Investment Review

Further to the article above, an extract from a newsletter by Cleary Wealth Management may help you in your assessment of the current market:

Market Summary

The second quarter of 2009 was, in a word, confusing. The global economic crisis is still very much part of the world we live in, but try telling that to the markets. During February and the early part of March, the markets were in freefall as the world was over the euphoria of the election of Barack Obama (that was so last year) and was now seen as going to hell in a hand basket. The selling was relentless as every single financial security except US Government bonds was sold aggressively. The US market bottomed on March 9 with the S&P 500 intraday low hitting the ominous number for conspiracists of 666. This represented a drop of 56% from the market peak in October 2008, a fall of a similar magnitude to the Great Depression.

Then, for some reason the markets, started heading up. Was it the ‘green shoots’ recovery (a phrase I personally am utterly sick of), the second derivative turning positive (things are getting worse, but more slowly), that investors had run out of assets to sell or that if prices get cheap enough, investors will eventually start buying.

Regardless of the reason, the market then went on a very sharp rally which was the story of the second quarter. In the first quarter the S&P 500 was down 11.7% while in the second quarter it rose from 797.87 to 919.32, a jump of 15.3%. This meant that from the very depths of despair in early March, investors are now actually ahead year to date.

The second quarter performance was the best since 1982. The Dow and other developed global markets followed the same tune, hitting their depths in early to mid March before rebounding strongly and hitting highs in mid June. However, it is fair to say that the rally has since stalled and trading volumes have been quite weak reflecting less certainty about investment prospects.

Risk appetite is certainly slowly returning to the markets as fears of global financial meltdown recede. However that seems to be not sufficient reason for markets to become wildly bullish again. As we have seen over the last couple of weeks since the quarter end, negative economic news (like the poor US job report on July 3) can have a large impact on markets (the Dow was off over 2% for the day).

Elsewhere, Asia was the most impressive of global markets partially reflecting the relative soundness of their financial systems and the robustness of the local economies. All major markets in Asia have recovered strongly in the second quarter. China and India also reaffirmed their estimates for (relatively) strong economic growth which helps neighbouring countries who are increasingly reliant on supplying goods and services to these economic powerhouses. Interestingly enough for the technically minded but Asian markets didn’t breach the November lows in March unlike Western markets. The Hang Seng for example bottomed in March at 11,344 versus a November low of 11,015.

Similarly commodities have staged an impressive rally with Oil jumping from a low of $47 per barrel to trade in the mid $70s recently while the price of copper, coal and zinc similarly surged. The Baltic Dry Shipping Index measuring shipping costs (and acting as a proxy for world trade), has staged a strong recovery after dropping by 90% in 2008. This indicates that economic activity is happening and that companies are rebuilding inventories that were depleted during the void of economic activity that occurred in Oct / Nov 2008. This was a common theme in presentations that we attended this year; fund managers noted in their company visits that managers reported widespread cancellations of orders in October and November 2008. The best anecdote we heard all quarter was from Kerr Neilson of Platinum. He reported visiting a truck builder in Europe who customarily builds thousands of trucks every quarter. In Q4 2008, they sold a total of 28! That level of demand was never going to continue for long.

Our view is that what we have effectively seen is the market recognising that we are NOT going to suffer a depression and are simply repricing financial assets accordingly. The gains seen in April, May and first part of June are thus a readjustment in expectations rather than the start of a new bull market. Fear has ebbed somewhat from the markets amidst diminished expectations of a dismal future. This combined with the need to generate a higher return than the near zero rates on offer for cash deposits has seen money flowing into other sectors of the market driving gains in those markets.

Furthermore the surge downwards in bond yields has seen what Buffett has described as the Great Treasury Bond bubble of 2008. This has destroyed any future investment returns emanating from this asset class – ‘return free risk’ is particularly apt description of the bond market currently. With Governments globally expected to require issue something in the region of $5 trillion of bonds in the near future, there is no reason whatsoever to own this asset class.

From here, our opinion is that there is going to need to be some catalyst to see markets driven higher in the form of stronger economic growth or stronger corporate profits (or both). The prospects for both are not that compelling. Economic growth – historically, economies take much longer to recover from financial crises than from normal economic recessions. While the threat of a repeat of the Great Depression has passed, the global economy is still very weak. Unemployment will continue to rise, access to credit will remain strict, and consumer spending will be weak (see Paradox of Thrift discussion below).

House prices in particular probably have further to fall. Government stimulus can only do so much and governments ability to stimulate is becoming constrained by budget deficits and funding costs. Few economies will see growth in 2009 and the growth outlook for 2010 is only tepid. A lot will depend on China and while their stimulus has been extraordinarily successful so far, it remains to be seen whether their domestic market can continue to grow to replace the demand lost from weak consumer markets in US and Europe.

Strong corporate profits – generally corporate profits are under pressure from falling demand, weak pricing power, excess capacity and rising commodity prices. Also, in aggregate, the major contributor to corporate profits over the last ten years has been the banking sector. Increased regulation and higher capital requirements will constrain the earnings power of this sector in the future, thus significantly lowering the profits of the market in total. The bright spot for corporate profits is that corporate analysts are probably the most highly paid idiots in the world. Wall Street’s finest have a long and distinguished track record of over-estimating profits in a bull market and significantly under-estimating profits in a downturn.

It is a perfect example of behavioural finance in action. Analysts extrapolate past profits to infinity during upswings, and project them down to zero in a downturn. Already in July we are seeing a majority of US companies beat diminished expectations for the 2nd quarter and this has led to gains in July to date.

The New Zealand story is more of the same but less so if that makes sense. Our economy recorded a -1.0% GDP for the first quarter reflecting the fifth straight quarterly decline. Yet the stock market has bounced off its lows in March to trade a little higher. Furthermore the NZ$ has staged a spirited rally touching highs of US$0.66c recently. This has been attributed to all manner of causes including increasing risk appetite, the return of the carry trade, the soundness of our banking system amongst others.

Fundamentally, our currency should trade lower but currencies are all relative and right now currencies don’t trade on fundamentals. As Brian Gaynor recently pointed out in a fascinating NZ Herald article (July 4th, NZ Herald), the NZ$ is a plaything for global traders. Despite our miniscule size, the NZ$ is the 11th most traded currency in the world with more volume than the Chinese Renminbi! The total daily transaction value is around US$59 billion dollars. This figure is roughly the same as the YEARLY volume of trade related foreign exchange transactions. Therefore the currency is not driven by how much we buy and sell each year, but whether foreign traders think it will likely go up or down in the future. To say this is unhealthy for such a small open trading nation at the bottom of the world is an understatement.

Our neighbours to the west continue to be our superior in just about everything except the production decent front row forwards. The economy has been reasonably well performed and may be the best performer in the OECD in 2009. Consumer spending resumed its strong growth responding to Government fiscal stimulus and the currency has also been strong. However the bright headlines mask some rather disturbing trends, particularly their relationship with China on which their economy is so reliant. Australia has been engaged in a bitter dispute with China over the pricing of iron ore sold to feed China’s ravenous steel mills. This has culminated in the detention on charges of bribery by one of Rio Tinto’s top executives. Whether this has any connection with the rejection by Rio Tinto of Chinese owned Chinalco’s attempt to take a large stake in the company is difficult to determine but they are hardly a promising foretelling of relations between the two countries.

Taking a global view on economic prospects for the next year or two, the major impediment to global economic recovery is what is known as the “Paradox of Thrift”. This Keynesian idea simply states that if everyone tries to save more, total savings will actually fall. One persons spending is another person’s income. If everyone tries to save, aggregate demand will fall, and the level of economic activity will fall. We are looking at the fallout from one of the biggest expansions of credit in the history of recorded commerce. Thus most every economic entity, individual, family, or company are trying to prudently deleverage their own personal balance sheets by paying down debts. Governments are the spenders of last resort and are correctly running massive fiscal deficits. But there are limits to what a Government can do to sustain aggregate demand. Firstly there is a budgetary limit, and secondly the ability to stimulate an economy suffers from decreasing marginal utility. Japan poured a lot of concrete in the 1990s but was unable to lift its economic performance. We are skeptical that the world will be any different this time.

Grant Cleary                                    Neville Giles
Principal                                          Associate
Cleary Wealth Management               Cleary Wealth Management

If you want the full Cleary Wealth Management Newsletter, just email me and I will forward it to you. And yes, Neville is my son!