 index has traded above what we would consider to be reasonable value for all but three or four of the last twenty years, which is why we have avoided this market. Whilst that market has performed well, it is vulnerable to significant and unrecoverable losses. Alternatively, as long as our own portfolios have been providing adequate returns with a reasonable degree of security, then we are meeting objectives with greater security and longer-term potential.

 

 

 

An example, of how we are selling overvalued funds can be observed from our recent activity regarding the Guinness Sustainable Energy fund, which we have begun to sell in order to preserve gains. It has gained 97.9% in the last year and is now trading at a price to book ratio of 2.75, along with high price to sales and price to cash flow ratios.

 

By comparison, other funds that have performed well, such as the BlackRock World Mining Trust and the Ruffer Gold fund, are trading at price to book ratios of 2.16 and 1.30 respectively. They also have attractive price to cash flow ratios. Furthermore, they are trending higher from low ratios and rather than being high or trending lower from high ratios.

 

Recognising long term trends

Very long-term trends indicate that stock, property and bond markets are at points which potentially offer lower long-term returns and the possibility of unrecoverable inflation adjusted losses within any reasonable time horizon. Consequently, they should be sold, avoided or hedged with inflation and credit protection orientated assets. Inflation and credit protection orientated assets currently offer the potential for higher returns and the prospects are that any losses are recoverable within reasonable time horizons.

 

Tweaking short term trends

Our performance targeted returns provide an excellent first check on identifying profit taking opportunities.  Where returns are above target, we would be inclined to draw some profits from areas where returns may have been the highest and to redistribute those profits to areas offering better value (i.e., lower price to book, price to sales and price to cash flow ratios). 

 

Technology has enabled us to improve the way in which we tweak portfolios on a short-term basis. Techniques such as Point and Figure charts (https://www.investopedia.com/articles/technical/03/081303.asp) and Relative Strength Indices (https://www.investopedia.com/terms/r/rsi.asp) assist us in identifying price targets and market over exuberance. The Relative Strength Index has a scale of 0 to 100 and I have never seen any investment (including Tesla and Bitcoin) exceed very much more than a high relative strength of 90.0. Again, taking the Guinness Sustainable Energy Fund, the relative strength of the clean energy index recently hit 90.0 and provided us with clear identification of over exuberance within the sector and justification for exiting the Guinness Sustainable Energy fund. In comparison, the BlackRock  World Mining Trust has a current relative strength at 82.42, the gold mining sector is at 57.39 and the conventional energy sector at 57.29. the Guinness Global Energy fund is also trading on an attractive price to book ratio of 1.18.

 

As our preferred assets offer good longer-term value, it is likely that we will suggest selling a proportion of the asset or fund that has become overvalued in the short term and to reallocate it towards a more undervalued asset. For example, as the BlackRock World Mining Trust currently has a high relative strength index, we have begun to recommend selling about 75% of any exposure to that trust for reinvestment into the gold and conventional energy sectors, which have lower valuations and relative strength.  

 

We will not always know in advance where any profits will be redirected. This will depend entirely upon valuations, technical analysis and economic and investment circumstances at the time.

 

 

Not attempting to act on every move in markets (accepting some volatility)

It is impossible to time markets and funds perfectly, indeed many professional investors struggle to identify longer term trends. Every investment bears some measure of volatility (rises and falls in prices). Comfort comes from understanding that you are investing in undervalued assets and funds which reflect the longer-term cycle, and that you are therefore reducing the risk of unrecoverable losses and increasing the probability of significant and sustainable gains.

 

We will contact you when we feel that it is appropriate to make alterations to your portfolio.

 

The views reflected herein are those of Vertis Private Wealth Management Limited 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.

Where you seek the advice of Vertis Private Wealth Management Limited, we continually monitor markets and will advise you where there is a change in the findings of our research and provide advice and guidance on any alterations that may be required to the investment strategy that we have previously recommended.

Vertis Private Wealth Management Limited 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. Your capital may be at risk.

Mitchell Neale

Vertis Private Wealth Management Limited