FYI | Dec 10 2012
By Tim Price
“There’s a stereotype of Goldman folks and he’s not really the stereotype. He’s a very good guy.”
– Michael Sabia, CEO, Caisse de depot et placement de Québec, quoted in The Financial
Times.
“Sir, Given the outpouring of plaudits for our Mark Carney (with the FT leading the way), might we expect Mr Carney to save money for the British government by walking across the Atlantic ?”
– Letter to the FT from Mr John H. V. Gilbert of Vancouver, BC, Canada.
To Hampshire, and to the rather wonderful Four Seasons Hotel, the setting for Citywire’s ‘Smart Beta’ retreat.. We went specifically to hear from Russell Napier and Dylan Grice. In the event, circumstances precluded Mr Grice’s attendance. But the first keynote speaker, Mr Napier, managed to steal some thunder from SocGen’s notorious ‘Ice Age’ analytical team.
Russell Napier has written the book on bear markets. Specifically, the book is titled ‘Anatomy of the Bear: lessons from Wall Street’s four great bottoms’, and it comes highly recommended. And bear markets are not necessarily to be feared. Provided one can survive them, they bring in their wake opportunities to create significant wealth. But this is not automatically a rapid process. As Marc Faber writes in his introduction to the book,
“Conventional wisdom has it that great market bottoms, which offer lifetime buying opportunities, occur quite soon after devastating market crashes. But, as Russell shows in this book, great bear markets have long life-spans.. at its 1921 low, the Dow Jones Industrial Average was no higher than it had been in 1899 – 22 years earlier – while during that period nominal GDP had increased by 383% and real GDP by 88% ! Similarly, by August 1982, the Dow was no higher than it had been in April 1964, and was down by 70% in real, inflation-adjusted terms..”
In any event, if you want to send a roomful of 100 wealth managers into an icy chill, have Russell Napier address them. His presentation, ‘Deflation in an age of fiat currency’, is thought-provoking, and the precise polar opposite of ‘investing as usual’. A wry and picaresque speaker, Russell starts with some conclusions. Among them:
- To reach record lows [akin to those on offer in 1921, 1932, 1949 and 1982], (US) equities will have to fall by more than 60%.
- Central banks are straining to produce inflation but developments in emerging markets (i.e.China) suggest a deflation shock is now likely.
- Capital exodus from China is disrupting the creation of inflation.
- In the search for yield, cash is trash – so now’s the time to own cash. (This is an example of his dry contrarianism.)
US stock markets aren’t cheap, not by a long chalk. Russell, like us, favours the 10 year cyclically adjusted price / earnings ratio or CAPE as the best metric to assess the affordability of the market. Unlike the traditional p/e ratio, CAPE smooths the near term volatility by taking a 10 year average.
At around 21 times, the US market’s CAPE is still towards the top end of its historic range. The S&P 500 stock index currently trades at a level of around 1400. Russell Napier, a financial market historian, believes it will reach its bear market nadir at around 450. That equates to a fall of roughly 70%. Food for thought.
There is better news, at least for non-Americans. Other markets, of course, have different valuations. Current CAPEs include:
- UK: 12.5x
- Italy: 7.8x
- Spain: 8.5x
- Greece: 1.8x
- Ireland: 6.0x
- Portugal: 9.2x
- Germany: 16.0x
- China: 18.0x
- Japan: 21.3x
On the face of it, the UK looks like fair value, and Greece, Ireland and Portugal all look cheap or very cheap. But as we know, these markets are also cheap for a reason.
To return, briefly, to that call about US stocks. Russell believes that the CAPE and separate Q ratio lows (the Q ratio being the market value of a company relative to its replacement cost) of 1921, 1932, 1949 and 1982 indicate that the S&P 500 will bottom out at around 450. He suggests that the bear market low, whatever it turns out to be, will be driven by a loss of faith in US Treasury bonds and the dollar by foreigners. The growth of the Treasury bond market coincided
with baby-boomers, medicare and social security entitlement. Its death will be triggered by falling demand for Treasuries as the emerging economies plump for consumption-driven growth (we have a promising investment, we think, in this regard). The funding requirements of western governments will squeeze private sector activity. Napier believes that the predicted rollover in the US Treasury market is already under way:
And his next chart is a killer: it shows the growth of China’s foreign reserves:
Growth, or lack thereof. Emerging market reserve growth created money and inflation. So when that growth goes ex-growth.
More conclusions ?
- US Treasuries could repeat their 83% price decline of 1946-1981.The supply / demand imbalance for US Treasuries can be met with higher rates – or higher
- savings and deflation. [Could we get both ?]
- Deflation is bad for equities but also for government bonds in the euro zone.
- Deflation has been good for government bonds in areas which print their own money “but this will end.”
Sobering stuff. We felt compelled to ask Russell, given these conclusions, how he felt about gold. He likes the asset. He also suggested that a plausible, defensive portfolio might include allocations to three key classes of assets:
- Gold
- Cash
- Equities.
Why equities ? Because, as he freely acknowledged, he might be wrong.
Provided one can survive them.. We think our clients’ financial fortunes over the months and years ahead will depend on how they survive the bear markets to come. We use the term in the plural because it strikes us as almost a certainty that a grotesque bear market in western government debt is approaching. (If we knew the precise timing we’d already be on the beach.) And if western government debt craters (choose your poison: US; UK; euro zone; Japan – they all
look appalling), stock markets will not be far behind. It is inconceivable to us that equity markets could simply ignore a savage sell-off in the, ahem, risk free markets of the world.
But that might also be getting ahead of ourselves. If Russell Napier is right, and we are on the cusp of a deflationary shock, western government bond markets might have one last hurrah. (Nobody ever said investing was easy.) His admittedly crude asset allocation split of cash, gold and equities doesn’t seem like a bad selection. We have somewhat refined it into four asset pots:
- Cash and objectively creditworthy bonds
- Defensive and sensibly valued equities
- Uncorrelated funds
- Real assets (with a hefty commitment to gold and silver, the monetary metals).
Wealth is going to be assailed by multiple challenges in the years to come. Financial repression; deflation; inflation; currency depreciation; selective default; an equity bear market.. If you can propose a better asset split that can offer at least some mitigation of these various threats to our financial well-being, we’re all ears.
Tim Price
Director of Investment
PFP Wealth Management
24th September 2012.
Email: tim.price@pfpg.co.uk Twitter: timfprice
Weblog: http://thepriceofeverything.typepad.com Group homepage: http://www.pfpg.co.uk
Bloomberg homepage: PFPG
Disclaimer: The views expressed are the author's, not FNArena's (see our disclaimer)
