The Politicisation of Asset Markets

Dear Reader,

Extract from a private letter issued 29.09.10

We aim to achieve 8% compounded annual growth rate in the long term (5 year measure). However, in a year like 2010, where my expectation was that developed equity markets would be flat, we were aiming to achieve 6%. We are slightly over performing, but as usual, the forecast was wrong (I could argue only slightly, at least for the moment!).

YTD performance of major equity market indices (remember, this is NOT net of fees):-

FTSE 100 + 4.89%
Eurostoxx 50 - 4.02%
S&P 500 + 6.15%
Nikkei 225 - 12.74%
Hang Seng China + 2.49%
Brazil Bovespa + 2.52%
NSE Nifty (India) Index + 15.22%

However, if we assume that you had converted EUR to USD on 31st December 2009 to
invest in the S&P 500 on the same day, your performance would actually be very close to 0.0%!

The aim of this perhaps rather long letter is to inform you, the client, of my deepest fears and highest hopes. Unfortunately, there is rather more of the former than the latter. It is a market that makes no real economic sense, but one which is heavily distorted by political forces. We must appreciate what those drivers are and how they can affect risk asset valuations.

IS THE MARKET CHEAP?

No.

Let us use the Shiller cyclically adjusted price/earnings ratio as a reference for valuation. This takes the index value and divides by the average 10 year earnings of the index. It is a means to remove cyclical factors that affect earnings such as variations in profit margins. The average Shiller price/earning ratio is 16.5. The graph below (no graph included) shows that the S&P 500 is currently trading at a 21.17 price/earnings. This is a 25% premium to fair value. Indeed, the graph below shows that market was only trading at fair value for a period of a few months, mainly from end 2008 to mid 2009. In all other periods during the last 15 years
the market has been over valued using this valuation reference. I tend to agree. Our estimation of fair value for the S&P 500 is between 930 – 950, as we have suggested over the last 12 months. It closed on the 28th October 2010 on 1183.78.

One could conclude that if markets are not cheap, then they should not be bought as
aggressively. This would make sense, and indeed, would agree with our 30 - 35%
weighting on equities for clients, However, I have come to believe that the markets may continue to trend in a non rational manner due to political influence.

Is the US market expensive for EUR based investors if the S&P 500 is trading at 1183 in 6 months time, but the USD has meanwhile dropped 20%?

PROTECTIONISM, A LA SOPHISTIACTED

Much fear has been projected by various economic participants including governments,
investors and consumers on the potential damage protectionism could have on the
global economy. Others are more optimistic by the fact that people are talking about it in a negative way rather than cheering it. Hence, they see it as difficult for it to become a reality. Whatever you think, the reality is protectionism is already here as far as I am concerned, but a la sophisticated.

When the asset markets in the US go up as they have, providing the perception that
investors and consumers are richer, whilst your currency becomes weaker, it becomes
more difficult to spend that “perceived wealth” abroad. Hence you are effectively being told to buy American!

What a clever and tacit way of achieving your objective of increasing consumer
confidence in the hope that 70% of the US economy can be steered back to life. However, there is a catch. If every economy plays the same trick it is a total waste of money! This is because it becomes harder to reduce your currency value by “creating money” to dilute its purchasing power, because everyone else is doing it as well!

QUANTITATIVE EASING (QE), WHY DO IT?

As a result, the much discussed QE2 has led the USD to weaken, but risk assets to go up. Why is the latter happening?

When the government buys bonds, they are not buying it from me and you, they are
buying them from large financial institutions. Hence these institutions will have large lumps of cash in their hands. They will not use this cash to buy shoes (i.e. to consume) they will invest it in risk assets. We have seen over the last 18 to 24 months yields on bonds effectively converge to zero as a result, and money being moved into other risk assets with the same consequence, reducing their yield.

Remember, as we have written in past letters, consumer spending is 70% of developed
economies GDP, and, in my opinion, supported by three important pillars:-

1. Wages; with unemployment so high they are unlikely to go up on average

2. Credit expansion; de leveraging is so prominent amongst banks that credit
growth is likely to remain weak for years to come

3. Asset prices; with risk assets relatively expensive considering weak GDP growth
for developed economies and the potential for inflation, this should not to go up
drastically

If you were the FED, which one of these variables is the easiest to manipulate in the hope of increasing consumer spending, the bed rock of developed economies?

They tried to increase credit expansion by capitalising the banks, no luck.

They tried to create jobs by proposing to create new projects, no luck so far.

This leaves us with asset prices. If they could create enough liquidity that would get into asset markets, we could increase their value in USD terms and give the perception that consumers are richer then they really are, hopefully boosting consumer confidence (does this sound familiar? It should do, we have been living off this model since the 90s). However, if the USD weakens, in global purchasing power, you are no richer.

QE therefore has the consequence of weakening the USD and increasing the price of risk assets. And it will have the same affect on any other country that applies the same strategy. However, if everyone done it, no one is getting richer, we are just wasting money, hence reducing its value, hence reducing the purchasing power of a unit of currency.

WHO WINS?

In such an environment, there is one economic participant, I believe, that can gain over others.

These are the participants that use the capital markets to receive money. i.e.
CORPORATES. If Pfizer, Microsoft and Johnson and Johnson’s can issue 10 year bonds and pay 2% for that money, we are effectively transferring wealth from consumers (who need the income, especially retirees) to corporates.

Furthermore, this advantage can be exacerbated if:-

1. They have low leverage to start, hence they can borrow to buy their leveraged
competitors and buy them at attractive prices as they suffer paying large interest
payments from bonds issued with much higher rates

2. They have pricing power, so can partially protect their operating margin if
inflation becomes an issue

3. Have low capital expenditures relative to revenues. If there is inflation, then
capex costs will increase. If you have little capex (i.e. are not a capital intensive
business) then you are less affected by inflation via input costs, but if you have
pricing power, can enjoy increasing your selling price.

4. Stable market share and high and stable returns on capital

The points above mentioned are what I subjectively call HIGH QUALITY COMPANIES.
I strongly believe this classification of companies have the cheapest equity in town, and are the companies that can do best in a difficult economic environment. It is for this reason we have been buying throughout the year these companies.

Below I include a table (no table included) to summarise some of our larger holdings of companies I classify in this category, and whose price is close to the past buying price. If you don’t hold them, I suggest you consider them as an investment solution. I can assure you I hold the vast majority myself.

CONCLUSIONS

I summarise below the asset allocation, on average, for portfolios during 2010:-

START 2010 CURRENTLY DIFFERENCE

CASH 30% 25% -5%
BONDS 30% 25% -5%
EQUITIES 30% 35% +5%
ALTERNATIVES 10% 15% +5%

Throughout the year we have:-

1. Continued using cash to buy the equity of high quality companies

2. Started selling bonds and buying Phoenix notes (we have discussed these
structured products in past letters. If you need further information please let us
know)

3. Bought exposure to emerging market debt via the Templeton Global Bond Fund.
However, we have not continued with this in the second half of the year

Due to my fears of continuous government intervention I would suggest reducing the
cash further. Hence cash should edge closer to 20%, and equities closer to 40%. This could also be supplemented by using cash to buying Phoenix notes. We do not suggest holding more than 15 – 20% of the portfolio in such securities.

We also like the idea of buying commodity exposure via oil and gas and tree growing
companies. However, the vast majority are now too expensive. To the above list we would be happy buyers of EXXON MOBIL at 65 USD or less.

There is no doubt that markets will eventually correct themselves. They are simply
becoming too expensive. However, it becomes harder and harder to ignore the loud
signals Mr. Bernanke is making: TAKE MY PUT OPTION. We slowly heed his statement but
refuse to have more than 40% equity exposure at current market pricing.

May I end with a point on many investors minds: currencies. My own personal portfolio
has a Q3 performance of approx. -5.0%. Stock picking contributed +2.5%, but currency
losses where -7.5% on a marked to market basis during that period. Currencies do matter!

As you may have guessed, 60% of this account is denominated in USD, which has been
destroyed during the Jul – Sep period. However, if I was to make one bet today as a
prediction for 2011, it would be that the EURO would weaken relative to the USD, edging closer to the 1.20 rate from its current 1.40 level. Though quantitative easing in the US will not disappear, I honestly do not believe that this is the main point, because everyone is doing it, or will do it, directly or indirectly.

What is important is to have a certain degree of currency diversification. We have
suggested to pure EURO investors that they should consider holding at least 20 - 25% in USD. The same would be true of other pure currency portfolios. Personally, I have an equal split amongst Euros and USD, as well as a range of other currencies such as CAD,HKD and GBP.

Furthermore, many of the high quality companies we have mentioned above are also
generating profits outside of their home country. As a result, they also offer a partial currency hedge. It is also worth noting that if a countries currency weakens, the exporters of that country enjoy a competitive advantage over a similar manufacturer whose home currency is increasing. It is for this reason that Siemens, Europe’s largest exporter, has a stock price that enjoys appreciation as the EURO weakens.

We thank you for your continued support in us, and look forward to discuss the above
mentioned ideas, or others you may have.


Yours sincerely,

Alessandro Sajwani