Tunnels and Light Part 1
Letter from Linlithgow - February 2009
"I'd like to share some reasons to be cheerful"
We know there's bad news out there. But any good news is buried. Currently all focus is on politics especially the US. You probably know about the massive Federal Government Stimulus Bill being pushed hard by Obama. You may know less about the Bank Bailout Plan continually postponed. And that's the more important bit.
Now we're all aware of the greed of bankers and hedge fund managers that led in part to the sub-prime disaster, but it couldn't have happened without the incompetence of Governments, Regulators and Central Bankers. They got us into this mess and by now they should have worked out how to get us out of it.
Thanks to the collapse of Enron and Worldcom, Governments listened to financial- model boffins who argued for a return to fair value accounting, or as it is better known, mark to market. This was re-introduced in November 2007, as sub-prime difficulties were beginning to come to light, and before we began to suffer from a lack of liquidity in money markets.
The return to mark to market accounting, for anyone with eyes to see, has created a disaster in the World's financial system. History has something to tell us. According to economist Milton Friedman, mark to market accounting in the Great Depression caused the failure of many banks. Little known by economic historians is that in 1938 President Roosevelt finally realised the mistake and suspended it. And from 1939 to 2007 the US had a relatively subdued business cycle, experiencing no panics or depressions, even in the '80s and '90s when more than 3,000 Banks and Savings and Loans Institutions failed.
There are signs Governments are beginning to realise their mistakes so we can keep our fingers crossed. In the meantime I would like to share with you some reasons to be cheerful. Let's start off with experts on telly. They're the same experts who last Summer were still telling us Property was the best investment for retirement savings. They're the same ones who said the Dollar was about to plummet against Sterling, and who predicted gold would double in price from January 2008.
And they're the same experts who predicted oil would hit $200 a barrel and we'd have increased inflation from continuing price rises of hard and soft commodities. Every prediction made was wide of the mark. History tells us when experts and headlines are fully aligned it's time for a sharp exit. It's what they don't tell us that matters. Such as?
Let's start with the Baltic Dry Index. It's a measure of bulk freight rates. The Index plummeted last year as trade fell off a cliff. The good news is, since the beginning of January, the Index is up 226%. Somebody's beginning to move heavy materials around. It looks like the Chinese. The Shanghai Index, correlated to the Baltic Indices, is up sharply since late last year. (Robert Peston of BBC fame referred to the above Index as it was falling but strangely enough hasn't mentioned it since.)
Long term successful investors buy when markets are oversold and sell when they are overbought. They prefer what is called fair value. Right now statistics here and in the US show stockmarkets to be at least 42% too cheap, and even cheaper elsewhere, including Emerging Markets. Also, corporate insiders who don't make many mistakes, are currently net buyers of their shares.
Private investor sentiment is rarely wrong. Or should we say rarely right. And you can measure this mathematically. US analysts Ned Davis Research show in the US, when private investors are at extremes of optimism or pessimism, it's a perfect contrarian indicator. So when private investors are overly pessimistic, it's a good time to buy, and vice versa. They're as pessimistic now as they've been at previous market bottoms.
Any economic comparison between now, and what was experienced in the early '30s, is wide of the mark. Right now monetary policy is loose, interest rates have been slammed down to almost zero, and job losses and mortgage foreclosures are far, far less than they were in the Great Depression. The differences couldn't be more extreme.
Always check the numbers. Experts report that unemployment in the US showed the worst job losses since December 1974 at around 600,000. What they forgot to tell us is the US labour force today is 65% higher. We're also told advertising revenues are falling - a bad sign. That's odd. According to on-line advertising revenues in the US last year, they're up 8%, with particularly strong performance in the last quarter.
As an interesting way of looking at increasing demand, Graham French of M&G tells us since Lehman Brothers collapsed in mid September last year, 56 million children (almost the population of Britain) have been added to the World's population. A further 80 million will be added by this September.
Levels of cash on the sidelines are excellent indicators. A US survey shows in December experienced investors had 42% in deposit, a record level since records began in the 1980s. The last two times when deposits were almost as high, 38% in 1991 and 38% in 2002, were the previous two best occasions to have bought equities since late 1987. And when we're on the point of timing the previous best time to have bought shares was December 1974.
Finally, studying US stockmarkets after Presidential Inauguration Days going back all the way to 1900, is encouraging. The average gain following an incoming Democrat President replacing an outgoing Republican is 13% - 126 days later. Also typically the first month after inauguration shows stockmarket weakness.
I appreciate we're sounding like a broken record but if Governments and academics get their finger out there should be a sudden change in sentiment, and oversold shares will head back to fair value and beyond more quickly than you think.
Alan Steel Asset Management Ltd