Bearing up well in uncertain times

The emotions surrounding investing can be similar to the fear some of us feel when contemplating an airline flight. Our rational voice tries to convince us that it’s perfectly safe and that the most dangerous part of the journey is actually the trip to the airport. Yet this voice of reason can be drowned out by a rising tide of fear that magnifies all of the unlikely things that could potentially go wrong.

It’s the same when we think about investing. We can arm ourselves with all the facts about markets going up over time and the power of compound returns, but there are always a multitude of risks and uncertainties surrounding the investment outlook. These can sometimes seem so overwhelming that we put off investment decisions, only to later regret not taking an opportunity.

The year ahead contains its fair share of risks and uncertainties. Many investors are no doubt worried that after four years of fantastic returns the good times must inevitably come to an end.

The best way to overcome our fears is to confront and understand them. We look at the big issues that feature in investor nightmares and ask whether they are worth losing sleep over.

Are markets due for a correction?

Probably the biggest fear for all investors is that they take the plunge just before a speculative bubble bursts.

Those investors who bought the NASDAQ at 5,000 in early 2000 will need plenty of patience before they get their money back.

But history generally supports the adage that it’s the ‘time in the market, not market timing that matters most’. The key, though, is to ensure that your portfolio is diversified enough. Buying the NASDAQ at 5,000 is a huge mistake if it’s your only investment, but it’s much less painful if it comprises a modest allocation from a well-diversified portfolio.

Market corrections that seem dramatic at the time can look far less significant when viewed through the passage of time (NASDAQ 5,000 is the exception rather than the rule).

Someone unlucky enough to have invested in Australian equities in September 1987 saw 40 per cent wiped off their investment over the next month. Even so, over the next 10 years this portfolio increased in value by 155 per cent.

It’s understandable that many investors are starting to get nervous after four years of 20 per cent Australian equity market returns. However, the market has returned a less alarming 12 per cent per annum going back to 2000.

More importantly, the key valuation metrics aren’t near the levels that have triggered sharp market corrections in the past.

For example, the Australian share market rose 82 per cent in the 12 months before the October 1987 crash and the trailing price earnings (PE) ratio rose steeply in the two years beforehand.

The PE ratio for the United States’ equity market rose steeply to 31 times just before the market peak in March 2000.

By contrast, the PE ratios for both countries have trended lower over the past five years as corporate earnings have risen at a faster pace than share indices. At 17.3 times in Australia and 17.9 times in the US, neither ratio looks especially onerous compared to the past 10 years.

Furthermore, Australian equities are presently delivering a dividend yield of 3.5 per cent (not including franking credits). This compares well with the average dividend yield of 3.3 per cent over the past decade. More often than not, a sub 3 per cent dividend yield has signalled negative share market returns over the next 12 months, and the market has rarely entered a sustained downturn when the dividend yield has been above 3 per cent.

None of this is to suggest that equity markets can’t have a setback anytime soon. Global equity markets fell around 10 per cent last May after an inflation scare, but just about all the major markets recovered strongly to finish the year in positive territory.

It would be surprising if markets didn’t experience something similar this year. However, the valuation pre-conditions for a multi-year bear market don’t look to be in place.

Conclusion: don’t lose sleep worrying about a market crash just yet.

What about geopolitics, war in the Middle East, terrorism and other global events?

The future always seems uncertain; it’s only with hindsight that investment decisions look easy and obvious.

One way to deal with the implications of big global events is to ask a few simple questions about how investment fundamentals will be affected.

~ How much allowance for risk is priced into asset markets?

~ What is the impact on the ability of companies to grow their profits?

~ What will be the likely policy responses of central banks and government treasuries?

The answers to these questions can provide a useful guide to whether an event will have a lasting or temporary impact on markets, and which asset classes will be most affected.

These questions, for example, would have helped separate the short-term from the medium term implications of the September 11 terrorist attacks.

Equity market valuations were still relatively elevated (US equities were trading on a 25 times PE ratio), so equity markets didn’t have much allowance for risk priced in.

However, there was no reason to believe that the attack had substantially altered the outlook for corporate profitability and, most importantly, the terrorist attack accelerated the process of global monetary policy easing.

A reasonable conclusion would have been to anticipate supportive liquidity and profit conditions and wait for an attractive valuation point to average into equity markets.

So, how are markets placed in 2007 to handle an adverse global shock?

In response to the first question, major equity market valuations are reasonable, and thus better placed to handle a shock than in, say, 2000. The same can’t be said for all other asset classes. Credit markets, in particular, have little allowance for risk. The spread between corporate bonds and risk-free government bonds is near all-time lows in most markets.

Corporate profit conditions are strong around the world. The impact on profit growth will depend on the nature of the event, but aside from an incident that led to permanently higher energy costs it is hard to envisage an event that could derail aggregate profitability over the medium term.

Most important, however, is that central banks have plenty of firepower to offset market shocks. The Fed didn’t have much scope to move in 2003 and 2004 when the funds rate was just 1 per cent. But with the policy rate now at 5.25 per cent, the Fed could deliver a lot of monetary stimulus to revive confidence and spending if required. Similarly, the RBA’s cash rate of 6.25 per cent gives it the ability to respond aggressively to any negative scenarios.

Equity markets, therefore, look reasonably well placed to handle ‘event-risk’. It will, of course, depend on the nature of the ‘event’, but valuations and central bank war chests should provide a level of comfort for the medium-term investor.

Conclusion: be alert but not alarmed.

Could the US dollar collapse?

Market bears have long worried about the possibility of a US dollar collapse and the consequences for global financial markets.

Their anxiety has escalated in line with the growth in the US current account deficit to almost 7 per cent of gross domestic product. Foreigners are stumping up almost US$900 billion per year (US$3 billion per day) to plug the gap between what the US earns and spends.

Surely, claim the bears, at some stage the rest of the world will stop financing US living standards. When this happens the US dollar will collapse, interest rates will be forced higher, equity markets will plunge and the US economy will contract. The consequences globally need little elaboration.

The bearish view has plenty of logical appeal, but anyone holding it has missed out on some pretty good investment returns over the past four years. To understand why, we need to look at how the US deficit has been financed in recent years and think about why this could continue for some time.

In short, it has been the central banks of China and Japan that have done most of the work, helped more recently by a solid contribution from OPEC.

The crunch time for the US dollar was from mid-2003 to mid-2004. The Fed had cut the official rate to 1 per cent and more easings were widely anticipated (the received wisdom was that the US was entering a Japan-like deflationary spiral), US 10 bonds were yielding just 3.25 per cent, the S&P 500 had fallen 45 per cent from its peak and the NASDAQ was barely above 1,000. It’s safe to say that foreign investors weren’t exactly lining up to finance the deficit.

The heroes in this story came from most unlikely sources — Japan and China. Their two central banks combined to finance almost the entire US current account deficit through a massive increase in foreign reserves. Their actions were guided by pure self-interest: China valued the financial stability provided by the US dollar peg and wasn’t about to give this up; Japan was still battling deflation and couldn’t face further downward price pressure from a rising Yen.

It could be thought of as the world’s largest ever vendor financing scheme; Asia lent money cheaply to the US, financing consumer spending and the current account, and in return the US bought Asia’s exports.

The pace of currency intervention has eased somewhat since mid-2004 as private capital inflows returned. However, the large current account surpluses in Asia, and more recently in the oil exporting countries, have more than offset the US current account deficit and provided a steady source of US dollar demand.

The US dollar has depreciated 17 per cent in trade-weighted terms from its peak in 2002, so a gradual currency adjustment has been underway. The most likely scenario is that the US dollar continues to decline gradually, eventually falling by enough to start reducing the current account deficit. Most importantly, China and Japan still seem unwilling to accept large appreciations against the US dollar and have the ability to again become large dollar buyers of last resort if required.

Conclusion: dollar bears need to hibernate.

No need to buy sleeping pills just yet

We have looked at three of the big issues that form the darkest fears of most investors; that a big market correction is around the corner; that global politics is making investing far too risky; and that those serious sounding warnings of a US dollar collapse might actually prove correct.

We could have added to this list the threat of more RBA tightening, the unwinding of the Yen carry trade and the growth in hedge funds and global financial leverage.

The key point is that 2007 seems no more risky than other years. In fact, equity market valuations and the capacity for central banks to counter any unforseen shocks makes 2007 look rather less risky than some recent years.

Andrew Pease is investment strategist at Russell Investment Group , Sydney.