Notes and Quotes 6 June 2010

MAY TURNED OUT to be one of the worst months on record for world equity markets, reports Andrew Lapthorne, the head number-cruncher and quant in Soc Gen Asset Management’s award-winning strategy team. The MSCI World Index dropped almost 10% in dollar terms, making it the worst May for this index since it began in 1970, and the worst monthly performance since February 2009, which turned out to be the final death throes of the great credit crisis bear market, the darkest hour before the dawn.

The worst country casualties, unsurprisingly, included the Eurozone countries whose debt problems have been so much in the headlines; Greece down 19%, Ireland 13% and Spain 11% in local currency terms. It turns out however that the falls in Asia were much greater: China’s Shanghai B market was down 16% and the Nikkei 225 down over 11%. The best performing markets year to date, as at the start of the month, more surprisingly, are mid and small cap stocks. Both the Russell 2000 and the FTSE 250 are still ahead year to date.

What is easily overlooked, of course, as with any short term data set, is that the recent falls in equity markets followed an exceptionally long and sustained period of market gains from February to April, with the S&P 500 rising for something like ten consecutive weeks, a most unusual trend. To use the jargon of the technical analysts, markets had become highly oversold. To that extent May’s falls were no more than a necessary and overdue correction.

However it seems clear that, just as Anthony Bolton predicted six months ago, equities are likely to be pushing against headwinds for some weeks yet. News will continue to be dominated by crises of one sort or another. The earnings upgrades that have helped to drive the markets higher are petering out. Valuations appear to have priced in a lot of future recovery already, with the MSCI World index trading on a 2010 p/e of 13 and a 2010 dividend yield of 2.7%.

Nevertheless the scale and strength economic recovery around the world continues to impress seasoned market-watchers. Few fund managers have navigated the crisis of the last three years better than Jonathan Ruffer and his team at Ruffer Investment Management.  To quote a recent note of theirs: “One of the by-products of the tumultuous events and the private sector bail-outs of the last two years has been a massive transfer of risk from the private to the public sectors”.

“In part it is precisely this factor which has enabled equity markets over the past year to display a raffish insouciance in the face of so many outstanding problems and risks; with risk being largely socialized and a negligible cost of money, the measures that the corporate sector has taken in terms of inventory liquidation, labour shedding and capital spending cuts means that its present rude financial health stands in stark contrast to the groaning public sector deficits on view across the globe”.

They go on: “While we never try to time markets, it does not seem outlandish to say that the next few months will see risk assets move into the departure lounge from the ‘sweet spot’. Improving economic conditions, which we fully expect, will bring into sharper relief the need for ‘exit strategies’, with a likely reduction in liquidity available for investment in financial assets”.

“Further sovereign bond crises, accompanied by default risk, may erode the valuation basis for equities. Meanwhile, even if the UK is an acute case, inflation is regularly outpacing forecasts and will prove indeed to be part of the solution. After the relative ease of the last twelve months, protecting capital and generating real returns is about to start getting more difficult again”. We shall see.

A LOT OF HEADLINES have been generated by the European School of Management’s report into hedge funds.  The main findings are that hedge fund investors chase recent past performance and merrily buy into investment styles that have been working well recently regardless of the huge differentials in risk that different styles entail.

The researcher, assistant professor Guillermo Baquero, concludes: “These results raise serious concerns about investors’ ability to make the right allocation choices and suggest that increasing investor protection and curbing unnecessary risks and speculative activity of hedge funds should be a priority for regulators”.

I am not so interested in the regulatory issues. It has always been my view that hedge funds are not appropriate for retail investors, and should remain what they once were, namely largely unregulated vehicles for professionals and consenting wealthy adults. There is plenty of evidence to suggest that a small minority of hedge funds, if you are lucky enough to find the ones with real talent, are proven and consistent wealth-generators. I certainly could name a few that fall into camp.

The majority, however, charge too much for what they in practice deliver, and their risk profile is skewed far too heavily in favour of the managers to make them prudent investments for most investors. Illiquidity too can be a problem, as became all too evident during the credit crisis. It is no real surprise that there has been a lot of pushback on the level of fees since the crisis. To blame them for causing the crisis is quite wrong however.

What these new research findings do show clearly, as many of us have long suspected, is that hedge fund investors are really no different from investors in general. They may be richer, and more sophisticated in other ways, but at heart they make just the same old mistakes – too greedy for results, too short term, too hyper-active, too blind to risk.

A SURVEY by the Association of Investment Companies names the top 20 investment trusts of the last decade, as measured (a) by their absolute returns and (b) by the consistency of their performance. Top of the list on both scores, gratifyingly, comes a trust that I own, Blackrock World Mining, which has returned an impressive 811% over the past decade and outperformed the average investment trust in eight of those ten years.

It is followed in the rankings by Fidelity European Values (once run by Anthony Bolton, but for most of the period in question by his successor Tim McCarron) and HgCapital, the private equity fund that spun out of Mercury Asset Management some years ago. (This is another fund which I happen to own, having bought some shares last year). The table of supporting data is worth looking at, although purists would argue that it suffers from taking no account of risk, gearing or volatility. A table of risk-adjusted returns would show some significant differences, as indeed would a table constructed on the same basis 12 months ago.

As a long term investor in investment trusts, the main message that I take from the survey is that identifying the big long term themes in the investment world and letting them run their course through a shrewdly managed, low cost vehicle is a much easier way to make money than furiously trying to pick winners over shorter periods of time.  Blackrock World Mining is a play on the commodity cycle. A good number of the other trusts on the list are essentially beneficiaries of emerging markets in one form or another, which has been the other big story of the past decade.  In a decade when the equity markets have produced little return overall, it is also noticeable how well some smaller company funds have continued to do.

AT A ROUND TABLE discussion I chaired for Spectator Business magazine last week, to be published shortly, a key theme on which all the participants agreed was the need for the new coalition government not to make a mess of the recovery by bungling the proposed Capital Gains Tax changes. As it happens, there is a powerful blast on the subject in this week’s Spectator from Art Laffer, inventor of the notorious Laffer curve. Economists may not be able to agree whether or not the Laffer curve is valid, but the general conclusion – that there is a point at which the marginal revenue from tax increases declines – is unanswerable.  The way that the Government crafts its CGT proposals is clearly going to be a critical test of how far Messers Cameron and Osborne are hampered by the need to make concessions on tax to its own coalition partners.

THE THOUGHTS of Canadian investment strategist and long termcommodity bull Don Coxe on the markets (from a recent conference call with clients): “No new bear market — we are going to have a correction here, but the global economy is still growing, but not as fast as the optimists would have hoped, and I don’t believe we can have a true bear market as long as liquidity is being supplied by the central banks at virtually zero cost. So much of that liquidity was misallocated before, but gradually as the economy grows it will be able to absorb it in actually productive activity”. That still seems right to me. I also liked this quote by the US founding father Thomas Jefferson, dug out by Marc Faber for his most recent monthly market commentary: “I predict future happiness for Americans if they can prevent the government from wasting the labours of the people under the pretext of taking care of them”.