A bumpy road ahead

Five years after the GFC and the economic future is still very uncertain. Investors with a balanced portfolio will be best placed to handle the financial speed bumps.

PORTFOLIO POINT: Following the trade trend and switching between cash and exchange-traded funds will help get over the inevitable financial speed bumps just ahead.

On November 1, 2012, it will be five years since the Australian All Ords share index (blue line in chart 1) reached its record high. At this stage our market is about 40% below that peak. By contrast America’s S&P 500 share index (red line) is just 13% off its record high of October 9, 2007.

Notice how Australia was not exposed to the technology tumble of late 2000, but felt the full brunt of the bank bust of late 2007. Australia’s low exposure to technology stocks served it well, but its large exposure to bank stocks did not, even though local banks weathered the GFC better than their peers overseas.

Of course, when Lehman Bros collapsed in 2008 our market was not to know how we would cope, so it panicked like all others. The subsequent share rally in 2009 was aborted by our strong dollar and more recently by falling commodity prices.

America benefited from a falling currency and loose monetary and fiscal policy, injecting liquidity that fuelled stock speculation.

The big issue now is whether fiscal and monetary stimulus fatigue will see the world lapse into another recession or whether governments and central banks will aggressively monetise debt in the belief that it’s less painful than allowing defaults.

The big difference with the 1930s is not the relative size of global debt (which this time is much higher relative to GDP), but the greater knowledge we have for dealing with it. In the Great Depression, national politicians and central bankers thought the answer was austerity. The Germans still believe that, notwithstanding that Adolf Hitler in the 30s staved off unemployment by building autobahns and Volkswagens and staging the first Olympic Games spectacle by printing money.

The governor of the US Federal Reserve Bank, Ben Bernanke, got the nickname Helicopter Ben because his doctoral thesis on the Great Depression concluded the best antidote was to shower the public with cash as Kevin Rudd did in late 2008 on the advice of Ken Henry, then Secretary of the Treasury. As one can see from the above stock chart, this cash splash plus extra infrastructure spending jump-started the Australian sharemarket in 2009, but its effects then wore off. By contrast, Bernanke introduced Quantitative Easing (a fancy name for printing money) whenever the US sharemarket stumbled, thereby keeping it on an upward trajectory.

What happens next is anyone’s guess. The St Louis Financial Stress Index tells us anxiety fell sharply in 2009, but since then has ranged at levels that are still abnormal by pre-GFC standards.

The run-up to America’s Presidential election should see US fiscal and monetary conditions stay loose. Also the commitment to austerity in Europe is waning as voters turn against Treasurers who sound like Uncle Scrooge and the European Central Bank (now guided by a spendthrift Italian rather than a frugal German) increasingly looks like Santa Claus.

But the US fiscal cliff in January 2013 (when public finances automatically tighten by a lot more than under President Herbert Hoover from 1929-33) and the vow by Mitt Romney to dismiss Helicopter Ben (a registered Republican, but hated by the Tea Party) risks creating conditions akin to those that precipitated the Great Depression. Meanwhile there is a risk that markets stop believing there is any solution to Europe and that China’s slowdown proves more severe than expected.

On the other hand western governments and central banks might decide that limping along like Japan is not politically tenable, and that drastic action is needed to break the impasse. Such a view could see them boost public spending with gay abandon knowing that their central banks will buy as many treasury notes and bonds as they wish to issue.

Would that be hyperinflationary? Not at first, since the world has excess productive capacity. Of course, eventually the genie would have to be put back in the bottle before things got out of hand. That could prove difficult. But politicians worry about the here and now, rather than what might happen down the track.

Our guess is that muddling through has a limited shelf life because baby-boomers (who are still the majority of voters) so indulged during the post-war credit fuelled boom that they won’t react stoically like the Japanese. As frustration grows with the muddle-through approach to the world’s debt crisis, the calls for decisive action could become shrill.

That would see parties of the right promise abstinence (extinguishing debt through massive defaults by allowing a slump to “clean out the system”) and parties of the left offer compassion (fuelling a money explosion that made it “easier to repay debt” by reducing its true worth). In the first scenario cash would be king followed by term deposits in safe banks and fixed-rate bonds with institutions that survived. In the second outcome, tangible assets such as precious metals, commodities, shares and property would be the best bet.

The main reason we market time is to position ourselves for either booms or busts and even muddle throughs. Even a crude trend-trading system (such as a 300-day moving average trend-line of the All Ords index as shown below) should keep one in cash (the most defensive asset) if we have another market meltdown and in shares (the most aggressive common asset) if we have a money explosion. And if we replicate Japan it will make sure we catch the upturns and avoid the downturns.

Of course, no ride is very smooth. Bumps in the road create whipsaws. But these are preferable to free falls that can extinguish wealth and cause acute anxiety. Also having a proven timing system means having the confidence to get back into the market after a crash when everyone else is too shell-shocked to notice bargains.

Those investors who have concluded that it’s safest being completely in cash and fixed interest could see their savings erode dramatically if politicians put their feet down on the money accelerator. Those who think permanently holding shares, property and gold will stand them in good stead could see their net worth plummet if politicians allow deflation to set in.

So having a balanced portfolio of defensive and growth assets is the best insurance against being on the wrong side of history. And switching between cash and share ETFs using a reliable trend-trading approach is the best strategy for positioning oneself to exploit whatever the future holds.

Percy Allan is Chairman of Market Timing Pty Ltd. For a three week free trial of its services go to www.markettiming.com.au